A long term view on oil
One of the advantages of being a long term investor is that you can detach yourself from the moment, filtering out the noise of a 24 hour news cycle. A headline in the Wall Street Journal about the S&P plummeting to X year lows means it's time to buy more U.S. index funds. Has the S&P hit bottom? I have no idea. But at least I can be content in the knowledge that I'm investing in the right direction.
Over the past year, I've watched headlines on crude oil go from bad to worse. It's currently trading at $30 a barrel, rebounding from 12 year lows of $27 per barrel following Saudi Arabia and Russia's agreement to freeze oil output on Monday.
All of this is mildly interesting, but it doesn't change the fact that supply still massively outstrips demand and will continue to do so for the foreseeable future.
In searching for an investment idea in energy, it might be instructive to list out the factors behind the oil price collapse:
- Faltering demand for crude oil in China
- The lifting of oil embargoes in Iran
- The growth and expansion of unconventional oil producers (i.e. the U.S. shale industry)
Arguably, the third factor has played the largest role in driving down prices. Prior to Monday's announcement, Saudi Arabia's refusal to cut output is in direct response to the growth of unconventional oil producers threatening its market share. Over the past year, all of these unconventional oil producers have been bleeding cash and loading up on debt. If current prices persist, the industry will inevitably start to see consolidations and bankruptcies.
Yet from a long term perspective, the future of the oil industry rests largely in the hands of these same struggling producers. Unconventional oil reserves make up two thirds of the world's total proven oil supply. And after Saudi Arabia, Canada has the second largest supply of crude oil.
If we accept the two premises that oil prices will rise in the long term but continue to stagnate in the short and medium term, and that unconventional oil is the future of the industry, then the ideal long term investment would be in an unconventional oil producer who is both a cost leader within its segment that can survive at current prices.
Which brings us to Suncor Energy (NYSE:SU) and the Athabasca oil sands.
The bull case for Suncor
Last month, Suncor reached a $4.2B deal to acquire Canadian Oil Sands, giving it a majority stake in the Syncrude mining project. This move is significant for two reasons:
- It demonstrates cost discipline, which has allowed management to pursue opportunistic deals during down cycles.
- Suncor now has a majority stake in 2 out of the 3 largest mining projects currently in operation, or roughly one third of the total output from the Athabasca oil sands.
The second reason has actual upside for the long term investor.
Source: Suncor COS shareholder presentation
As unconventional oil reserves go, the Athabasca oil sands represents its crown jewel. It is the single largest reserve of unconventional oil that is producible at current prices and is the only large oil sands reservoir in the world that is suitable for large scale surface mining. The majority of unconventional oil reserves are either too costly to extract or unreachable with current technology. Low oil prices effectively places a lid on further investments.
With its ability to produce at a cost of $20 per barrel, Suncor has all the characteristics of unconventional oil with the economics of the Saudis. This means that the longer oil prices are allowed to stagnant in the short to medium term, the harder this will hit Suncor's competitors, at the same time strengthening Suncor's market position within its segment.
Suncor's survival prospects
Earlier this month, the market reacted to news of Suncor posting a $2B loss over Q4 2015, sending the stock down 10% over the following week. Considering that even national entities are feeling the heat at current prices, one only has to delve deeper into the financials to realize that this news was no cause for alarm:
Of the $2B loss, 20% was in unrealized foreign exchange losses on U.S. denominated debt. An additional 40% of that was in impairments to the company's non-core interests in Libya and the North Sea. And despite the worst rout that the industry has seen in over a decade, Suncor has still managed to maintain a positive free cash flow of $136 million on the year. This is in an operating environment where the company continues to cut spending while at the same time increasing output in the oil sands by 8% year over year.
The recent move by the Saudis to freeze output has signaled a floor for oil prices. With its strong balance sheet of $4B in cash, coupled with improved earnings from its downstream refining assets, Suncor is well positioned to weather the storm even as 'lower prices for longer' continues to batter the industry as a whole.
For the long term investor, owning Suncor is like playing a game of Monopoly where you've purchased two hotels on Park Place and Boardwalk. As long as you can survive the early rounds, your chances of winning increase with the number of times your opponents go around the board.
Currently trading at close to book value, Suncor represents an opportunity to own a dominant player within its segment with a real competitive moat as the industry's cost leader over the next decade.
Disclosure: I am/we are long SU.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.