How to Play the Canadian Oil Sands

by: Jeffrey Dow Jones

For some reason, "peak oil" has become more of a political issue and less of a scientific one. I suppose it's similar to global climate change in that sense. It seems strange to the scientist how such a simple topic could be perverted by so many misleading voices and divergent narratives. What happened to simple research, data and conclusions?

But relax. This isn't an article about politics. It's about how to make money off the Canadian oil sands.

We have to start at the macro level, though. And to understand that we have to understand a few things about peak oil. Today we'll ignore all the theories, conspiracies and stories and focus instead on just the facts.

Depending on where you sit on the political spectrum and what your economic interests are, you either buy into the peak oil story or you don't. But the real answer is that both of these perspectives are correct in their own ways. The world's oil production has not, in fact, peaked. There's still a vast amount of oil out there and that production will continue to increase year after year for a long time. But the problem is that an increasing proportion of this supply is in places that are more difficult and more expensive to get to.

I call it "Peak EasyOil". Unlike global warming and the New York Yankees, I think that this is something that pretty much every one of us can agree on.

Here's a beautiful chart from the International Energy Agency:

Click to enlarge

Don't trust an independent organization that calls itself "the world's most authoritative source of energy market analysis and projections?" Fair enough. In the past the IEA has been criticized, but for being too rosy with its forecasts. I don't see anything rosy in that forecast above. I see ever-rising cost. So for today's analysis this ought to work.

Either way, here's a chart from the probably-less-biased U.S. Department of Energy that tells basically the same story. "Unconvential oil sources" in these charts are basically oil sands, heavy oil and shale oil:

Click to enlarge

The details are impossible to forecast and don't even really matter anyway. It's the general conclusion that's obvious.

  • Total oil production will rise.
  • The current fields will run out (no surprise) and be replaced by fields that haven't been drilled or haven't been discovered yet. They haven't been discovered and drilled because it's expensive to get to. It's not worth it for a company like ExxonMobil (NYSE:XOM) to dig a hole and pull this oil out of the ground unless market prices are sufficiently high to justify the costs of doing so.
  • As the easy, already-drilled oil runs out we're going to have to get more of it from somewhere else unless demand for crude oil drops off at a similar rate. If you think that's going to happen then stop reading this article immediately and start placing some bets some major car companies to go out of business. Or the airlines.

I don't think demand for crude oil is going to go down any time soon, and since you're still reading I doubt you do either. Ultimately, whether or not we truly need an alternative source of energy to power our cars and trucks and airplanes is more a debate about how much we're willing to pay and how quickly the costs of alternative sources converge with conventional ones.

So that's the backdrop for an investment like the oil sands. It begins with the question of how serious is the world going to get about electric cars or an infrastructure of natural gas filling stations.

The most important variable in that equation is the United States. When it comes to the United States we have a country that, psychologically and culturally, prefers living in the now and would rather not worry about any future beyond the next political cycle. We are the grasshopper, not the ant.

Despite all the jazzy political rhetoric, I don't think we're going to get truly serious about a different transportation-energy infrastructure for a while. I believe that the oil in these hard-to-reach places will remain extremely relevant as will these unconventional sources of oil.

At least for the next decade or so. Never underestimate the ability of a good old fashioned crisis (or harsh winter) to get those grasshoppers to finally act.

How It Works

All of you have heard the term but I'll bet that most of you are wondering just what the heck this "oil sand" stuff looks like.

As the name implies, it's about 90% sand and clay. The rest is bitumen, a fancy word for natural oil in a solid state. It's in a solid state because Canada is cold and the ground freezes up there. When it warms up in the summer time the bitumen gets a little more viscous, but it's still a lot less liquidy than the stuff buried deep in the earth where it's hot. Most of this sandy mix is just lying around on or near the surface, but a lot more lies a little deeper in the ground and that requires a different type of digging to extract.

Step one is to separate the bitumen from the sand which is easy enough. It's mixed with water into a sludge and then pumped to an extraction facility where the heavy sand settles and the lighter bitumen rises to the surface of the tank. Then the rest is centrifuged and cleaned up and shipped off for refinement into gasoline or synthetic crude oil. Pretty simple, but it costs money to dig and transport and heat.

The bad news is that - environmentalists, look away for a minute - all this is naaasty for Mother Earth. Each barrel of synthetic crude uses three barrels of water, destroys about four tons of earth, and requires a decent amount of natural gas. That's from the Worldwatch Institute, an admittedly biased organization. But still, the general case is that this is by no means Earth-friendly. If environmentalists are opposed to conventional drilling, then they're really going to hate this kind of operation.

