Suncor Energy Inc. (SU) – Not The Time To Sell by Burgandy Blog

Suncor Energy Inc. (Suncor) announced a hostile offer to buy all of the outstanding shares of Canadian Oil Sands Limited (COS) on October 5, 2015. As the owner on behalf of our clients of COS shares, Burgundy will not accept the original Suncor offer. In this issue of The View from Burgundy, we outline why. In short, COS owns a stake in a unique and extremely valuable long-term asset, a scarce resource that is almost impossible to replicate. And the price Suncor is offering, representing one-half of what it would cost to recreate this asset (if it was possible), is unacceptable.

The Battle for Syncrude

COS is a pure play “upstream” oil production company. It owns 37% of the Syncrude Canada Ltd. (Syncrude) joint venture, an oil sands mining operation near Fort McMurray, Alberta (see Figure 1). Suncor is the largest oil company in Canada and owns a 12% stake of the Syncrude joint venture. Besides producing oil mainly in Alberta’s oil sands, Suncor also has a large “downstream” business that processes the raw material into useable products and sells them to end users. This business unit operates in a very profitable oligopoly in Canada and is rewarded for scale economics. It is also benefiting from a glut of Canadian oil production that lacks sufficient pipeline takeaway capacity. This depresses its local raw material costs and allows it to earn fat margins on end products like gasoline that sell at higher prices based off of global benchmarks. As such, it is generating substantial profits, even in this depressed oil price environment.

Suncor acquired its stake in Syncrude through its 2009 acquisition of Petro-Canada. That deal worked out brilliantly for Suncor, coming as it did at the bottom of an earlier oil price cycle. Besides the Syncrude stake, the Petro-Canada purchase brought Suncor most of its downstream refining assets, whose profitability is allowing the company to ride out this current period of weak oil prices. To its credit, Suncor is trying to recreate this magic with the counter-cyclical COS offer.

Both COS and Suncor can trace their respective histories back to the two original oil sands mines in Alberta: Great Canadian Oil Sands and Syncrude. Suncor emerged from the Great Canadian Oil Sands consortium, which began production in 1967, while Syncrude started operating 11 years later. Both operations produce bitumen, or oil that is too heavy to flow on its own, which is extracted from oil-soaked sands located at the earth’s surface using shovels and trucks. This “heavy oil” is then processed and upgraded into light oil that refiners  prize because it can be converted into very valuable end products like diesel, jet fuel and gasoline.


A Valuable Asset

Oil sands mines are attractive assets for several reasons. First, once built, they produce oil at steady rates for many decades. This stable production makes these assets very valuable. In contrast, conventional oil wells see their production rates steadily decline.

Conventional producers are on a treadmill where they must continually discover or acquire and then develop new sources of production.

Canada’s oil sands mines also contain huge reserves in a world where non-government oil companies are increasingly challenged to own resources. It is estimated that more than 85% of the world’s oil and gas reserves are held by government-owned national companies like Saudi Aramco. As such, the ability for private sector companies to control billions of barrels of reserves and decades of future production is a valuable commodity.

In addition, many oil reservoirs are located in politically risky areas like Venezuela, Nigeria and the Middle East. Again, getting access to huge proven reserves in a safe political locale for shareholders
is valuable.

Fewer Risks

The billions of barrels of reserves that oil sands mines control in a safe political locale means they have far less operating risks to manage. Importantly, oil sands mines have no reserve risks. Conventional oil properties can perform less than expected – they can “water out” or fall prey to other geologic risks. This exposes their owners to potentially large losses and wasted investment spending. With the oil sands mines, the reserves are there.

And oil sands mines have no exploration risk. Conventional oil companies that are on the treadmill caused by ongoing well declines must constantly replace their produced reserves via exploration or the acquisition of someone else’s discovered reserves. Unlike the reserves at the oil sands mines, there are no guarantees that future exploration will be successful.

Lastly, once built, the oil sands mines are subject to limited capital spending risk. While intermittent projects to move equipment away from produced areas to undepleted zones must be undertaken, by their nature the oil sands mines do not face the consistent investment risks that conventional companies do as they continually attempt to replace their produced reserves. Again, there are no guarantees that conventional reserves can be replaced in a cost-effective manner.

A Scarce Asset

In economics, scarcity helps determine value. It is why diamonds, a non-vital commodity to most, are so much more valuable than water, which is a necessity for life. A high value is realized because diamonds are rare. Oil sands mines are rare too.

Alberta’s oil sands are unique on a global scale.

Oil sands production only accounts for 5% of global oil production. Only Venezuela has similarly sized deposits, but high political risk has led to minimal development. These are indeed scarce assets.

In addition, most of Alberta’s oil sands are too deep to mine. Of the 140,000 square kilometres of oil sands, more than 135,000 are located far too deep where expensive steam must be injected to allow the oil to flow to surface. That is why there is only a half-dozen oil sands mines in Canada where the oil-soaked sand deposits are shallow enough to economically mine.

So an ownership stake in a rare surface deposit like Syncrude’s is a scarce asset.

A Pure Play

A “pure play” is an investment security that is made up of a single type of asset. In finance theory, because investors can optimize their own portfolios by selecting a collection of individual investments according to their unique risk tolerances and goals, pure plays are especially attractive. Pure plays typically trade for higher valuations as stand-alone securities, rather than when the assets are hidden inside conglomerates where a diverse collection of assets typically trades at a large “conglomerate discount.”

COS’s share of the Syncrude oil sands mine is its only asset. Moreover, all the other oil sands mines are owned inside large, multinational oil companies that have many assets. COS is thus the only way for investors to gain “pure play” exposure to oil sands mining, itself a scarce resource. While this uniqueness may not be worth much at the bottom of the oil price cycle, it can have very positive effects on valuation in stronger oil price environments, as we shall see.

Huge Exposure to the Price of Oil

Oil sands mines are fixed-cost businesses. Once a mine is operating and incurring expenses, it costs almost nothing extra to produce an incremental barrel of oil. So the mines produce what they can, regardless of the price of oil.

Operating costs to run a mine are higher than for

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