Canadian Oil Sands: Are Downgrades Based on $80 Price Deck Justified?

| About: Canadian Oil (COSWF)

Canadian Oil Sands (OTCQX:COSWF $25, COS-UN.TO) was hammered Friday as the company announced 2011 budgets below expectation, with share prices dropping 11% on the day. Share prices now sit just above their 52 week low. COS fortunes are directly tied to oil pricing at or above current levels and to production increases closer to its design capacity. If oil stays above $80 and if Syncrude production can increase, further stock weakness could be seen as an adequate long-term entry point.

COS is 37% owner in the Joint Venture Syncrude, an oil sands project with current design capacity of 350mb/d. Partners include Imperial Oil 25%, Suncor 12%, Sinopec 9%, Nexen Oil Sand 7%, Murphy 5%, and Mocal 5%.

COS forecasts 2011 will experience only a marginal increase in production to 110 million barrels accompanied by higher capital expenditures. Lower production, combined with its pending conversion from a Canadian unit trust to a corporation, forced management to reduce distributions to $0.80 a year. This was the catalyst for analysts to cut their estimates and recommendations.

However, most forecasts use $80 a barrel for their price deck. At projected production, every $10 rise above the $80 price deck adds $0.60 a share to operating cash flow. If production can increase by 2million barrels, or 1.8%, and oil averages $85 in 2011, ocf would increase by the same $0.60 a share. Forecast costs are expected to be around $37/bbl, similar to this year. CapEx is expected to be an additional $23/bbl.

CapEx is expected to jump from $525 million this year to $930 million next year and all of the CapEx projects are non-growth oriented. While maintenance and shifting of raw material locations expenditures are expected to peak in 2011, CapEx levels will continue to increase in 2013 and beyond as multi-year production growth initiatives move from planning to implementation.

The key for COS is generating production in the 120 million barrels range. This has been management’s target for a while, and reliability issues have held production below this level. At 120 million barrels production and an $80 price deck, ocf should be around $3.25/share, sufficient to fund CapEx of $1.90/shr, a dividend of $0.80-$1.00/shr, and generate $1.34/shr in free cash flow. However, as the growth initiatives requirements are funded going into 2013 and beyond, CapEx could grow to $2.50-$3.00/shr, eating into free cash flow.

At production levels below 120 million barrels production, future CapEx needs become more problematic. At 110 million barrels production and an $80 price deck, ocf is estimated at $2.62, CapEx is estimated at $1.90/shr, dividend at $0.80 and free cash flow of $0.70.

Sinopec bought into the Syncrude JV this year, buying a 9% interest for $4.65 billion. Using a 15% discount to this acquisition price, COS’s 37% interest, less debt, could be worth around $30/shr.

There is some speculation COS could be added to various indexes upon their corporate structure conversion. This would add a new base of investors to the company and, at least in the short-term, could counteract investor selling due to weaker performance.

Nibbling on an initial position here could be an intriguing long-term position. If share prices continue to weaken to the $19 to $20 range as recommendation downgrades make their way through the market, COS risk/reward would favor share additions. Watch COS share prices over the next few weeks for weakness and if it materializes, look for astute investors to begin buying.

As always, investors should conduct their own due diligence, should develop their own understanding of these potential opportunities, and should determine how it may fit their current financial situation.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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Tagged: , Major Integrated Oil & Gas, Canada
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