Canadian Natural Resources: The Case for Tar Sands

| About: Canadian Natural (CNQ)

The higher the price of oil goes, the more the need for that heavy, gooey, sticky stuff we call "tar sand" that is found in abundance in certain provinces of Canada.

There is a particular company poised to benefit greatly, and its stock price might double over the next 18 months as a result.

Matt Badiali is, as far as I'm concerned, one of the finest energy company analysts in North America. I've subscribed to his S&A Oil Report from its inception and I can't speak too highly about it. Following his recommendations has made me mucho dinero.

He recently visited the tar sands area in Alberta, Canada and sent me an important report that reflects the quality of his workmanship and analysis.

Canadian Natural Resources (NYSE:CNQ) produces about 525,000 barrels of oil and gas per day. Eight and a half out of every 10 barrels comes from Canada.

The company also trades on the Toronto Stock Exchange, where it's one of the three largest listed oil companies. At $56 billion in market value, it's just larger than one of its rivals, Imperial Oil.

The company's management makes a point of not crisscrossing the globe, following the crowd and chasing the latest discoveries. Rather, this company specializes in specific locations and controls as much as possible. Canadian Natural Resources knows tar sand, and it dominates the region.

Heavy oil and tar sand reserves are different from conventional oil and gas because they produce steadily for many years. Conventional oil fields go through sharp peaks and declines. For example, the Cantarell field in Mexico was discovered in 1976. Its production peaked in 2004-2005 and has begun a steep decline. In contrast, the heavy oil fields in Kern County, California, produced several billion barrels of oil over the last century.

Canadian Natural Resources holds many deposits in Athabasca similar to the Kern County fields.

For example, the company's latest giant tar sand project is the Horizon mine. Canadian Natural Resources will begin production at Horizon in the third quarter of 2008. The company will gradually ramp up production in five phases culminating in 2017. At full tilt, it will produce 40 million barrels of light, sweet, synthetic crude per year.

The company also has three heavy-oil projects in Alberta – Birch Mountain, Gregoire Lake, and Kirby – that will come on line between 2011 and 2023. Those three projects will add another 210,000 barrels per day. That means within the next 15 years, this company will produce more than a million barrels of oil per day.

Finally, the company pumps heavy oil at several projects in the region. Canadian Natural Resources produces about 600,000 barrels of oil equivalent (oil and gas together) per day from fields in the North Sea and off the coast of Africa.

I'm not as interested in the offshore assets because, while they add value to the company, they aren't going to add hundreds of thousands of barrels of production per day like the tar sands will.

We're investing because of those huge, long-lived assets.

How Does Canadian Natural Resources Compare

The company's management is unique compared with similar, mid-sized oil companies, in that it holds $1.66 billion in shares, nearly 10 times the management of Devon Energy, the next closest in ownership. Canadian Natural Resources touts that fact because it shows the managers' priorities are the same as your priorities… I agree.

The company's performance since 1989 reflects the management's financial stake. Just 20 years ago, Canadian Natural Resources was worth about $1 million and produced just 1,400 barrels of oil per day. A decade later, production rose to 200,000 barrels per day and the market value rose to $3.7 billion. In the first quarter of this year, the production is split, 44% natural gas and 56% oil, and averages 583,000 barrels and barrel-equivalents per day.

Oil production more than doubled in less than 10 years.

The company's financial position is stable and liquid. The cash flow from operations hit $1.7 billion in the first quarter.

The company has $2.6 billion in bank lines waiting for a rainy day. In addition, it locked in prices on some of its current oil and gas production to protect its investment in the Horizon mine.

The company borrowed heavily to build Horizon. Its current debt is about 1.4 times its earnings, but that ratio will shrink as the mine goes into production this year and the company begins paying down the debt.

The company's reserves are priced exceptionally low. You get about 3.7 barrels of oil for every share of Canadian Natural Resources you buy. Those barrels sell for more than $90 each right now. So you pay $105 per share for $330 worth of oil.

