Suncor: An Undervalued, Growing Company

| About: Suncor Energy (SU)

Summary

Suncor is growing organically and with acquisitions.

Suncor’s financial position remains strong.

The current valuation does not reflect the true potential of Suncor.

More than 250 mbpd has been acquired by Suncor in oil sand projects.

Suncor Energy (NYSE: SU) is clearly one of the oil cycle downturn's winners. Suncor has cleverly understood the opportunities brought by the oil price fall. Having the financial resources has allowed Suncor to enter into an expansion program exactly when the oil price was testing its lows.

Suncor, based in Calgary, is the largest integrated oil company of Canada. It counts with three main business segments: Refining and Marketing, Exploration and Production and, finally, Oil Sands. Suncor leads the development of the Athabasca oil sands where it has been expanding strongly in the last two years. It has taken advantage of the oil price downturn started in 2014.

Being a fully integrated company has helped Suncor expand when other companies were simply fighting for survival. There is no doubt that when the oil cycle reverses, the recently acquire assets will pay good dividends to Suncor investors. In addition, it is important to note that all Suncor´s assets are placed in a geopolitical safe environment.

Main characteristics of the oil sands production

The peculiar characteristics of the oil sand production should be clearly understood for assessing correctly Suncor.

One of the main characteristics is the vast and well-known amount of reserves and the low risk of production. There are no exploration risks, as there is no risk of drilling and finding the well dry. In the case of mining, the risk is zero.

On the other hand, the need of initial capital for completing an oil sands project is very high.

So, both, the high amount of capital needed and the vast amount of reserves make the oil sand projects a very long term investment. Short term changes in the oil price have a minimal impact on the oil sands project cost efficiency.

Taking this into account, the oil crude price lows would be an opportunity for those with enough financial resources to take profit of it. Present depressed assets, due to the gloomy feeling of the sector, would be, once oil prices recover to the mean, a cash machine.

This has been the approach followed by Suncor. In less than six months, with the oil price depressed, Suncor made three significant purchases in the oil sands sector and one in the offshore sector to add to the already on-going organic projects.

The fact of being a fully integrated company has helped Suncor to pass under the worst of the oil shrink, while at the same time it has expanded.

Oil sands acquisitions and organic growth

Suncor expects to reach a production of 800000 mbpd by 2018. This production growth is going to be attained by well-timed acquisitions and organically grow.

Source: Suncor

Since the start of oil price shrink in 2014 Suncor has performed three important investments in the oil sands sector, all of them adding more production to Suncor, either forthwith or by 2018:

a) September 2015: Fort Hills 10% stake acquisition for (NYSEARCA:CAD) 310 million, increasing the participation of Suncor to 50.8% and with an estimated capacity of 98 mbpd (Suncor working interest). Suncor should invest (CAD) 700 million extra. The project is expected to finalize by end 2017, being the project currently on schedule. The acquisition represents 19 mbpd extra production for Suncor, being the acquisition valued in (CAD) 47900 per flowing barrel of oil.

b) January 2016: Suncor acquired Canada Oil Sands for (CAD) 4.3 billion, taking Suncor (CAD) 2.4 billion of debt. The total stake of Syncrude acquired by Suncor was 37.5%. 130000 (NYSEARCA:SCO) barrels a day of capacity were added to Suncor production. The deal represented a purchase of (CAD) 52000 per flowing BOE.

c) April 2016: Suncor bought Murphy's stake in Syncrude -5 %- for (CAD) 937 million. The deal increased Suncor's oil sands production capacity by 17500 (SCO) barrels a day, representing 53500 (CAD) per flowing barrel of oil.

Source: Suncor

Taking into account that Fort Hills project costs are (CAD) 84000 per flowing barrel of bitumen, the acquisitions done by Suncor are quite well-priced. They are almost discounted by 40%. Moreover, Syncrude produces (SCO), with a significantly better netback than Suncor´s bitumen.

These purchases have already added 147500 mbpd to Suncor production and the last quarterly report already reflects it. 19000 mbpd more will be added in 2018 when Fort Hills is fully operational.

And we should add the organic growth part, represented by the previous stake held by Suncor in Fort Hills with 69000 more mbpd to add by 2018.

In the table below are compared the three recent acquisitions with Suncor original Fort Hills project. As it can be seen the three acquisitions have a strong discount, quite impressive in the case of Syncrude. If the (NYSE:WTI) trades at $80 the payback will be only three years.

