Oddball Stocks Newsletter Excerpt - Canadian Oil Sands (Issue 37)

 This is an excerpt from our Feature article in Oddball Stocks Newsletter Issue 37 (November 2021), "Value in 'Dying' Industries":

One of our theories is that mineral landowners (i.e. energy royalties) and pipelines are the best part of the hydrocarbon value chain. In particular, we shy away from explorers and producers, which have trouble creating as much long term value for shareholders because management's incentives are bad. They get paid to grow asset size, and they only have the money to do that at the top of the cycle when properties are expensive. An exception to this is oil producers with very long reserves. If you have decades worth of oil in the ground, you can focus on producing it instead of trying to outbid other producers for new reserves. The prime examples in this category are the major Canadian oil producers.

Suncor Energy is fully integrated with oil sands, conventional oil production, refining (462k bbl/d), and retail operations. Together, Cenovus and Suncor produce about as much oil (~1.2mm boe/day) as the entire Bakken region in North Dakota, or a smaller OPEC member like Algeria or Angola. The big story with Suncor's business is the upstream (oil sands and conventional) production, which produced almost 700k barrel of oil equivalents per day in the third quarter, of which 600k was from oil sands production. Oil sand is a mixture of bitumen, sand, clay, and water. It does not flow like conventional crude oil which is a liquid; it must be mined or heated underground before it can be processed. Suncor extracts bitumen in two ways: mining and in situ.

About 20% of the oil sand is close enough to the surface (under 200' depth) to be mined. They use large trucks and shovels to extract these, and then use hot water to separate ("extract") the bitumen from the sand. Bitumen is heated and sent to drums where excess carbon (in the form of petroleum coke) is removed. Vapors from the coke drums are sent to fractionators where they condense into naphtha, kerosene and gas oil. The end product is synthetic crude oil, which is shipped to refineries across North America to be further refined into jet fuels, gasoline, and other petroleum products.

The other 80% of oil sands are too deep to be mined with trucks and shovels. This is extracted in situ, using Steam Assisted Gravity Drainage. Horizontal wells inject steam to heat the reservoir of underground oil sands. The heat separates the bitumen and gravity brings it into a lower horizontal well bore which collects it and pipes it to upgrading facilities.

Suncor was founded in 1919 as Sun Company of Canada, a subsidiary of Sun Oil. In 1979, Sun formed Suncor by merging its Canadian refining and retailing interests (Great Canadian Oil Sands) and its conventional oil and gas interests. In 1995 Sun Oil divested its interest in the company and Suncor became an independent public oil company. In 2009, Suncor merged with Petro-Canada, a downstream refiner and retailer. In 2016, Suncor acquired Canadian Oil Sands, which had a 37% ownership stake in a project called Syncrude in Alberta. Together with Suncor's existing 12% ownership of Syncrude and the purchase of Murphy Oil's 5% stake, Suncor became the majority shareholder in the project, which produces 350k bbl/d from the Athabasca Oil sands outside Fort McMurray, Alberta.

Suncor is listed on both the NYSE (SU, US$25) and the Toronto Stock Exchange (SU.TO, CAD$31.67). (As you can see, a CAD$ is equal to 0.79 US$). The market capitalization is $36 billion. (This and other figures in US$.) They have $15 billion of debt at Sept 30 and $1.9 billion in cash for net debt of $13.5 billion and an enterprise value of $49 billion. (Suncor is able to borrow long term very cheaply: their debt due in 2047 yields only 3.2%.)

For the third quarter, Suncor's cash from operations (excluding changes in working capital) was $2.1 billion and its capital expenditures were $990 million, for free cash flow of $1.2 billion. That's just for the quarter: annualized that would be $4.8 billion. They have another metric that they call "discretionary free funds flow," which was $1.2 billion for the quarter as well.

