Suncor Energy (OP/A): Oil sands remains attractive despite 2Q 2005 noise
Goldman Sach July 28, 2005
We continue to recommend Suncor Energy shares due to our belief in long- term oil sands returns and free cash flow, our medium-term expectations for continued strength in oil prices and positive expected short-term newsflow regarding insurance proceeds and production resumptions. While Suncor's 2Q 2005 was noticeably weaker than expected, much (though not all) could be attributed to noise surrounding the January upgrader fire, and is not necessarily sustainable. While we worry about capital costs, we believe that further inflation will be a function of commodity price strength and that Suncor will be compensated for higher costs in the form of higher-than- expected cash flow. We see 11% upside to a $55 traditional peak value. Suncor is rated Outperform relative to an Attractive coverage view.
KEY COMPANY-SPECIFIC CATALYSTS
(1) Timing of upgrader start-up and insurance proceeds. The company is on track for the #2 upgrader to be back online this quarter and back to full production by the end of the quarter. This was the company's initial expectation after assessing fire damage in January. In addition, Suncor is receiving insurance proceeds at faster-than-expected levels. We believe that Suncor should receive additional payments for upgrader replacement and business interruption of US$915 million net of royalties, which we have currently allocated into 2006. We expect continued earnings noise during 3Q and 4Q 2005 from the January upgrader fire and believe that 1Q 2006 will be the next clean quarter.
(2) Capital and operating costs. While we are concerned regarding higher oil sands costs, we believe the Street is too focused on the issue which has impaired multiple expansion for Suncor. Both capital and operating costs have risen, but mainly due to four cyclical factors: the stronger Canadian dollar vs. the US dollar; increased natural gas costs; greater steel costs; and the impact of the labor boom on the availability and cost of labor. The Street is concerned that in a lower oil price environment, these factors will impede returns. We disagree on all four factors and believe that in a lower oil price scenario, costs would fall as well. The stickiest is labor cost, though we believe that even the Ft. McMurray labor market can get back to balance in a $30 per barrel WTI oil price environment. We believe that cost pressures will be more sticky for conventional oil and gas producers where it is secularly more expensive to find new reserves due to geologic maturity. Strong oil prices are the driver of higher oil sands costs, and if costs continue to rise, it should be because oil prices remain high. For companies that have strong sources of production that receive close to WTI oil prices such as Suncor, higher costs should be offset by higher-than-expected cash flow.
(3) Developments toward 2010-12 expansion. We believe there is a good deal of skepticism regarding returns from Suncor's Voyageur expansion, which is expected to add 200,000 bpd in 2010-12. The company is working toward identifying the source of feedstock for the upgrader - further in-situ expansion at the Firebag steam assisted gravity drainage (SAGD) operation, mining expansion or third party processing. The final result is expected to be a mix of all three. Given that Suncor's Firebag operation has been slow to ramp up to full capacity and has been consuming greater-than-expected levels of natural gas per barrel of production, the Street is skeptical of the reliability of a SAGD expansion. Suncor is also still in the exploratory drilling phase to test the extent of additional mining opportunities. While we understand that there is some lack of visibility on sourcing later-year growth, we nevertheless believe that SAGD will mature and that management will allocate capital wisely regardless of the SAGD/mining split.
For greater detail on oil sands and on Suncor's expected expansion returns versus other oil sands projects, please see our May 31 report, "Inflated concerns over oil sands cost inflation." Message 21372738
2Q 2005 RESULTS BELOW EXPECTATIONS
Suncor reported generally weaker than expected 2Q 2005 operating and financial results. Reported EPS of US$0.19 ($0.21 adjusted for special items) was below our estimate of $0.23, reflecting lighter than expected production and price realizations combined with higher than expected unit costs. Adjusted earnings would have been an estimated US$0.10 when deducting insurance proceeds. Operating cash flow of $245 million was below our estimate of $262 million. Net oil sands production of 109.6 Mb/d and natural gas production of 138 MMcf/d were below our estimates of 113.2 Mb/d and 155 MMcf/d, respectively. Costs were generally higher than expected, with all-in unit costs averaging $32.71 per BOE versus our estimate of $27.70 per BOE. The average oil sands price realization was $36.95 per barrel versus our estimate of $38.90 per barrel, while realized natural gas price of $5.86 per Mcf was slightly above our estimate of $5.60 per Mcf. Downstream performance in Canada was weaker than expected due to a refining margin of $12.63 per BOE versus our estimate of $17.00 per BOE. However, US refining volumes and margins were strong, contributing to US downstream EBITDA of $40 million versus our estimate of $18 million. Net debt/tangible capital was 36% at quarter-end.
UPDATING ESTIMATES
We have updated our quarterly 2005 and full-year 2006 EPS estimates to incorporate changes to our assumptions for production and unit costs as well as the level and timing of insurance proceeds. We now estimate EPS of $0.21 for 3Q 2005 ($0.27 previously), $0.65 for 4Q 2005 ($0.69 previously), and $1.23 ($1.25 adjusted) for full-year 2005 ($1.37 previously). Our 2006 EPS estimate is now $4.65 versus $4.50 previously. There are no changes to our 2007-2010 (normalized) EPS estimates.
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. |