Cost per flowing Barrel (CAD) Netback:(WTI) $49.35 (CAD) Payback (years) Netback: (WTI) $80 (CAD) Payback (years)
Fort Hills 84000 15,8 14,5 30,8 7,5
Fort Hills (10 % acquisition) 47900 15,8 8,3 30,8 4,3
Syncrude (COS acquisition) 65000 30,1 5,9 60,1 3,0
Syncrude (Murphy acquisition) 53100 30,1 4,8 60,1 2,4
Netbacks for Fort Hills ((WTI) $49.35) are taken from current Suncor bitumen netbacks as stated in the last quarterly operating summary
Netbacks for Syncrude ((WTI) $80) are estimated with current operation cash costs

Source: Author calculations

Oil sands versus shale oil

A typical shale oil project requires little capital, but once in operation, the oil production declines quickly and so does the operating cash flows of the company developing the shale project. So the project cost efficiency is determined by the oil price in short-term.

Many shale oil projects started because of the high oil prices, when exploited after the oil price downturn, have been unprofitable. Several shale oil companies with a poor financial condition have expensively paid bad-timed expansions on the oil cycle highs and some of them have gone bankrupt (i.e. NYSE: MHRCQ).

But this is not the case for the oil sands projects. The investment is on the long, very long term. So when analyzing oil sands producers, a different approach should be followed. The investment on Oil Sands requires a high initial capital and has a very, very long investment cycle, longer even than 50 years. So that means that the full project cost effectiveness is not affected -or it is less affected- by an oil price short-term decline.

For comparison, the purchase of the Harmattan concession by TransGlobe Energy has represented a price of (CAD) 26000 per flowing BOE with an expected life of 20 years. Compared with Fort Hills, with (CAD) 84000 per flowing barrel, seems inexpensive (in fact the Harmattan concession acquisition is, from TransGlobe side, quite well-priced). But if we realize that:

a) Fort Hills complete project life is longer than 50 years, more than twice the expected life of the Harmattan concession.

b) It provides constant output.

c) There is no need periodic drilling for sustaining the oil production, with all the risk it brings with it, as for example drilling dry.

Then the comparison is not so bad for Fort Hills. In addition, if we look at Syncrude´s acquisition, we can see what a bargain Suncor has gotten.

Main factors in Suncor´s earning growth

In our opinion, three factors are going to sustain Suncor benefits growth in the future:

1. An increase in oil production: Suncor´s estimations are 800 mboe/d of production for 2019. Taking into account that 2015's production was 575 mboe/d, there will be a 40% production increase in three years, with 150 mboe/d of growth already attained. And once Fort Hills is finalized in 2018, 98 more mboe/d will be added. In the previous sections, it was explained in detail how this production growth will be attained by Suncor.

2. Decrease operating cash cost: Oil sands operating cash costs have decreased constantly since 2011 -a 30% reduction as can be seen in the picture below- and now Syncrude´s cash costs are expected to decrease even more. The proximity of Syncrude´s operation site will help to find possible synergies with Suncor´s Oil Sands division and achieve further cost reductions.

Source: Suncor

In the pictures below is presented the result of Suncor´s cash operating costs sensibility analysis.

Source: Author. Quarterly earnings sensibility to sash operating costs.

Cash Operating Costs Q4_2015 Q4_2016 E1 E2 E3 E4 E5 E6 E7 E8 E9 E10 E11 E12
(WTI) ($) 43.35 49.35 49.35 49.35 49.35 49.35 49.35 49.35 49.35 49.35 49.35 49.35 49.35 49.35
Production Syncrude(mbpd) 30900.00 187000.00 187000.0 187000.0 187000.0 187000.0 187000.0 187000.0 187000.0 187000.0 187000.0 187000.0 187000.0 187000.0
Production Oil Sands (mbpd) 420000.00 420000.00 420000.0 420000.0 420000.0 420000.0 420000.0 420000.0 420000.0 420000.0 420000.0 420000.0 420000.0 420000.0
Cash Cost Oil Sands (CAD) 28.00 24.95 24.2 23.5 22.8 22.2 21.5 20.9 20.3 19.7 19.1 18.6 18.0 17.5
Cash Cost Syncrude (CAD) 40.00 32.55 31.6 30.7 29.8 28.9 28.1 27.3 26.5 25.7 24.9 24.2 23.5 22.8
Gross revenues ((CAD) millions) 2035.56 3459.05 3459.1 3459.1 3459.1 3459.1 3459.1 3459.1 3459.1 3459.1 3459.1 3459.1 3459.1 3459.1
Operating Cash Costs ((CAD) millions) 1285.63 1604.06 1559.7 1516.6 1474.7 1434.1 1394.7 1356.4 1319.2 1283.1 1248.1 1214.0 1181.0 1148.9
Net earnings ((CAD) millions) -607.28 276.79 321.18 364.28 406.12 446.74 486.18 524.48 561.65 597.74 632.79 666.81 699.84 731.91
(CAD)/$ratio 0.74 0.74 0.74 0.74 0.74 0.74 0.74 0.74 0.74 0.74 0.74 0.74 0.74 0.74
(WTI) (CAD) 58.6 66.7 66.7 66.7 66.7 66.7 66.7 66.7 66.7 66.7 66.7 66.7 66.7 66.7
shares outstanding (millions) 1665.0 1665.0 1665.0 1665.0 1665.0 1665.0 1665.0 1665.0 1665.0 1665.0 1665.0 1665.0 1665.0
$/share (annualised) 0.5 0.6 0.6 0.7 0.8 0.9 0.9 1.0 1.1 1.1 1.2 1.2 1.3
Stock price ((NYSE:PE) = 15) 7.4 8.6 9.7 10.8 11.9 13.0 14.0 15.0 15.9 16.9 17.8 18.7 19.5