I take no official stance here. I just understand and accept that life is about sacrifices and trade-offs. Extracting oil from sand is an expensive endeavor regardless of how you define "cost" and whether or not you are willing to pay it.

The good news is that all this is located in Canada. In fact, the Athabasca tar sand deposit is the largest reservoir of crude bitumen in the world. There is an estimated 1.7 trillion barrels of oil in the ground, but only about 10-15% of that is economically recoverable at today's prices. Still, at somewhere around 200 billion barrels it would more than double the largest conventional oil deposit in the world, the Ghawar Field. When you take the oil sands into consideration, Canada has the second biggest oil reserves in the world.

Let me repeat that: the second biggest oil reserves. In. The. World. Only Saudi Arabia has more oil. And most of its production is now on the wane.

I've never been to that part of Canada before, but seriously... who among us have?

There's not much of interest up there unless you're an oil company:

Canada is currently producing over a million barrels per day at this field. Most estimates show this region producing between three and four million barrels per day by 2020. Nevermind the reserves, that kind of production would make Canada one of the largest producers in the world. On top of that Canada is the biggest supplier of oil to the United States. So like, its No. 1 customer is pretty rock solid.

I know there are environmental bogeymen out there and angry Gaians dancing on the steps of the Canadian parliament, but honestly, do you think Canada doesn't see the upside for how this could all play out? If you were in charge of assembling a 10-year economic strategy for Canada, wouldn't you try and encourage growth in this area?

As you sit around and think about that 10-year plan, also consider that Canada owns a lot of Uranium which we covered in greater detail here. Plus, Canada has a whole bunch of timber which we wrote about extensively here at Seeking Alpha and over at our weekly newsletter.

As you can see, Canada has a whole lot going on for it in terms of satisfying the world's future resource needs.

Go Canada!

(Canadians, don't get up too high up on that horse. I know you gave us hockey and Leonard Cohen and plenty of other awesome stuff, but we still haven't forgiven you for this.)

How to Play It

OK, now for the money-making part. There are a few ways to go about it.

The first is to directly invest in the stock of the companies that are extracting oil from the sands. It's possible you thought these companies were rinky-dink speculative plays. Uh uh. These are huge firms with huge operations.

Suncor (NYSE:SU) is the biggest. They're a $64 billion company and the bulk of their revenues come from their oil sands operations which are about 300k barrels/day. They're trading at about 16 times 2011's earnings estimates and about 11 times the estimates for 2013. This is an energy company that's exhibiting good growth right now, almost tripling total revenues since 2005. It's more exciting than a traditional name like like Exxon or Chevron (NYSE:CVX).

Click to enlarge

On a technical basis, I love that chart. They've been growing steadily for 15 years but they've actually been active in the Athabasca oil sands since the late 1960s.

Right now the stock is trading at the support/resistance area of around $40. It's possibly putting in a foundation for the next leg higher. Suncor also happens to pay about a 1% dividend, which is like, whatever. But if I can get a little dividend now and then and some solid growth in the same investment, it's a deal I think long and hard about making. Especially if the fundamentals and the macro thesis are sound. The dividend is just proof that they're generating good cash flow from sustainable operations.

If you want to get tactical about it, go ahead and buy it on pullbacks or if there's a little deflationary shock in crude oil. There's always risk in forecasting growth rates indefinitely into the future, but all the pieces are in place for these guys right now and the earnings multiples are still somewhat easy to justify. We're not talking about Facebook here.

Cenovus (NYSE:CVE) is a smaller company with a market cap of about $26 billion but they get a slightly higher percentage of their revenues from oil sands. Their three major mines are joint ventures with ConocoPhillips (NYSE:COP) and are currently producing almost 200,000 barrels/day with expectations to double that in the next decade. It's a little more expensive at 22x this year's estimated earnings and 18x 2013 earnings estimates but this a younger company with a more aggressive growth profile. They also pay about a 2.5% dividend which gets a somewhat interesting.

Canadian Natural (NYSE:CNQ) is another one to look at. The company's operations are a bit more diverse but they do get a significant chunk of revenue from oil sands. It trades at similar valuations to Suncor and at a similar multiple. There might be a little bit less risk with these guys, but still, all of these companies are going to do well if oil prices continue up and up, and all of these companies will get hurt in any deflationary mini-panics.

And finally there's Syncrude, another big name in this space, curently producing about 350k barrels/day. They don't trade publicly and are a joint venture formed by a handful of other companies. They are about 1/3 owned by Canadian Oil Sands Limited, which trades up on the Toronto Stock Exchange.

