Canadian Oil Sands (COSWF.PK), a producer of synthetic crude oil, has dramatically underperformed other oil stocks as well as oil prices. While WTI oil has run from around $76 per barrel last fall to a healthy $102 per barrel today, Canadian Oil Sands has tumbled from over $35 per share last year, to around $20 and change today. In fact, the stock is spitting distance from its early 2009 lows of $15-17 per share, having seen $50 plus prices back in early 2008.
I would argue that the stock is quite cheap, and merits owning here.
- Company: Canadian Oil Sands
- Ticker: COSWF
- Price: $20.20
- Shares: 485mm
- Market Cap: $9.8BB
- Debt, net: $0.4BB
- TEV: $10.2BB
- EBITDA 2011: $2.0BB
- 2011 EPS: $2.36
- 2011 FCF/Share: $2.31
- 2011 Dividend: $1.10 (47% payout ratio)
- 2012 Dividend Guidance:$1.20
- Yield on 2012 Div's: 6.0%
- (Given that 1 USD = 0.99 C$, amounts are essentially interchangeable, although reported in C$)
Canadian Oil Sands is a 36.74% owner of Syncrude Canada Ltd. Syncrude is one of the largest crude oil producers from Canada's oil sands, operating large oil sand mines, a utilities plant, a bitumen extraction plant, and an upgrading facility that processes bitumen into light sweet crude oil. The Syncrude Project's owners are:
- Canadian Oil Sands (36.74%)
- Imperial Oil Resources (25%)
- Suncor Energy Oil and Gas Partnership (12%)
- Sinopec Oil Sands Partnership (9.03%)
- Nexen Oil Sands Partnership (7.23%)
- Mocal Energy Limited (5%)
- Murphy Oil Company Ltd. (5%)
The operator of the project, Imperial Oil, is a 75% owned subsidiary of ExxonMobil. So generally the oil sands project here benefits from the best industry and production expertise.
As far as the oil in place, it is high quality crude, literally dug up and mined from bitumen deposits in Alberta Canada's Athabasca Oil Sands. To date, approximately 2.2 billion barrels of oil have been produced from this project, with proved reserves of another 4.8BB in place. That is simply a massive amount of oil in the ground, and with recovery rates of 90%, Syncrude will be able to produce steady amounts of oil for decades.
Even ignoring an estimated 5-7BB of additional contingent barrels in place, current proved reserves ensure that Syncrude has at least 40 years of oil production in the ground. Different from producers like Exxon (XOM) or Chevron (CVX), Syncrude doesn't have to acquire any existing hydrocarbons (at higher and higher prices) to keep its production levels from declining.
Why has Canadian Oil Sands underperformed so much? Generally, management has shown an uncanny ability to miss production guidance. In fact, for each of the past 4 years, management has guided to production between 110,000 and 120,000 barrels of oil per day. And yet the actual number has been below the bottom end of this guidance, every single year since 2008!
Not by a lot, but production clearly missed the low end of guidance with daily production averaging 106,000 in 2008, 103,000 in 2009, 107,000 in 2010, and 106,000 in 2011. Design capacity is even higher than guidance, at around 128,000 barrels per day. The problem has mostly been relating to issues in the final upgrading stage, or from less efficient, older mine trains, which simply break down.
Canadian Oil Sands produces oil using giant mine trains that essentially do the following: 1) crush bitumen ore after it has been dug up, 2) feed the oil sands via a surge bin into a mix box, and 3) add warm water to the oil sand in the mix box to produce a pumpable slurry. In total the company operates 5 mine trains on its leased acreage.
To improve production, Syncrude plans to replace or relocate 4 of their 5 mine trains by 2014. Two mine trains at the company's Mildred Lake mine site will be replaced, and newer wet crushing technology should improve recovery rates and lower maintenance costs. Fortunately, production will not be affected during the process, but the bigger concern will be the costs to upgrade and replace the mine trains.
Free Cash Flow
The net cost to Canadian Oil Sands from the mine train replacement process will be sizable. While prior years' capital expenditures have ranged between $300 and $500mm (compared to $1 to $2BB in EBITDA), capex will jump to $1.46BB in 2012, then fall to $1.1BB in 2013, and $800mm in 2014. Afterward capex should normalize back to $500-700mm give or take.
Fortunately, 1) the balance sheet almost entirely unlevered today (at 0.2x Debt/EBITDA), and 2) all of this capex could be funded with free cash flow from operations. To ensure adequate liquidity, the company issued $700mm of bonds last month, ensuring they have all the cash needed to fund capex over the next two years, as well as to fund dividends. Not to mention that EBITDA should be north of $1.7BB for the next few years, assuming WTI oil prices of $90 per barrel.
Even better for shareholders during this cash expenditure phase, there will still be plenty of room for dividends. Here is the FCF breakdown:
Click to enlarge.
There potentially is a lot of downside in oil prices today. Whatever your views on oil, there seemingly is a larger Middle East premium than is typically the case. Worries over Iran and the Strait of Hormuz have boosted prices, and peaceful headlines could ameliorate oil price jitters. Economic weakness in Europe and China might also reduce demand for oil, so to some extent price risk is higher than at other times.