Source: Author. Sensibility study of Suncor quarterly earnings to Cash operating cost decrease

3. Increase in the oil price: It is possible that in the next three years would be a significant increase in oil prices. The US Energy Information Administration estimates in $79 the Brent price for 2020 ($58 in the lower scenario and $149 in the higher scenario. See below the prevision provided by (NYSEMKT:EIA)). The average oil price in the last 10 years has been around $80. Just a return to the mean will have a significant impact in Suncor´s income statement.

Source: EIA, 2016

The analysis of sensibility performed to Suncor´s quarterly earnings shows the high impact that oil prices have in Suncor´s earnings. As it can be seen in the picture below, with the (WTI) oil price at $80, Suncor´s quarterly earnings are more than ten times higher than Suncor's current -Q4 2016- earnings.

Source: Author. Suncor´s quarterly earnings versus WTI price

(WTI) sensibility Q4_2015 Q4_2016 E1 E2 E3 E4 E5 E6 E7 E8 E9 E10 E11 E12
(WTI) ($) 43.35 49.35 52.5 55.0 57.5 60.0 62.5 65.0 67.5 70.0 72.5 75.0 77.5 80.0
Production Syncrude (mbpd) 30900.00 187000.00 187000.0 187000.0 187000.0 187000.0 187000.0 187000.0 187000.0 187000.0 187000.0 187000.0 187000.0 187000.0
Production Oil Sands (mbpd) 420000.00 420000.00 420000.0 420000.0 420000.0 420000.0 420000.0 420000.0 420000.0 420000.0 420000.0 420000.0 420000.0 420000.0
Cash Cost Oil Sands (CAD) 28.00 24.95 25.0 25.0 25.0 25.0 25.0 25.0 25.0 25.0 25.0 25.0 25.0 25.0
Cash Cost Syncrude (CAD) 40.00 32.55 32.6 32.6 32.6 32.6 32.6 32.6 32.6 32.6 32.6 32.6 32.6 32.6
Gross revenues ((CAD) millions) 2035.56 3459.05 3720.5 3928.1 4135.6 4343.1 4550.6 4758.2 4965.7 5173.2 5380.8 5588.3 5795.8 6003.3
Operating Cash Costs ((CAD) millions) 1285.63 1604.06 1604.1 1604.1 1604.1 1604.1 1604.1 1604.1 1604.1 1604.1 1604.1 1604.1 1604.1 1604.1
Net earnings ((CAD) millions) -607.28 276.79 538.28 745.81 953.33 1160.86 1368.39 1575.92 1783.45 1990.98 2198.50 2406.03 2613.56 2821.09
(CAD)/$ 0.74 0.74 0.74 0.74 0.74 0.74 0.74 0.74 0.74 0.74 0.74 0.74 0.74 0.74
(WTI)(CAD) 58.6 66.7 70.9 74.3 77.7 81.1 84.5 87.8 91.2 94.6 98.0 101.4 104.7 108.1
shares outstanding ( millions) 1665.0 1665.0 1665.0 1665.0 1665.0 1665.0 1665.0 1665.0 1665.0 1665.0 1665.0 1665.0 1665.0
$/share (annualised) 0.5 1.0 1.3 1.7 2.1 2.4 2.8 3.2 3.5 3.9 4.3 4.6 5.0
Stock price ((PE) = 15) 7.4 14.4 19.9 25.4 31.0 36.5 42.0 47.6 53.1 58.6 64.2 69.7 75.2

Source: Author calculations. Sensibility study of Suncor quarterly earnings to oil price

The probability of increasing oil production, according to Suncor own estimations, is almost certain. Syncrude´s acquisition is already adding more output to Suncor and Fort Hills is running on schedule. So Suncor´s estimation should be taken as correct.