In other words, we're buying oil for $28.40 per barrel.

At first glance, Canadian Natural Resources doesn't look cheap. It trades at nearly 20 times earnings and has a paltry 10¢-per-share dividend. However, that's a false impression. Two metrics I use tell me this company isn't as expensive as it looks...

The first thing I use is the price to reserves. This tells us how much we pay for the company's oil in the ground. And as I wrote, with Canadian Natural Resources, we're buying at $28.40 per barrel.

The next thing I calculate is how much we pay for a barrel of oil produced in a year.

That's a new one for the S&A Oil Report readers. I don't usually base an investment on it. But I'm using it for Canadian Natural Resources because of the impending production.

Canadian Natural Resources price -to -reserves is only $28.41 per barrel. Its price per barrel of production is $29.

The other four companies that are tar sand producers Imperial Oil (AMEX:IMO), Husky (OTCPK:HUSKF), Nexen (NYSE:NXY) and Suncor (NYSE:SU) (except Nexen, which has pending production). Also, all those other companies trade at a much higher price to production than CNQ.

That means, when Horizon comes on line, we should see it gain about $11 billion in market value… or 20% from its current price. That's at $291 per barrel. But the average price per barrel of production of the top 10 Canadian oil companies is $357.

That's our safety net.

It would be tough for Canadian Natural Resources to fall far when the rest of the industry is valued much higher. It would take a collapse of the entire group, which is always a risk.

However, as the tar sands get more recognition in the market, I expect the value of Canadian Natural Resources' production to approach its peers. Two of the closest companies to ours are Imperial Oil, an ExxonMobil subsidiary, and Suncor, the giant oil sand miner.

Price per barrel of production/ Our gain with Horizon's production

  • $291 – Current 25%
  • $357 – Industry Average 54%
  • $493 – Imperial Oil 112%
  • $639 – Suncor 175%

While I don't think Canadian Natural Resources will suddenly leap up 175% in one year, I do think the company will close the gap with its peers as Horizon starts producing next year.

Here's why: Canadian Natural Resources beat earnings expectations on average by 20% over the last four quarters. The analysts' average forecast predicts earnings will rise from $5 per share this year to $7 next year. If the average holds up, the company will hit $6 per share this year and nearly $8.50 next year.

If that happens, smart investors will follow us into the stock, simply because of the strong earnings growth. That will drive our price to production metric up towards $357 per barrel and we'll make a 50% gain.

On top of that, the company averaged 33% growth, every year for the last five years. If the company remains consistent we could see an 80%+ gain for the year.

I'm not recommending this stock as a get-rich-quick oil speculation. And I continue to recommend Oilsands Quest (AMEX: BQI) as the best speculation in the region.

Rather, Canadian Natural Resources is a long-term growth investment. I think of it as the ExxonMobil of the oil sands. As demand for oil continues to outrun supplies, the projects like Horizon will become more valuable with time. You could pass along these shares to your grandchildren like investors of the 1950s did with Exxon's."

Analysts like Matt think CNQ is buyable up to $115 a share, and that might be true if you are willing to hold the stock for at least two years.

I'd much rather buy it on pullbacks below $100. The first time I bought CNQ, back in the beginning of this year, I paid around $78, but I don't think we are going to see that price again for quite awhile.

If the Goldman Sachs analyst who predicts $150 oil by the 4th of July is correct, stocks like CNQ might be going higher from here before they correct, that is why being a long-term buyer sure makes sense with this one.

CNQ is one that the rumor mill thinks is a takeover target in the near future. It would make a good fit with a company like BP (NYSE:BP) Apache (NYSE:APA) or ConoccoPhillips (NYSE:COP), but there is nothing officially "in the wind". All we know is that CNQ is a decent value with remarkable assets at the current level. Caveat Emptor!

Disclosure: none

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