Check Out The Oil Sands Trifecta

by: Anthony Cammara

There are many critics for Canadian crude oil, since crude realization prices are currently below WTI (West Texas Intermediate) prices. But even at these current discount prices, oil sands plays are returning great earnings and spinning off a ton of cash. We must also keep in mind that the landscape in North America is changing. Despite their delays, there are two pipeline projects in the works that will help oil sands companies get their oil to the world markets and realize prices that are closer to Brent ($125 a barrel and rising). I am of course talking about the TransCanada Corporation (NYSE:TRP) Keystone XL pipeline, which will help ship crude oil to the U.S. refineries, and the Enbridge Inc (NYSE:ENB) Northern Gateway pipeline, that will ship oil to the west coast to open up the Asian market.

My oil sands trifecta that will take advantage of all of this is Canadian Natural Resources Ltd (NYSE:CNQ), Cenovus Energy Inc (NYSE:CVE) and Suncor Energy Inc (NYSE:SU).

The trick here is that we can't wait for the differential in prices to tighten up before we get into these stocks. The market always anticipates news and if we wait we'll miss the majority of the move. Also, these stocks are cheap on current valuation metrics and current realizations and they are not being rewarded for their long life, high quality asset base, and are trading at significant discounts to historical P/Es and NAV (Net Asset Value). (Side Note: please don't mistake Net Asset Value with Book Value, NAV considers the present value of after-tax cash flows from reserves [at 10% discount rate] as well as the present value of cash flows from future exploration/development activities).

Canadian Natural Resources Ltd
I've written about and analyzed CNQ in the past, so for succinctness I won't repeat that analysis here.

Cenovus Energy Inc.
Out of the three, Cenovus trades at more of a premium but there is good reason for it. These guys are the premier players in SAGD (Steam Assisted Gravity Drainage) oil sands development, which is a cleaner way to develop the oil sands instead of traditional mining. These guys are the Sidney Crosby or Micheal Jordan or Anthony Cammara (see what I did there) of their field. The company has one of the best-in-class Steam-to-Oil ratios in the industry, which means that it requires less water (which translates to less cost on the environment and its pocket book) to extract the oil. The company also has the best dividend out of the three, which it recently just raised by 10% when it reported 4th-quarter earnings (Dividend yield of 2.5%). Cenovus has also set out a production growth plan that will see it hit 500,000 boe/day by 2021 which is a CAGR (Compound Annual Growth Rate) of 14% using 2011 as the base. So we're looking at 14% growth in production and if you, like me, feel that oil is only going to continue its march higher, we're looking at much higher than 14% profit growth. Let's jump into some fundamental info and then some NAV calculations (Data as of December 31, 2011):

Full Year 2012 Production Guidance:
Oil and NGL of 163,000 boe/day
Nat Gas 588 million cubic feet/day

Proved and Probable Reserves:
2.7 Billion boe

Economic Contingent Resources:
8.2 Billion boe

Refining Capacity:
266 million barrels per day

Net Asset Value:
NAV (2P + 2C) = $40.10

If we apply a conservative 8% growth rate to this (conservative because management has said we will see 14% CAGR) we get an NAV of $43.10

Cenovus closed at $35.85 on Friday March 23, 2012, which means it's trading at an 11% discount to its 2P + 2C NAV and a 17% discount to its growth adjusted NAV. So we have significant upside just for Cenovus to reach its Net Asset Value.

If this upside wasn't good enough, we have a near-term catalyst coming in the next couple of weeks as Cenovus is in the process of looking for a joint venture partner to develop two other large oil sands assets. Cenovus is looking for a partner to help with the initial cost of developing these assets and is also looking to expand its coking or refining capacity in this joint venture deal. There has been significant interest from many different big name players (BP, Total etc.). I think the stock will get a lift when this joint venture is announced because analysts will start factoring in these assets in their NAV calculations and thus start lifting their price targets.