The probability of cutting the operating costs is also high, especially those of Syncrude. Finally, the increase of oil price is possible too. And in the case of a short-term decline in the oil price, there would be another opportunity to acquire Suncor shares at even better price.

Oil Price Increase, Cost Production Reduction, and Oil Production Increase Combined

Let's analyze what would happen in the case that the three factors affecting Oil Sands earnings vary in the right direction. Let´s assume a WTI price of $80, a significant reduction in the operating cost in Syncrude and Suncor Oil Sands - (CAD) 24, and (CAD) 19- and Fort Hills producing at the nominal rate (98000 mbpd of bitumen).

Just to try to make the analysis more realistic, let's fix the United States Dollar to Canadian Dollar exchange rate, that will work in the opposite direction, to 1. In that instance, the quarterly earnings will escalate to (CAD) 1.8 billion. Were this sustained in time, Suncor stock value, just from the Oil Sand earnings contribution, will more than duplicate current prices.

Cash Operating Costs Q4_2015 Q4_2016 E1 E2
(WTI) ($) 43.35 49.35 52.50 80.00
Production Syncrude (mbpd) 30900.00 187000.00 187000.0 187000.0
Production Oil Sands (mbpd) 420000.00 420000.00 420000.0 420000.0
Fort Hills (mbpd) 98000.0 98000.0
Cash Cost Oil Sands (CAD) 28.00 24.95 25.0 19.0
Cash Cost Syncrude (CAD) 40.00 32.55 32.6 24.0
Gross revenues ((CAD) millions) 2035.56 3459.05 4096.9 4772.6
Operating Cash Costs ((CAD) millions) 1285.63 1604.06 1757.3 1380.3
Net earnings ((CAD) millions) -514.27 276.79 761.34 1814.06
(CAD)/$ 0.74 0.74 0.74 1.00
(WTI) (CAD) 58.6 66.7 70.9 80.0
shares outstanding (millions) 1665.0 1665.0 1665.0
$/share (annualised) 0.5 1.4 4.4
Stock price ((PE) = 15) 7.4 20.3 65.4

Source: Author calculations

Waiting for oil price recovery: Suncor dividends and financial position

For ending a few words on Suncor`s dividends. Although it appears clear that oil prices are going to recover, it could take some time until it occurs. While waiting for the recovery, investors will receive around a 3% annual dividend.

Even with all the new asset acquisition (more than (CAD) 8.5 billions), Suncor not only has continued paying its dividend regularly but also has increased it. It should not be discarded that Suncor could increase the dividend again, as the recently acquired assets continue increasing benefits.

Suncor´s financial position remains strong, even after the expansion performed. Some disinvestment, as the sale of the lubricant division of Petrocanada and the emission of shares to fund part of the Syncrude acquisition, have allowed Suncor to continue with a strong financial position, with a debt to equity ratio below 0.4.

Source: Suncor

Risks

One of the major risks facing Suncor is an environmental regulatory change affecting oil sands operations.

The environmental impact of oil sands is high and it includes:

a) Deforestation: loss of vegetation and habitats, decrease of the carbon capture and therefore an increase of total carbon footprint of Canada.

b) Carbon dioxide emissions during operation: Due to (NYSE:GHC) direct emission. The company is working intensively to reduce the percentages of emission, but even though the emission remains high. The global oil sands sector is reported to produce more than the 9% of Canada`s carbon emissions.

c) Pollution: Air and water pollution. Through emission of the noxious pollutants to the air and accumulation of toxic waste in tailing ponds.

The high environmental impact can lead to environmental laws that will require cleaner operation methods with greater costs, operating license denial for new projects or the establishment of general green taxes to carbon dioxide emissions and pollution.

Summary

Suncor is a clear winner of the oil downturn. Since the oil price reversal, it has bought three well-priced projects in the oil sands sector. They will add, together with the finalization of Fort Hills, over 250 mbpd to its production by 2019. Suncor had already earlier interests in the assets acquired. Now Suncor has majority in these projects, which are in the same area where its main operations take place. This will allow Suncor to look for common synergies to reduce operating costs.

The growth in production brought by new holdings is already paying benefits and they will increase to higher levels once the oil prices turn upwards. The analysis performed shows that the stock has an extraordinary potential.

Not only has Suncor kept paying its dividend with the new holding acquisitions (more than (CAD) 5.5 billion), but also it has increased it. Moreover, Suncor operation sites are placed in a geopolitical safe region, although environmental regulation could affect the company operations.

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.

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