However, it should be noted that while WTI prices are down roughly 5% over the past twelve months, COSWF is down a surprising 43% over the past 12 months. I think the market is either overly reacting to smallish production shortfalls, or investors are far more fearful of falling oil prices than is justified.
The company's guidance document dated February 24th, for the first time in five years indicated guidance lower than the normal 110,000 and 120,000 barrels per day. This year (2012), management is guiding to 107,000 to 118,000 of daily production, which to me means that there is a better shot that management hits its numbers, and the stock avoids a selloff come earnings season. There is one cautionary note however.
In the guidance document (pdf), in footnote 1, the company details its quarterly production guidance, and there is quite a bit of lumpiness to the quarterly numbers. Because of planned maintenance on Coker 8-1 and a planned turnaround of Coker 8-3 in Q2 this year, quarterly production will look weaker, perhaps much weaker in the first 2 quarters of 2012. Production guidance midpoints are:
- Q1: 28 mm barrels
- Q2: 22 mm barrels
- Q3: 31 mm barrels
- Q4: 31 mm barrels
- Total 2012: 113 mm barrels
As you can see, Q2 will be perhaps awful in terms of production, and Q1 won't be so great either. I hate to get too caught up in quarterly noise, but it's good to keep some dry powder during the first half of the year until we have seen the worst of the company's production behind them. Expect to see Q1 earnings out at the end of April.
The key in any investment (to me at least), is Free Cash Flow. Yet again, this is a very stable company from a production and reserve perspective, with decades of stable production ahead of it. Finding and Development (F&D) costs are minimal here on the plus side, but then again on the negative side lifting costs so to speak (or mining costs) are higher than perhaps other companies in the industry. Operating costs (plus maintenance capex or D&A) are in the high $50s per barrel historically, which isn't bad, but means investors are more levered to rising and falling oil prices.
Reported marginal costs of oil in the industry are probably $60-70 per barrel, which generally is my downside in oil prices. If oil falls below $70, then FCF per share here would fall to around the $1.35 range, which is barely enough to support current dividends of $1.20 per share. Likely they would be cut. A sensitivity table is below:
The good news is that the current dividend is pretty safe unless oil falls by 30% or more. The bad news is that for 2012 and much of 2013, capital expenditures will be unusually high, limiting growth in FCF and in the dividend. I think it's safe to say that the stock may remain in the penalty box for awhile, until much of the capex spending is behind it and until production begins to creep back up.
However, on a pure FCF per share basis as illustrated in the chart up top, FCF/share will be approximately $0.54 this year, $1.77 in 2013, and $2.39 in 2014. Before 2011, Canadian Oil Sands traded between 5% and 9% FCF yields. Today, excluding this year's upgrading capex (for its mine trains which I consider non-recurring), the FCF yield is 12%. If I look two years down the road, and consider that the company could do $3.30 in FCF per share (using $100 WTI), then at a normalized or average 7% FCF yield, that implies a $47 stock price, which is a 125% return in two years not counting dividends.
That does seem a little aggressive, but if WTI oil remains at $100 in 2014, then it is conceivable that a two-thirds payout ratio on $3.30 in earnings (or $2.20 in dividends) could mean a 6% dividend yield, or $37 per share. Even last year, COSWF traded above $35 a share, and is my minimum upside over the next couple of years. Its peak before the financial crisis was well over $50 per share, and in two to three year's time doesn't seem a crazy level for a patient investor.
One other point. In June 2010, Chevron sold its 9% stake in Syncrude to Sinopec for $4.65BB. That implies a $51BB equity value for Syncrude, or a $19BB valuation for Canadian Oil Sands equity. That is $39 per share. It's quite conceivable that Exxon, as operator, or somebody else for that matter may want to increase its holdings of this investment, and buy out Canadian Oil Sands.
This one may take a full year or two to work out. Production may be spotty as mine trains are moved, torn down and replaced/upgraded. Not to mention the quarterly lumpiness in production that the company has guided to for 2012. Management has a poor record of projecting production, and capex will limit FCF growth for a couple years.
That said, once the major upgrade cycle is behind them, Canadian Oil Sands should throw off tons of FCF. Production risk will fall too with upgraded mine trains. Investors will be heavily exposed to oil swings, so keeping some dry powder for a recessionary oil market makes sense.
While I wouldn't normally initiate a position in an oil company with WTI at over $100 a barrel, this stock seems overly beaten up. I call $16 my downside, as I do not see this falling below 2009 lows. There are simply far too many barrels of oil in the ground for this to be worth less. In fact, if you assume $75 oil and $60 in costs, the NPV of the company's proved reserves at a conservative 9% discount rate is $20 per share.
On the upside, I wouldn't be surprised if this reached the mid $30s, perhaps even in late 2012 or early 2013. If they can actually hit their 2nd half production guidance of 31.5mm barrels, then sentiment perhaps can be turned around on this stock. Downside of $4-5, upside of $20 equates to solid risk reward.
Disclosure: I am long COSWF.PK.