Suncor Energy Inc.
Suncor is the largest and the most experienced oil sands player out of these three companies. Back in 2009, Suncor in an all stock deal merged with Petro-Canada to create a Canadian oil super power. At the time, Suncor touted that there would be many cost savings and synergies created through this merger. Investors were skeptical and Suncor has been trading at a discount on many valuation metrics including NAV, P/E, and Price to Cash flow. A large merger like this usually takes between 2-3 years for the companies to fully integrate and start realizing all of the efficiencies and synergies they created. We are now at the 3-year mark and Suncor is firing on all cylinders. Fourth-quarter earnings showed Suncor hitting many records:

Record Net Earnings:
$1.4 billion in Q4
$4.3 billion in 2011

Record Operating Earnings:
$5.7 billion in 2011

Record Cash Flow:
$2.8 billion in Q4 2011
$9.7 billion in 2011

Record Oil Sands Production (excluding its portion of syncrude production):
345,000 boe/day in December 2011
305,000 boe/day in 2011

Suncor has set out production growth that will see it hit the 1,000,000 boe/day mark by 2020, which is an 8% CAGR from 2011 production numbers. If you're an oil bull this production growth looks terrific and onto of that, Suncor said that it will not be aggressively hedging production. So if oil prices continue to rise, Suncor will be able to realize these higher prices.

With all this in mind let's take a look at some fundamental info and some NAV calculations (data as of December 31 2011).

Full Year 2012 Production Guidance:
Oil and NGL of 515,615 boe/day
Nat Gas 295 million cubic feet/day

Proved and Probable Reserves:
7.2 Billion boe

Economic Contingent Resources:
20.4 Billion boe

Net Asset Value:
NAV (2P +2C) = $47.23

If we apply a conservative growth rate of 2.5% (conservative because Suncor is promising 8% CAGR) we get an NAV of $48.41

Suncor closed at $32.82 on Friday March 23, 2012, which means it is currently trading at a 30% discount to 2P + 2C NAV and 32% discount to growth adjusted NAV. Because of this huge discount, Suncor is embarking on yet another share buyback program, where it said it will buy another $1 billion back in stock.

All in all these three stocks are trading at cheap valuations and I feel that in the long run all three are great plays.

Bonus Oil Sands pick

I've also got a smaller-cap oil sands name that I like: Meg Energy Corp (OTCPK:MEGEF).

MEG Energy reported a fantastic quarter back on February 2, 2012. The company beat on the bottom line and reported that it reached record production of over 30K barrels a day. MEG in my opinion, is a mini Cenovus Energy.

They both use an SAGD (Steam Assisted Gravity Drainage) system to extract the oil from their oil sands assets and as a result both have best-in-class Steam-to-Oil ratio. They also both have similar P2 reserves (Proved and Probable) of just over 2 billion barrels and growing. (MEG has 2.1 billion boe in 2P reserves).

MEG is only a couple of years into production, and it is producing just over 30,000 barrels a day, where as Cenovus is at just over 163,000 barrels a day (Cenovus also produces natural gas and natural gas liquids). Cenovus has a 2.5% dividend and MEG does not. Also, MEG is a pure play on oil production and Cenovus is integrated (they also own refineries).

Differences Explained/Justified

I don't think that MEG will get into the refining game, but that's not a bad thing. Pure plays often get a premium multiple, because they have pure exposure to the commodity. An 'integrated' has to worry about the refining business which is harder to make a profit.

I can't speak for MEG's management but once it gets production ramped up and the cash flows are flying high, I can see it instituting a dividend. Right now it'll be using all its cash to get production where it wants it to be.

Lastly the oil production difference will be met with time. MEG has a plan to hit 260,000 barrels a day in production by 2020.

Future Valuation Potential
So lets look at some valuations and what kind of return we can get for a patient investor.

Cenovus with over 2.7 billion in reserves, and 163,000 barrels a day of production is valued at about $27 billion.

MEG with over 2 billion in reserves and 30,000 barrels a day of production is valued at $7 billion.

MEG will be ramping up production to 260,000 barrels, which is almost twice the current rate of Cenovus. They are very similar companies in their extraction methods and in their asset area. If we give MEG the same valuation as Cenovus now, we're looking at MEG almost quadrupling in stock price ($27 billion/$7 billion = 3.8).

There are risks associated with MEG: the hardest part of extracting oil in the oil sands is getting production up with as few delays as possible. But thus far, through MEG's career it has quickly and efficiently ramped up production to 30,000 barrels a day on budget and on time (which is hard to do).

So if you're a patient investor you'll be rewarded over time as MEG becomes the next Cenovus, that is if someone doesn't come along and take it out first.

Disclosure: I am long CNQ, SU. I may initiate a long position in TSE:MEG (MEGEF.PK's) and CVE over the next 72 hours.

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