How To Play Peak Cheap Oil: Looking For Yield And Growth In The Canadian Oil Sands

by: Bayesian Investing

If you are like me and you were always skeptical of the peak oil theory, you are feeling pretty smug right now. New technologies and new oil discoveries are being made daily and politicians are once again musing about America becoming energy independent. You never even hear the phrase "peak oil" anymore unless it is from some jerk like me enjoying a self-satisfied pat on the back for being right.

However, I am becoming a believer in peak oil theory's little cousin: peak cheap oil. Or peak conventional oil, if you prefer. Whatever you call it, it is undeniable that the face of oil production is changing. Conventional oil deposits are shrinking, as are margins at the oil majors. Oil exploration is becoming more expensive and most new oil reserves are coming from deep horizontal wells, hydraulic fracturing and deep-sea drilling.

As a young investor, I figured that the world would have an ever increasing need for oil. As such, a couple of decades ago, I launched my genius investment plan:

  1. Buy Oil Stocks
  2. ????
  3. Profits

It turned out to have been a good plan, although it's debatable whether I was smart or lucky. Twenty years later, I am still a big believer in the world's thirst for oil but believe my plan may need a little tweaking. As the face of the world's oil production is changing, I want my investments to keep up.

I am going to take a look at a few oil related themes in the coming weeks, but I want to start with one that I know quite a bit about: the Canadian Oil Sands.

For those of you that may have been blissfully unaware, the oil sands are an enormous bitumen (semi-solid oil) deposit in the Western Canadian Sediment Basin. Bitumen is an extra-heavy oil that is typically mined and is unfortunately much more expensive to produce than conventional light oil and more harmful to the environment - although new technologies are reducing both of those faults.

The oil sands' bad rap aside, the amount of recoverable oil there is simply massive. A 2004 study by the Alberta Energy Board estimated that the oil sands contained the equivalent of 1.6 trillion barrels of oil. To put that in perspective, that is roughly equal to the amount of the entire world's conventional oil reserves combined. So, with all due respect to my less capitalistic brothers and sisters, I don't think an oil hungry world will ignore these deposits no matter how much of a fuss Greenpeace makes.

Up Stream Companies

The largest oil sand company by production is the Syncrude project, which can be invested in through Canadian Oil Sands (trades under the symbol OTCQX:COSWF on the NYSE and COS on the TSE). Canadian Oil Sands is a pure play on the Athabasca oil sands as its only asset is a 33% stake in the Syncrude Project. The shares have taken a beating due to everything from natural disasters to production problems to being the target of an international environmental opposition campaign, but like any good company with good free cash flow they have continued to raise their dividend. The end result has been to make Canadian Oil sands the sometimes dangerous "accidental high-yielder". While there may be no immediate catalyst for this stock, improved technology will lead to increasing oil recovery and profit margins; in the meantime, investors can enjoy a healthy 5.2% dividend yield.

Next, we have the Canadian oil behemoth Suncor (NYSE:SU). They are the largest oil sands producer after Syncrude (of whom they own a 12% stake) and Canada's largest oil producer by volume. Suncor has massive reserves and are growing their oil production; but unfortunately, because of the nature of their reserves they also have one of the highest costs of production per barrel of oil. The company was routed in the 2008/2009 recession as the price of oil dropped below Suncor's production cost and the company's share price plummeted over 70%. As you probably have already figured out, an investment in Suncor is a bet on higher oil prices. If the price of oil remains high, Suncor's massive reserves will make a fortune - but if they soften, both Suncor's margins and share price will likely lag their competitors.

Finally, we should take a look at Canadian Natural Resources (NYSE:CNQ) - Canada's largest oil company by reserves and second largest behind Suncor by production. Unlike the first two companies, Canadian Natural Resources is not a pure play on the oil sands. Their Horizons Oil sand mine counts for a large part of their production but the company also has very significant conventional oil reserves throughout the Western Canadian Sedimentary Basin. I consider their access to light oil in a politically stable climate to be a strong tailwind for the company as CNQ has the potential for much larger increases in production than their pure oilsand rivals. The cost for this growth, other than increased exploration risk, is a much higher P/E ratio. CNQ has also increased their dividend for ten straight years and their stock has handily outperformed their rivals. The timing for this article is somewhat ironic but it should be noted that the company was forced to suspend operations at its Horizons mine for several weeks due to technical problems. Analysts expect this to trim 1-2% off the full year EPS, yet the share price plummeted around 10% in the following days after the announcement, which may present a nice entry point.



