Over the past three months, Canadian Oil Sands (COSWF.PK) has declined from the low 30s to the low 20s despite posting higher earnings and raising the dividend by 50%. Is the current price justified based on lower future earnings due to a continued subdued oil price, or has the selling now been overdone?
Canadian Oil Sands owns a 36.74% interest in Syncrude Canada, which produces light synthetic crude from the Athabasca Oil Sands in Northern Alberta. Its output is unhedged, making the stock price highly correlated to the price of oil. YTD COS’s share of production has been ~112,000 barrels per day which currently sells at a premium of approximately $12 per barrel over WTI. However, going forward its product could become more correlated with Brent, which currently sells for ~$25 premium to WTI, depending on the ultimate approval of two additional pipelines out of the Oil Sands (more on that later).
I like to approach the investment process via a two tiered approach; first, identifying promising growth industries, and second, finding companies that are selling below their fair market value within said industry. In this article I will focus on the oil industry and Canadian Oil Sands.
Warren Buffett has stated that the biggest mistake he ever made was his initial purchase of Berkshire Hathaway (BRK.A), a textile mill in the Northeast. He bought it at a time textile manufacturing was moving to cheaper locales in the emerging world; as we all know this enterprise went bust after several years of Buffett unsuccessfully trying to stem the bloodletting (although he has maintained the name for his operating company to this day). Of course Buffett bounced back and ended up doing okay in the end, but for the rest of us mere mortals it would be better to not be long an industry undergoing a rapid decline.
Energy is a growth industry due to increasing populations and especially the rising living standard in the developing world. Although alternative energies are making headways (20GW of solar power will be added in 2011), they still only make up a fraction of global energy use. Nuclear has suffered yet another setback after the tsunami hit Japan, making it unlikely that it will be increasing its 7% share of world primary energy supply any time soon. Coal and hydro are expected to maintain their share of energy use at ~30% and 7% respectively. Natural gas is likely to continue to increase its share from ~25% today. Although oil’s overall share of the world’s primary energy use will decline from ~34% today, on an absolute basis it will continue to increase. [Source: BP’s Statistical Review of World Energy]
At some point global oil production will peak as easily accessible resources are consumed and its price becomes less competitive at the margins. Oil and gas majors are already scrambling to secure energy reserves in less hospitable geographies: read deep sea and all its associated problems, the arctic and “cooperating” with unfriendly or unstable governments. However, this need not adversely affect a company operating in the O&G industry that has access to reserves and in actuality this rise in price will be constructive for the stock price. Since I am bullish on oil mid-to-long term I prefer companies that operate in friendly jurisdictions where the risks are more or less known. One such place comes to mind – the Athabasca Oil Sands in Canada with the world’s second largest proven oil reserves.
Now that we’ve identified an industry that we believe has growth potential, how do we determine what company to invest in? Although there are hundreds of different metrics to measure a stock’s intrinsic value, I concentrate on the following four:
- Price to Earnings (PE)
- Return on Invested Capital (ROIC)
- Free Cash Flow Yield
- Willingness to pay a dividend
Today COS trades at 7.5X its trailing earnings (PE=7.5) and less than 7.5X when looking at its predicted forward earnings; this is considerably below the market average. Its ROIC is approximately 16%, which is more than double its weighted average cost of capital (WACC). There are several different methods available to calculate ROIC. I use the Motley Fool's definition of ROIC in this example, which takes after-tax operating income divided by invested capital. The company has a 14% free cash flow yield which should be sufficient to continue with planned investments in the business and pay a healthy dividend. Company management has a history of paying a varying dividend based on earnings and in the second quarter it increased the quarterly dividend from $0.20 to $0.30 per share. Some companies generate plenty of free-cash flow, but refuse to pay a dividend. Instead, they build up cash buffers on their balance sheet – several tech companies come to mind. Therefore, I like to see a history of management returning money to its investors, not just the ability to at some unidentified future date.
As mentioned, today COS’ product is priced at approximately a $12 premium to WTI, which trades at around a $25 discount to Brent. This is due to a myriad of reasons mainly surrounding the intricacies of Cushing Oklahoma and the fact that more pipes go into the region than come out, making it less tied to global demand than Brent (as an aside it would be great if someone could explain how this came to be).
Two proposed pipelines are in the works to break the bottleneck at Cushing and get Canadian crude to a place it can be refined. First, TransCanada (TRP) has just gained regulatory approval for its 2,700 km Keystone XL pipeline that would transport up to 700,000 b/d to the Gulf Coast in Texas. It is scheduled for early 2013, depending on it successfully running the gauntlet of remaining environmental and regulatory concerns. The other proposed pipeline is Enbridge’s (ENB) Northern Gateway project which would transport 525,000 b/d (with a potential additional 325,000 b/d expansion) to northern B.C. where it could be shipped to the energy-hungry Asian markets. This proposal has a hearing scheduled with Canada’s National Energy Board in 2012, but already faces environmental opposition from first nations' groups. Today, only a small pipeline with a capacity of ~100,000 b/d exists to transport crude to the B.C. coast, although Kinder Morgan (KMI), the owner of the pipeline, is also hoping to increase its capacity.
Considering the potential jobs that the Keystone pipeline would create and America’s desire to reduce its dependence on energy imports from unfriendly states, this one seems a no-brainer. The Northern Gateway project will likely also go through as Canada wishes to expand its crude export market beyond the US, almost as much as the US wishes to expand the relationship. In the past when this much money has been at stake, deals tend to get worked out between the pipeline companies and landowners. With these pipelines in place, a narrowing of the $25 differential between WTI and Brent should occur, which will be a huge boost for COS. According to COS’s quarterly report, its sensitivity to a $1/bbl increase is equivalent to $0.06 in operating cash per share.
- The main risk to an investment in COS is the price of oil as this is its only product and it does not hedge. Considering that most OPEC countries and Russia require a minimum oil price of $80/bbl to maintain their promises to their populations and considerably more going forward, this does provide somewhat of a mid-to-long term floor on the price of oil.
- Environmental issues surrounding the pipelines or oil extraction itself. The oil sands do produce more carbon than conventional oil extraction and at some point this will increase operating costs or potentially even reduce demand.
- Specific company risks include the inability to control costs (Syncrude is currently undergoing large capital expenditures to move several mining trains) or increase production, both of which will adversely affect future earnings.
Returning to the question posed at the start of this article, no, I do not believe that the current price is justified over the mid-to-long term. I would look to initiate or add to positions at current prices (under $20). If the global economy does fall back into a recession, oil prices can drop further and you may be able to pick up COS closer to $15, however, I view this as a long term investment and believe that five years from now a $20/share price will look pretty good. In addition you are paid a 5% dividend to wait (subject to change of course).
For reference and further research, the other companies that have a stake in Syncrude in descended order of ownership: Imperial Oil (IMO), Suncor (SU), Sinopec (SHI), Nexen Oil (NXY), Mocal Energy, Murphy Oil (MUR).
Disclosure: I am long Canadian Oil Sands and adding to my position at prices below $20.