Suncor Energy (OP/A): Super-spike not being priced in, even assuming significant cost inflation Goldman Sachs August 22, 2005
We continue to believe that oil sands shares can continue to be a major beneficiary of higher near-term and long-dated oil prices, and we continue to recommend shares of Suncor Energy. While oil sands shares have rallied significantly since mid May, we believe that Suncor's current valuation represents expected "traditional peak values" with further upside to super- spike adjusted peak values. We believe that capital cost inflation will play a greater role assuming a super-spike in oil prices, but that Suncor's Voyageur expansion would have to see more than 120% cost inflation before it would be dilutive to our $75 per share super spike-adjusted peak value. We rate Suncor Outperform relative to an Attractive coverage view.
OIL SANDS COMPANY SHARE PRICE PERFORMANCE HAS BEEN IN TOP TIER
Since the end of May, shares of Suncor Energy have risen 41%, versus 37% for a basket of oil sands companies in the Goldman Sachs Custom Canadian Oil Sands Index. While many of the companies in the basket have been top performers among oil and gas producers, we believe that the rally in oil sands shares can continue. We continue to believe 2006 Street commodity price expectations are too low, and that near-term and long-dated oil prices will remain above expectations for the medium term.
AND CURRENT VALUATION CLOSING IN ON TO "TRADITIONAL PEAK" SCENARIO
We attribute much of the rally in oil sands shares to reduced concerns that oil sands economics will generate sub-par returns in a lower oil price environment. Suncor's current valuation supports this notion, with EV/gross cash invested approaching the 2.0x level that we believe fairly prices in the combination of the manufacturing nature of Suncor's business, a 10% annual volume growth rate and Suncor's full-cycle returns. Assuming that continued spending were to receive this multiple, Suncor shares could get beyond our $55 traditional peak value.
SUPER-SPIKE NOT BEING PRICED IN, AND OIL SANDS COULD BE MAJOR BENEFICIARY
We believe shares of oil sands companies are not pricing in upside from a super-spike period in oil prices that we believe we have entered. While we see similar levels of upside from other oil and gas stocks, we believe that from a trading perspective oil sands shares can continue to outperform those of conventional oil and gas companies because of the vast resource potential that could be profitably tapped in an environment of higher long-dated oil prices. We believe that oil sands companies are unique in having resource for multi-year growth in sharp contrast to conventional opportunities that are relatively resource-starved.
CASH FLOWS FROM HIGH OIL PRICES SHOULD OFFSET COST INCREASES
When assuming higher oil prices in a super-spike scenario, one must also assume further cyclical cost inflation in the oil sands business. Budgets continue to rise above expectations (the Athabasca Oil Sands Project being the most recent victim), and we do not see costs decreasing assuming flat or higher oil prices from current levels. However, there are two issues regarding cost inflation that are still not being fully considered by the market:
(1) Companies that have major existing sources of oil sands production should receive much greater cash flows from high oil prices, and upgraded oil sands production should be the largest source of WTI price exposure. We believe that Suncor in 2006 would receive an additional US$3 billion in cash flows when considering $68 per barrel WTI prices and $8.00 per MMBtu Henry Hub natural gas prices versus $30 per barrel WTI and $4.50 per MMBtu Henry Hub. This represents 40% of a 200,000 bpd oil sands expansion assuming a budget of C$47,000 per bpd of capacity.
(2) Cost inflation is not an oil sands specific phenomenon. Conventional companies are seeing similar levels of cost inflation, for secular in addition to cyclical reasons. We would note that Petrobras, Brazil's national oil company with a world-class set of offshore growth assets, announced on August 19 that its 2006-10 E&P budget is now expected to be $28 billion versus $16 billion previously with essentially no change to 2010 production targets. We believe that cost inflation is an industry issue which is driving mid-cycle oil prices higher. We believe that oil sands companies - despite capital cost inflation - should benefit relative to industry from higher mid-cycle oil prices.
WE SEE UPSIDE TO SUNCOR SHARES EVEN ASSUMING MID-CYCLE RETURNS DILUTION
We believe that Suncor shares could withstand returns dilution of at least 120% from its Voyageur expansion project (see enclosed exhibit).
Our base case expectations are $55/bbl WTI oil and $7.00/MMBtu Henry Hub natural gas in 2006 and $30/bbl oil and $4.50 per MMBtu Henry Hub in 2007-10. For Suncor, assuming a C$47,000 per bpd Voyageur expansion budget would yield 2010 cash return on cash invested (CROCI) of 11.7% and 2010 yearend net debt of $2.9 billion. At a 2.00x EV/GCI multiple, Suncor's expected yearend 2010 value would be $97 - which if discounted at 8% back to 2005, would imply a fair value $66 per share. Our alternative scenario assumes both higher commodity prices and greater cost inflation.
Our alternative commodity price assumptions are $68/bbl WTI oil and $8.00/MMBtu Henry Hub natural gas in 2006 and $60/bbl oil and $7.50 per MMBtu Henry Hub in 2007-09 and the same $30/bbl oil and $4.50 per MMBtu Henry Hub in 2010. We assume that the Voyageur costs rise 120% to C$103,000 per bpd of capacity. In this scenario, 2010 CROCI would be 8.6% and 2010 yearend net debt would be $3.2 billion. Because of the lower returns, this would translate to a lower expected multiple. Discounting the 2.0x EV/GCI multiple to reflect the decrease in returns would yield a multiple of 1.47x, and an expected 2010 yearend value of $97 - which discounted to 2005 represents the same $66 fair value per share as in the base case scenario.
This means, in our view, that assuming this scenario of four more years of high oil prices (at levels below our super-spike scenario), Suncor's Voyageur project could withstand cost inflation of 120% before it would be dilutive to expected share price value. Our super spike-adjusted peak value of $75 assumes a higher suite of 2006-09 commodity prices and 125% cost inflation for the Voyageur expansion.
IN-SITU CONSISTENCY CAN UNLOCK FURTHER VALUE
Aside from higher commodity prices and cost inflation, the key industry-specific catalyst for oil sands shares is the consistency of production from various in-situ oil sands developments. While much of the production growth from oil sands over the next 5-10 years is expected to come from mining facilities, there is significant un-mineable resource that can be developed using existing in-situ technology. We believe that oil sands resource from deeper horizons is being heavily discounted to the relative immaturity of steam-assisted gravity drainage (SAGD) and other in-situ technologies. For Suncor in particular, much of the company's future growth is expected to come from in-situ resource, and production rates from the company's small Firebag facility has been volatile while natural gas consumption has been above expected steady-state levels. Greater consistency of gas-oil ratios combined with less fluctuations in production rates could improve Street confidence in existing in-situ facilities, let alone future in-situ development.
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. |