Recent Price


Dividend Yield

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Canadian Oil Sands












Canadian Natural Resources






Down Stream Companies

For those of you who want a smoother ride than what E&P companies provide, consider investing in the energy infrastructure that the oil sands need. Oil sands production is increasing faster than pipeline capacity, which should provide growth for pipeline companies.

Canada's two largest pipelines stocks are Enbridge (NYSE:ENB) and TransCanada Pipeline (NYSE:TRP). Both are cash cows that have consistently raised their dividends. The two companies have competing plans on how to deal with the glut of oil sands oil: Enbridge wants to build the Northern Gateway Pipeline to ship crude to western ports for transport to Asia, while TransCanada wants to build the Keystone pipeline to the U.S. I am going to skip commenting on length about the projects as they have been in the media a lot, but like most industry experts, I believe both projects will be approved eventually.

Another pipeline name that U.S. investors may be less familiar with is Pembina Pipeline Corp (OTC:PBNPF) which is heavily involved in transporting oil sands crude. Pembina recently announced a deal to buy midstream energy company Providence Energy (PVX) which is primarily involved in the storage and refining of crude and natural gas liquids and the combined $10B market cap company will make it a major player in oil sands' energy infrastructure. Provident Energy produces and refines a large number of natural gas liquids which are highly valued as diluents by companies that produce bitumen. Those valuable products can now be delivered directly to the big players in the oilsands through Pembina's pipeline system. Analysts, who had little use for the high-yield but low-growth Pembina, have been falling all over themselves for a chance to upgrade the company since the announced acquisition.

Construction & Transportation

Energy companies are not the only ones to benefit from the billions of dollars pouring into the oil sands. Investors should consider the midcap Canadian company Black Diamond Group (OTC:BDIMF), which produces temporary and permanent modular housing for the mining and energy industries. Investors in Black Diamond Group (BDI on the TSE) don't care whether CNQ or SU out performs, or who wins the potash battle between BHP Billiton (NYSE:BHP) and Potash Corp (NYSE:POT), as long as the billions in new projects keep rolling in. Black Diamond Group grew earnings by 96% in 2011 and is projected to grow EPS by another 22% this year. Despite a 70% run this year, after a nice dividend increase, the stock still yields over 3% with plenty of room for growth.

While I fully expect new pipelines to handle the increasing production of crude oil coming from the oil sands, it will take years for those new projects to be completed. In the meantime, rail and truck transportation is seeing a nice boost in profits from all this activity. Canadian National Railroad (NYSE:CNI) is the country's largest rail provider and has benefited immensely from the ongoing commodity boom - the company has raised dividends for 17 consecutive years. Also, consider Trimac Transportation, a provider of bulk truck transportation (the company only trades on the TSE, under the symbol TMA). This small cap firm is involved in the short route transportation of oil sands crude and sports a generous 5.6% dividend yield.

Buying Canadian Stocks

This article has recommended some stocks that don't trade on a U.S. exchange. Pink sheets are one option but liquidity is always a problem. Some brokers such as E-Trade, TD Ameritrade and Schwab allow trading directly on the TSX exchange.

Investors interested in Pembina Pipelines should be aware that the company plans on listing on the NYSE after their acquisition of Provident Energy is complete. Investors can also buy Provident Energy directly which will be exchanged for Pembina Pipeline Stock on a 1:0.425 ratio, pending regulatory approval.

Disclosure: I am long CNI, CNQ, ENB, OTC:BDIMF, OTC:PBNPF.

Additional disclosure: I recently trimmed my position in Enbridge due to its valuation and invested part of the proceeds into Pembina Pipeline.

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