All of these companies have very little debt, which is one of the first things I check for in all my fundamental analysis. Maybe that makes me old school, but it's just a lot more difficult to really screw up your business if you aren't carrying a whole bunch of debt. As an investor, things like that matter to me. I don't like businesses that are easy to screw up. I know there's more excitement to be found in companies with much higher higher leverage and marginal growth rates, but I'm boring.

It also bears mention that all of these companies are in the natural gas business as well. This is a good thing for two reasons, the first of which is that these guys need the natural gas to ultimately separate the oil from the sands. But natural gas is a good business to be in regardless. It's the most popular way to heat our homes and there's a chance we get really serious about using it for transportation in this country. There's a reason that these major integrated oil companies are expanding their natural gas operations. Exxon's epic purchase of XTO (XTO) sorta tipped their hands about where they thought the growth would be in the future, didn't it?

Diversify Your Exposure

If you want to simplify and diversify your investment you can buy something like the Canadian Oil Sands Trust (OTCQX:COSWF) and pick up a whole bunch of these companies at once. That one trades OTC, so maybe take a look at the Guggenheim Canadian Energy Income ETF (NYSEARCA:ENY) instead.

Click to enlarge

It yields about 3.4% right now. Those you that are starving for yield might want to take a look at it for that reason alone, though you should know that there are much less volatile ways to get a 3.4% yield. There are all sorts of different companies in the portfolio but the biggest are the ones that we just talked about above. The fund is only about $100 million right now, which is a good thing. This ETF won't disrupt the movement of its component stocks the way that other ETFs can.

I've written before that I think the best way to play alternative energy is through traditional energy sources. In the big picture, it's hard to envision a scenario where alternative energy companies (wind, solar, etc.) win out and traditional energy companies don't win out. The flipside risk is that there are lots of scenarios where alternative energy fails and traditional energy wins. I still think that something like the Energy Select Sector SPDR (NYSEARCA:XLE) is a better, safer way to play to play alternative energy than a lot of alternative energy investments.

But these Canadian oil sands companies are something of a hybrid. Like alternative energy companies, there is risk in the sense that if oil prices go lower many of these businesses aren't so viable anymore. But these companies are a critical part of the future of traditional energy sources. They don't suffer from the adoption cost of switching to other methods of energy delivery. The refineries and the gas stations are already there. The plug-in stations are not.

In fact, you can even own XLE and ENY with basically zero positional duplication. In that situation you are, however, sorta chained to what happens with the price of crude oil. Which brings us back to our original macro thesis of "what happens to oil prices in the next decade and beyond?"

A Final Word: Additional Risks and Bonuses

As a portfolio manager, what I particularly like about these companies is that they are a good way to hedge out geopolitical risk or, depending on your strategic objective, leverage the effects of geopolitical events. Maybe you're a global macro hedge fund manager looking for a way to play instability in the Middle East. If there's a major event in Iran or Saudi Arabia, oil prices will spike and these companies will benefit disproportionately because of their proximity to the United States and the super-stable trading relationship we have with Canada. We saw proof of this with Egypt last week. All of these oil sands companies rocketed upward as the market fell and traditional energy companies lagged.

They're also a good tool to guard against ever-rising energy costs. When you're spending more of your paycheck to fill up your car, companies like these are the ones that benefit. Stocks aren't a great inflation hedge, but energy stocks work rather nicely for it. And they don't carry as much volatility as the commodity markets, either.

If you own them, the thing that will keep you up at night is the possibility of a deflationary shock in the oil market. If you aren't sure whether or not you have the fortitude to ride out that kind of volatility for the long run, then own these companies alongside something likely to benefit in a deflationary shock. Any deflationary shock in the oil market will probably be linked to a deflationary shock in the economy and bonds are my favorite way to guard against that.

Generally speaking, bonds do well in low-inflation environments and spike during deflationary panics. Energy companies do well in high-inflation environments and spike in inflationary panics. And over the long run, they both probably make money. So with the bonds find some quality and duration that you're comfortable with, maybe something like the 7-10 year Treasuries via the IEF or 10-20 year Treasuries via the TLH.

Mathematically, I know that's not a perfectly hedged trade, but risk management isn't just about crunching numbers and calculating probabilities and correlations. It's about preparing yourself to handle unknowable and impossible-to-model outcomes. There's a lot more abstract strategy and game theory to risk management than plugging-and-chugging VaR in an Excel spreadsheet. You know, the kind of stuff that got the banks into all that trouble. (zing!)

Look, the Canadian oil sands companies can be a great asset for your portfolio. They might even be a candidate for the Trades of the Decade. They are tools that you can use tactically but they are part of a fundamentally convincing story. In a world where more and more crude oil will be more and more expensive to get to, these are sound businesses that make progressively more sense.

Disclosure: I am long XOM.