Since 1990, annual oil discoveries have equaled only half the annual production. It is getting more and more difficult to find conventional oil. Consumption will not decrease in the coming years. Emerging economies like China and India will significantly increase their oil consumption. An additional 10 million cars on the road in China equals a demand increase of a million barrels a day. China alone sells more cars than that in a year to first time buyers.
Unconventional oil will become more and more important. A big part of this will come from bituminous sands, also known as oil sands or tar sands. Oil sands are found in large amounts in many countries throughout the world, and in extremely large quantities in Canada and Venezuela. Most of the oil sands of Canada are located in three major deposits in northern Alberta. They cover an area larger than England and hold reserves of 1.75 trillion barrels of bitumen. About 10% or 173 billion barrels is estimated to be recoverable at current prices, using current technology.
My favorite Canadian oil sand investment is Suncor (NYSE:SU). Suncor is a pioneer in the oil sands development. It is active in the extraction and production of oil sands since 1967. In 2009, it merged with Petro-Canada to create the Canada’s largest integrated energy company. Suncor now combines a leading position in the oil sands, with expanded operations in refining and marketing, North America natural gas production, and conventional oil production internationally and offshore east coast Canada. The merger resulted in a company with a stronger balance sheet, more robust earnings and cash flows enabling the company to invest more effectively in the Oil Sands growth opportunity. The proven and probable reserves are estimated at 7.2 billion barrels enough for 35 years of production against current rates.
Suncor has ambitious growth plans. It targets average oil sand production growth of approximately 10% a year through 2020. It expects to produce 1 million barrels of oil equivalent by that time, with 80% coming from oil sands. It will also continue to integrate oil sands products into their downstream refining and marketing operations, and modestly expand the international and gas operations. Going forward the company should be able to finance it growth plans through the capital it generates from operations. The beauty of the 2009 merger with Petro-Canada is that conventional oil and gas operating cash flow can finance the expansion in oil sand production. Graph 1 gives an overview of the capital and exploration expenditures versus the cash flow from operations.
Graph 1: Capital and exploration expenditures & cash flow from operations
Operating cash cost for oil sands this year is around $40. Suncor requires high oil prices to be profitable. Graph 2 shows the relation between oil prices and the share price of Suncor (adjusted for splits). As you might expect, there is a strong correlation between the two.
Graph 2: Oil prices and Suncor share price
The thesis to invest in Suncor is based on the assumption that higher oil prices are here to stay. In the introduction I have explained why I believe this is the case. The other assumption is that Suncor will be able to execute on its growth plans to produce 1 million barrels a day equivalent in 2020. Almost double of expected daily production in 2011, and is able to do fund that through its operating cash flow.
Suncor has traded between a low of $23 and a high of $47 in the last 12 months. It recently announced third quarter results: Net earnings of $1.287 billion ($0.82 per common share), compared to net earnings of $1.224 billion ($0.78 per common share) for the third quarter of 2010. Total upstream production averaged 546,000 barrels of oil equivalent per day, compared to 635,500 boe/d during the third quarter of 2010. The decrease in production volumes reflects the divestiture of non-core assets throughout 2010 and 2011, operational issues at Buzzard, and the shut-in of production in Libya.
The company is now trading around $30. I consider any price below this as an opportunity to increase my position. I estimate the intrinsic value of Suncor to be around $48 a share. This is based on a discount rate of 10%, a 10 year annual growth rate of 7% and a terminal growth rate of 0%. This is below the growth outlook the company is providing. With this conservative estimate you’re looking at buying one of the biggest oil sands players at a 36% discount. In this scenario you will have a good return. If oil prices increase even further and the company is able to deliver on 10% growth a year, then you will be looking at an extremely good return on investment.