Keep in mind that WTI oil in the third quarter averaged $71 and WCS crude sold at an average $13.6/bbl discount to this. Crude oil is now $10 higher (low $80s) and the differential is about $16/bbl, for a crude oil realization that's about $7.5 higher. The FCF yield on the current enterprise value is 10% at a lower oil price than today. That provides room, even if oil prices were to retrace from here, to pay a 5.6% dividend ($1.36 US on $24.18 share price) and buy back significant amounts of stock, i.e. 4.4% of the market cap annually if the share price and earnings stay at this level. So no wonder they are buying back stock aggressively. You will also notice that in the third quarter they returned 83% of free cash flow to shareholders through dividends and buybacks.

As of December 31, 2020, Suncor had proved and probable (2P) reserves, net of royalties, of 6.7 billion barrels of oil equivalent. This was calculated when oil prices were lower, which would mean that less of the resource was booked as being profitable to extract than may ultimately be extracted. At the present production rate of ~0.7 million barrels of oil equivalent per day, or 255 million barrels per year, those 2P reserves are enough to last for 26 years. And the enterprise value per 2P barrel of oil is $7, a figure about the same as Cenovus. (This also ignores the value of Suncor's refining and marketing operations.) The oil sands business spent $2.2 billion to produce about 54 million barrels of oil during the quarter, which is a production cost of $40 per barrel.

Another Canadian oil producer is Cenovus Energy, listed on the NYSE (CVE, US$12.12) and the Toronto Stock Exchange (CVE.TO, CAD$15.34). The current market capitalization is US$24 billion and the enterprise value is $37 billion. The third quarter's CAD$1.7 billion of free cash flow, which annualizes to CAD$6.8 billion (US$5.4 billion) gives a FCF/EV yield of 15%. Thanks to the leverage and the low cost debt, Cenovus equity is trading at only about 4.4x cash available for distribution. Also impressive is the level of FCF conversion; out of $2.3 billion CAD in adjusted funds flow, $1.7 billion is "free" (in excess of capital expenditure), which is 72%. Management commented on further uses of cash flow in the Q3 conference call:

“We finished the third quarter with net debt of about $11 billion, a reduction of $1.4 billion since the end of the second quarter. And today, we are very close to achieving our interim net debt target of below $10 billion, which takes me to our shareholder returns announcement. We have been clear that increase in shareholder returns would be our first priority, upon reaching our interim net debt target. Delivering on that commitment, our Board has approved doubling the dividend on our common shares effective for the fourth quarter dividend to $0.14 per share. In addition, the Board has approved filing of an NCIB application with the TSX for share buyback program of up to about 150 million common shares, which we expect to commence following the achievement of net debt below 10 billion. We will provide more context on how we think about capital allocation at our virtual investor day on December 8th. However, as we have said previously, when we are below 10 billion net debt, you should expect to see a more balanced approach to free funds flow application between further de-leveraging and shareholder returns. And at current commodity prices, we would expect to be able to execute our buyback plan in 2022, while achieving net debt under eight billion around mid-year.”

Dorchester Minerals, L.P. (DMLP) was mentioned by a participant at the February 2019 Oddball Meetup, and in Catahoula's Issue 26 guest piece, “A Report from the Pasture”. It is a publicly traded partnership that owns royalty, overriding royalty, and net profits interests in crude oil and natural gas acreage in multiple basins nationwide. Unlike exploration and production companies that drill wells, Dorchester has no debt, little capital expenditures, and high margins.

The current market capitalization of Dorchester is $631 million, and year-to-date it has earned $54 million of EBITDA. Free cash flow conversion is extremely high (actually above 100% due to the sale of some properties). The result is that the FCF yield to the enterprise value (annualizing the first three quarters' results) is about 11.9%, but of course this was in a lower oil price environment than what is prevailing now. (Dorchester distributed $48.2 million to limited partners in 2020. Their average selling prices of oil were high $40s/bbl and for natural gas a bit below $2/mcf.)

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