SU (OP/A): Inflated concerns over oil sands cost inflation
Goldman Sachs May 31, 2005
We believe that oil sands projects can achieve excess returns even at a $30/bbl mid-cycle oil price and that Suncor Energy can maintain its returns advantage relative to the majors and domestic oils. We believe that Suncor shares can be revalued to US$55.
We continue to rate Suncor Outperform relative to an Attractive coverage view. Please see our detailed 24-page report, "Inflated concerns over oil sands cost inflation." If you are on our e-mail distribution list, a .pdf will be sent today.
Oil sands projects are sustainable with excess returns at $30/bbl We believe internal rates of return for most mining and upgrading oil sands expansion projects are around 10%, above cost of capital, reflecting current estimated capital costs and assuming $30 per barrel WTI over the life of each project. Cost of capital returns can be achieved at oil prices of slightly below $30 per barrel in our view, in contrast to Street consensus that $40 per barrel or greater WTI oil prices may be needed. Significant resource and growth potential remains using existing technology, even for future mining projects, a key competitive advantage in an environment where more conventional sources have matured and access in non-OECD areas is often restricted. Technological advances can improve growth and returns, mainly by lowering gas consumption and improving in-situ process and reliability.
The Street is too concerned with cost inflation Both operating and capital costs are higher, due to four factors: higher natural gas input costs, higher steel prices, appreciation of the Canadian dollar versus the US dollar and increased labor costs. Each of these factors is cyclical rather than secular - assuming $30 per barrel WTI oil prices, we would expect a weaker Canadian dollar, lower steel costs and lower natural gas prices. While we see potential for some oil sands projects to be delayed to smooth out demand for construction workers, we nevertheless believe that the labor market can rebalance over time and that labor costs would fall in a $30 per barrel oil price environment. Cost inflation is not exclusive to oil sands, and in fact we see greater potential for cost decreases in oil sands operations than we do for conventional oil and gas production. Much of the cost inflation for conventional oil and gas producers has been due to rising finding and development (F&D) costs, a secular increase.
Suncor's existing operations and expansion projects have superior IRRs Suncor showed superior returns to other measurable oil sands projects in 2004, especially when considering its higher royalty rate. We expect Suncor to continue to show higher cash flow returns versus majors and domestic oils over a five-year period going forward, as it has since 1995-99. Suncor's Voyageur expansion is currently expected to show superior returns to other mining/upgrading projects such as Horizon, Fort Hills and Syncrude. Suncor is uniquely positioned as a company that has numerous expansion projects while still simultaneously benefiting from today's high commodity price environment. If capital costs remain high for Suncor's current expansion spending, WTI prices should also stay high, which should give Suncor better-than-expected cash flows. We see more risk for companies which are currently constructing their first oil sands facility and are not benefiting from high WTI prices.
Valuation attractive; ramp up from fire could be initial catalyst toward $55 per share We believe the fire at Suncor's #2 upgrader has created a buying opportunity in its shares with production expected to restart in 4Q2005 and expand to a capacity of 260,000 bpd. While Suncor shares trade at premium valuation to those of other oil and gas companies, we see no Street consensus on how to value Suncor, and we believe that Suncor's strong secular growth rate is not fully reflected in its current enterprise value/gross cash invested multiple. Cyclical semiconductor companies are the closest comparable companies to Suncor in terms of growth and returns, in our view. We believe that Suncor shares are trading below both mid-cycle and peak values on that basis. We see 5% upside to a $40 per share mid-cycle value and 44% upside to a traditional $55 per share peak value, both of which still assume discounts to the 1.5X and 2.0X enterprise value/gross cash invested (EV/GCI) semiconductor-based mid-cycle and peak multiples, respectively. Suncor today trades at about 1.3X EV/GCI.
Each of the analysts named below hereby certifies that, with respect to each subject company and its securities for which the analyst is responsible in this report, (1) all of the views expressed in this report accurately reflect his or her personal views about the subject companies and securities, and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report: Brian Singer, Arjun Murti. |
