SU – Divestor

Rights of First Refusal coming in handy – Surmont Oil Sands

Suncor, April 27, 2023:

Suncor Energy (TSX: SU) (NYSE: SU) today announced that it has agreed to purchase TotalEnergies’ Canadian operations through the acquisition of TotalEnergies EP Canada Ltd., which holds a 31.23% working interest in the Fort Hills oil sands mining project (Fort Hills) and a 50% working interest in the Surmont in situ asset. This will add 135,000 barrels per day of net bitumen production capacity and 2.1 billion barrels of proved and probable reserves to Suncor’s oil sands portfolio. The acquisition is for cash consideration of $5.5 billion, with the potential for additional payments of up to an aggregate maximum of $600 million, conditional upon Western Canadian Select benchmark pricing and certain production targets. Subject to closing, the transaction will have an effective date of April 1, 2023.

Two assets were purchased. It wasn’t entirely clear what the price allocation between both assets were. Now we know:

31.23% Fort Hills – CAD$1.5 billion / $160 million contingent consideration
50% Surmont oil sands – CAD$4.0 billion / $440 million contingent consideration

Suncor purchased from Teck 21.3% (minus Total Energies’ right of first refusal component of 6.65%) for $1 billion. Suncor ended up with another 14.65% in total. The 31.23% consideration for $1.5 billion is roughly in-line with what Teck paid.

How did we figure this out the split between the two major assets?

May 26, 2023:

ConocoPhillips (NYSE: COP) today announced that it is exercising its preemption right to purchase the remaining 50% interest in Surmont from TotalEnergies EP Canada Ltd. for approximately $3 billion (CAD$4 billion), subject to customary adjustments, as well as contingent payments of up to approximately $325 million (CAD$440 million). ConocoPhillips currently holds a 50% interest as operator of Surmont and will own 100% upon closing. This transaction is subject to regulatory approvals and other customary closing conditions.

Here’s the kicker:

Based on $60 WTI, the transaction will add approximately $600 million of annual free cash flow in 2024, inclusive of approximately $100 million of annual capex for maintenance and pad development costs.

That’s US dollars – US$60 WTI = US$600 free cash flow, or about CAD$817 million. Suncor was paying about 5.4x free cash flow. Logically it is even better when WTI is greater than US$60! This should have been a pretty easy decision for ConocoPhillips to exercise the right of first refusal.

All of this was unfortunate because Total Energies was planning on doing a spinoff of these two assets and depending on valuation, I was planning on getting into this firesale. No longer!

It is no kidding that Suncor stock is down today – Surmont is 75,000 boe/d of low-cost production. Fort Hills has a rated capacity of 194,000 boe/d. While it is a nice consolation prize (especially as the entire operation is now consolidated in Suncor), the Surmont asset is something I’d like to get into at the price Suncor was paying!

Can Teck unload their met coal operation?

Teck (TSX: TECK.A/B) had some interesting news yesterday – they dumped their 21% interest in the Fort Hills oil sands project for $1 billion to Suncor (the majority owner and operator), and they also released their quarterly report.

The Fort Hills project was the black sheep of Teck, primarily because it goes against their “wokeist” image they are trying to project and is clearly not in their strategic mandate to be a lead producer of “low carbon metals” (aren’t all metals non-carbon?). Once the Frontier Oil Sands project was shelved, pretty much the days were numbered for the Fort Hills division.

For Q3, Teck’s share of the project was 37,736 barrels of oil a day, and the consolidated project is 180,000 barrels – not a trivial size.

The project historically has been plagued by operational issues and, in my quick evaluation, the deal is good for both Teck (who wanted to get out) and Suncor (who is likely to consolidate 100% of the project in the near future). The Frontier project might get revived in a future decade when regulatory concerns get alleviated, but I would not hold your breath.

Of note is that both companies (Teck and Suncor) will be taking non-cash accounting losses on the disposition – in Teck’s case, the amount of capital dumped onto the project is less than the amount that they were able to get back from it with this disposition. The impairment charge on the books was $952 million. The conference call transcript indicated there was a ‘small capital loss’ on the transaction.

Teck’s major project in the works is the QB2 copper mine in Chile. One reason why their stock had a tepid response to the quarterly report is because of the usual announcements of delays and construction cost escalation, coupled with a decreased expectation for production in 2023. However, this is yet another sign that one cannot click a few buttons on Amazon and expect a mine to start producing – the scale and scope of these projects is gigantic and this one has taken about 5 years to get going from the “go-ahead” decision to when things will be materially completed. If this decision was pursued today, the costs would likely be even higher (not to mention the regulatory climate would be even worse than it is today).

QB2 is the example of their “low carbon metals” strategy, where apparently they can be dug up from the ground without emitting carbon, but I digress. The “to-go” capital expenditure on QB2 is anticipated to be US$1.5-$1.9 billion from October 1, and once this is completed, Teck will be a free cash flow machine barring some sort of total collapse in the copper market (beyond the 30% drop from half a year ago).

The balance sheet is very well positioned, with $2.6 billion in cash and no major debt maturities until 2030 other than a US$108 million bond due February 2023, which they can easily pay off. As a result, Teck will be in a position to either buy back stock or issue increased dividends later in 2023.

But the focus of this post isn’t about QB2 or Teck’s future prospects, it is about their metallurgical coal operation.

Their met coal operation generated $1.24 billion in gross profits in Q3, and $5.55 billion year-to-date. It is single-handedly the reason why Teck is in such a fortunate financial position to be able to dither on QB2 and not get terribly concerned about it.

However, it flies in the face of their “low carbon metals” strategy and this reminds me of last year’s article which rumoured that Teck was looking at getting rid of, or spinning off their met coal operation.

My question is still the same – who would buy this? It is making so much money that even if you paid 2x annualized gross profits (an incredibly generous low multiple), somebody would still need to cough up $15 billion to buy the operation. This puts pretty much every coal operator out there except for the super-majors (like Glencore) out of the picture.

However, if Teck were to dispose of the coal unit, it would likely be in conjunction with a significant distribution to shareholders – a $15 billion sale would result in roughly a $22/share distribution, assuming a 25% tax rate (the actual tax paid will likely be less since Teck’s cost basis will be considerably higher from the Fording Coal acquisition). At a zero-tax rate, that would be roughly $29/share.

However, a giveaway is the non-answer during the conference call:

Orest Wowkodaw
Analyst, Scotia Capital, Inc.
Hi. Thank you. Jonathan, your number two priority seems to be rebalancing the portfolio to low carbon metals. I’m wondering if that if your strategy there is solely around growing the copper business and i.e. diluting the coal business, or do you see the potential for accelerating that transformation perhaps by either divesting some of the coal business?

Jonathan Price
Chief Executive Officer & Director, Teck Resources Limited
Yeah. