Published on 1/9/2016
Warren Buffett only owns two stocks in the energy sector, and they both pay a dividend – Suncor (SU) and Phillips 66 (PSX). SU’s dividend yield is 3.7%, and it has increased its dividend for 13 consecutive years.
Buffett first bought into SU in 2013, investing around $500 million at the time. He subsequently purchased more shares during the third quarter of 2015, making SU close to his 20th largest holding.
Depressed oil prices have most energy investors worried about the safety of their dividend payments, much less their future growth potential (which is expected to slow significantly in 2016).
However, much like Buffett hopes a new stock purchase remains stagnant or even declines so he can buy more, part of us hopes that today’s oil environment persists awhile longer to set up an even brighter long-term outlook for SU.
The downturn is demonstrating how a strong balance sheet, integrated model, and focused strategy can help a company weather a sea of change and emerge much stronger on the other side.
SU is uniquely positioned for this depressed environment given the strength of its cash flow generation, low-cost production assets, and excellent balance sheet. These factors are allowing it to act counter-cyclically (e.g. pursuing attractive acquisitions) when other companies can’t.
While we certainly cannot and will not begin to guess when oil prices recover and where they recover to, we are very comfortable owning SU in our Conservative Retirees dividend portfolio.
Business Overview
SU is an integrated energy company focused on developing Canada’s oil sands. Oil sands is a mixture of bitumen, sand, fine clays, silts, and water. Because it does not flow like conventional crude oil, it must be mined or heated underground before it can be processed.
Since pioneering the first crude oil production from the oil sands of northern Alberta in 1967, SU has grown to become Canada’s largest integrated energy company with a balanced portfolio of high quality assets.
During 2014, the company generated 51% of its segment profits from upstream oil sands operations, 16% from upstream exploration & production activities, and 33% from midstream and downstream (refining & marketing) operations, which include four refineries, a lubricants plant, Canada’s largest ethanol plant, and over 1,500 Petro-Canada retail gasoline stations.
With the crash in oil, SU’s profit mix through the first nine months of 2015 was 6% oil sands, 6% exploration & production, and 88% refining and marketing.
Business Analysis
Despite its sensitivity to oil prices, we believe SU has several enduring competitive advantages that ensure it can outlast most other oil production firms. The company’s significant asset base, strong balance, and integrated model set SU apart from its peers and have helped it remain the low-cost competitor in its sector.
SU’s oil sands resource base is one of the largest in the world and has nearly 40 years of production left at current rates. The company also completed its first oil sands plant in 1967. For the most part, other energy companies did not begin investing in land and extraction infrastructure in that region for several decades.
This probably helped SU to claim ownership over the most attractive territories while also building up meaningful operational expertise to efficiently run complex oil sands projects.
SU’s integrated model serves as another competitive advantage. The company has a network of assets (e.g. thousands of kilometers of pipelines, over 7,000 rail cars, more than 11 million barrels of storage capacity at terminals strategically located across North America, etc.) that helps its take advantage of differentials that may occur between extraction of resources and selling them to the final customer. SU believes its midstream assets and expertise added an average of $2 to every oil sands barrel it produced in 2014.
Having upstream and downstream operations also improves SU’s trading capabilities and diversifies cash flow sources during times of unexpected commodity swings.
We are also very impressed with the communication of SU’s management team. Their earnings calls and annual reports sound very much like Buffett, which is perhaps another reason why he likes SU. The following excerpt is from SU’s third quarter earnings call and highlights the company’s disciplined capital allocation:
“Our strategy has been, first of all, we have to earn the right to spend money, so we have to run our existing assets very, very well. That’s what operational excellence is about and I’m pleased with the progress we’re making, still more to come, and you will see that in terms of reliability and continued reduction in operating costs. We’re not finished yet; we still have some more of that to deliver. So run the assets really well.
The second part then has been about a very disciplined allocation of capital. And we have three ways that we look at using that capital. The first one is organic growth and, you know, what’s so pleasing about these results are that we are still funding our organic growth. We’ve grown it nearly 10 percent for the last four or five years, per year, and we are growing at 5 percent through to the end of this decade with investments that are in place.
And we then have a very long list of organic projects which are there, but they have to compete with the other two buckets. One of those buckets is the world of M&A and we’ve been looking and, you know, whether we’re at the bottom of the cycle there’ll be as many views as there are individuals having the conversation. What we know is that in the M&A world at these prices some companies have started to look reasonably attractive to Suncor. So we’re letting those compete. And then, you know, I think our track record speaks for itself on the third bucket, which is we return money to shareholders. We talked in our prepared comments about the $10 billion of free cash that we’ve generated and returned. We’ve done that through a mix of dividend and buying back through share buybacks 10 percent of the company.
So we let those three compete and the beauty of that is that given the very healthy balance sheet we have we’re in no hurry. We have very good opportunities in each of those. Our shareholders, very happy to take returns themselves. The organic growth list is a very long list, which takes us forward for the next, you know, 20-plus years, and we’ve got some of these targets. The commitment that I’ve been giving very clearly to share-holders is we will not move from that capital discipline. If things don’t fit in on those lists we will not pursue them or move away. We’ll do that on organic projects, we’ll do that on potential M&A targets, and we will use the tools available to us in terms of returning to shareholders.”
SU’s asset base, operational expertise, and capital discipline have helped it establish extremely low production costs. Management expects SU’s cash operating costs per barrel for oil sands operations to approach $20 per barrel in 2016. The company has done an excellent job reducing costs despite enjoying consistent growth in oil production, which is 9% higher than it was in 2014.
Importantly, the company is one of the few oil companies in the world to keep generating free cash flow in today’s oil price environment. Even despite investing over Cdn$900 million of growth capital in the third quarter, SU generated free cash flow. Through the first nine months of 2015, SU has generated Cdn$5.5 billion of cash flow and Cdn$875 million of free cash flow after Cdn$2.7 billion of growth capital spending.
SU’s balance sheet is another advantage. The company finished last quarter with Cdn$5.4 billion in cash and undrawn lines of credit of Cdn$6.9 billion for total liquidity of over Cdn$12 billion. It also has an investment-grade credit rating from S&P.
All of these advantages are allowing SU to make opportunistic investments while practically every other energy is significantly curtailing investment dollars. Two examples are the company’s recently stepped-up investment in the Fort Hills project and its proposal to acquire Canadian Oil Sands.
Fort Hills is a Cdn$15 billion project that is set for first oil production at the end of 2017. SU recently bought another 10% interest in the project for Cdn$1 billion, bringing its total ownership to about 51%. Fort Hills has an expected operating life of over 50 years with an anticipated cash operating cost of less than Cdn$25 per barrel. The price SU paid for the additional 10% interest was about Cdn$56,000 per flowing barrel compared to overall project costs of Cdn$84,000 per flowing barrel, creating potential for a very strong return.
However, SU’s $4.3 billion offer to acquire Canadian Oil Sands’ is even more opportunistic. Canadian Oil Sands owns 37% of Syncrude, a project which mines and upgrades bitumen in Alberta and has decades of valuable supply. SU currently owns 12% of the project.
SU believes it can drive real operational improvements in Syncrude’s performance with a larger ownership interest. Syncrude ran at only 67% of capacity during the third quarter compared to SU’s 90%+ reliability rate for the year. It is also bleeding cash and has a debt rating only one notch above speculative.
Of course, many of Canadian Oil Sands’ shareholders feel that SU is trying to buy the asset at a distressed level price. SU’s offer has been extended through 1/27/16, and we hope it is ultimately accepted.
All things considered, SU shares many qualities with some of our favorite blue chip dividend stocks.
Key Risks
The increasing likelihood of lower for longer oil prices is the main risk impacting practically every energy company today. The Organization of Petroleum Exporting Countries (OPEC), which supplies around 40% of the world’s oil today, effectively abandoned their production limits in December 2015. These countries are intent on crushing new U.S. shale oil players in an effort to take back market share, even if it comes at a significant near-term price.
Fears of slowing global growth are only adding to the carnage in oil prices.
With global oil prices quickly approaching an unthinkable $30 per barrel, many energy companies won’t survive if such conditions persist.
SU shouldn’t be one of them due to its low-cost operations, strong cash flow generation, and investment-grade balance sheet.
We suppose that SU’s risk is making an “opportunistic” acquisition that backfires (e.g. buys a higher-cost producer, only to realize it is unable to take as much cost out as expected), reducing the company’s financial strength as macro conditions remain depressed.
It oil sands production is also more costly than conventional oil production because of its energy-intensive production methods. However, SU’s E&P and refining & marketing segments and extensive logistical network help diversify its cash flow. In its 2014 annual report, SU noted that it was able to capture global-based pricing on volumes equivalent to 97% of its upstream production, mitigating some of the risk associated with being an oil sands producer during periods of low oil prices.
Overall, SU looks like one of the best houses in a bad neighborhood. The company has the financial strength to buy up some of its neighbors for potentially $0.60 on the dollar, but it’s a bet on management to feel comfortable about this opportunistic risk.
Dividend Analysis
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. SU’s long-term dividend and fundamental data charts can all be seen by clicking here.
Dividend Safety Score
Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
SU’s dividend has a Safety Score of 43, which is close to average but better than about 90% of all other dividend-paying energy companies in our database.
Through the first nine months of 2015, SU paid dividends of Cdn$1.23 billion. Over that same time period, the company generated Cdn$875 million of free cash flow – not enough to cover the dividend at first glance. However, this figure included a whopping Cdn$2.7 billion of growth capital spending, which is ultimately discretionary in nature if things ever got really bad.
If SU cut all growth capex, it would have generated about Cdn$3.6 billion of free cash flow compared to its dividends paid of Cdn$1.23 billion – nearly 3x coverage. Additionally, SU has Cdn$5.4 billion in cash and undrawn lines of credit of Cdn$6.9 billion. The company also maintains an investment-grade credit rating with S&P (although it will be reviewed if it acquires Canadian Oil Sands).
Its consistent free cash flow generation (see below), growing production base, integrated business model, and strong balance sheet are allowing it to continue paying the dividend while pursuing opportunistic acquisitions.
Source: Simply Safe Dividends
Most oil companies are scrambling enough just to find ways to continue paying their dividends, much less think about growth.
We can also see the quality of SU’s resource base, operational excellence, and capital discipline reflected in its return on invested capital metric, which has remained positive and relatively stable for a commodity company:
Source: Simply Safe Dividends
Before oil prices collapsed during the second half of 2014, we can see that SU’s long-term earnings payout ratio was around 30%. For a cyclical, commodity-sensitive business, this was a safe level heading into the crash, especially considering SU’s free cash flow generation and balance sheet.
Source: Simply Safe Dividends
With operating costs continuing to come down, production set to predictably rise over the next 5-10+ years with projects such as Fort Hills, and flexibility with growth capex, we believe SU’s dividend will remain safe even in a much “lower for longer” oil environment.
Dividend Growth Score
Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
SU’s dividend Growth Score is 7, suggesting that the company’s dividend growth potential is weak. With the rapid decline in oil price, this is no surprise. Furthermore, with potential opportunities to purchase competitors at $0.75 on the dollar, we would rather see SU continue investing for the long term than substantially up the dividend in this environment. Collecting a 3.7% yield and waiting for much better returns in future periods is worthwhile.
As seen below, SU has increased its dividend for 13 straight years and most recently hiked its dividend by 3.6% during the summer of 2015. As seen below, SU’s dividend has nearly tripled over the last five years (all figures below are in Canadian dollars).
Source: Simply Safe Dividends
Once oil prices begin to normalize and SU’s growth projects start ramping up (end of 2017), dividend growth potential should meaningfully improve.
While SU is not eligible to join the S&P Dividend Aristocrats Index, (it is not a member of the S&P 500), it has many of the characteristics we like to see in consistent dividend growth stocks.
Valuation
SU trades at 25x forward earnings and offers a dividend yield of 3.7%, making the stock attractive for investors living off dividends in retirement. From an earnings multiple perspective, cyclical stocks typically look “expensive” when earnings have troughed and cheap when earnings are peaking – the market is forward-looking.
Consensus earnings estimates call for SU’s profits to come in close to where they were during 2009. We think it is very reasonable to assume that the company’s profits could at least double or triple over the next 2-4 years as a result of higher production levels (growth projects come online in late 2017), additional cost savings, and potentially higher oil prices (even back into the $40s or $50s per barrel would likely be enough).
If such a scenario played out and the stock traded at 15x earnings, it could trade closer to $35-$40 per share (up from $23.50 today). It’s hard to see how things get worse from here unless SU makes a dumb acquisition and oil falls into the $20s.
Conclusion
SU has a world-class resource base, an extensive logistical network, proven capital allocation abilities, extremely low-cost production, and substantial operational excellence. It’s no surprise that this company is one of Warren Buffett’s two holdings in the energy sector.
We believe the dividend is very safe and that SU’s financial health has positioned it extremely well to take advantage of its distressed competitors. Whenever oil prices start to normalize, SU will emerge much stronger than it was going into the slump. We are happy to collect SU’s 3.7% yield in our Conservative Retirees dividend portfolio and patiently wait for better times ahead.
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