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Summary and Recommendation
Buy-recommended Canadian Oil Sands Limited (OTCQX:COSWF) offers unlevered appreciation potential of 84% to a McDep Ratio of 1.0, where stock price would equal Net Present Value (NPV) of $52 a share. On December 28, we raised NPV from $38 a share on the basis of expecting a higher long-term oil price of $100 a barrel, up from $75.
After the market close on January 27, management raised its guidance for 2011 cash flow as it reported results for 2010. Declaring a quarterly dividend of C$0.20 a share as it had indicated earlier, management completed a transition from a high income paying trust to a lower, but surer payout policy pursued by strong financial corporations. Management estimates that cash flow of C$2.72 a share, up from C$2.59, would match the total of annual dividends and capital expenditures for 2011.
At recent futures prices we estimate that the dividend could be increased to C$0.50 a quarter in the second half of the year, also after covering capital expenditures. We expect management to apply the potential increase to a financial reserve and continue the dividend at C$0.20 a quarter until 2012. The main appeal in COSWF is its concentration on long-life oil production that is becoming increasingly valuable as a consequence of political environmentalism among other driving forces.
Current Markets Undervalue Long Life
A discounted cash flow calculation illustrates how value can be hidden in a long-life asset like COSWF (see table Present Value of Future Cash Flow on page 5). Projected cash flow at a constant price of oil before allowance for inflation is discounted at the rate of 7% a year, also before allowance for inflation. The return before inflation is higher than practically any corporation achieves on a long-term basis. The future is discounted even more heavily by investors as it would take a 14% a year discount rate to have NPV equal current stock price. The fortuitous outcome for long-term investors in quality assets is that the return is competitive in the early years and then after shorter life assets have expired, the future for the long life asset remains just as bright as ever. In other words, the widely applied discounted cash flow rationale undervalues long-term assets in a way that helps explain why long-term investors can profit by the pricing inefficiencies in a market dominated by traders with short-term time horizons.
Political Environmentalism Drives up Price
What started out as a movement that raised our sensitivity to the more subtle negative environmental consequences of economic activity seems, in many ways, to have degenerated into a political movement with an anti-business and especially anti-oil bias. Though the hypocrisy of the movement offends us, we are profiting from its consequences for oil price and the value of real assets. Oil sands have attracted disproportionate attention that we have commented on in the past. Fortunately, an independent author has analyzed the politics in great detail. The book is Ethical Oil: The Case for Canada’s Oil Sands by Ezra Levant. It is available in traditional hard copy or as an online download from Amazon among others.
Political environmentalism is embodied at the highest level in the President of the United States. Last year’s exaggerated hysteria over the BP oil spill has resulted in the near elimination of the Gulf of Mexico as a source of additional oil supply. The president would compound the pressure to increase global oil price by raising taxes on oil beyond already high levels. Mr. Obama increasingly looks like his predecessor Mr. Carter, whose oil taxes and international stance contributed to a tripling of oil price in the last two years of his administration on top of the quadrupling that had already occurred in the decade. We don’t need such increases as we think Canadian Oil Sands Limited is an attractive long-term investment at current or an even lower oil price.
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Originally published on January 28, 2011.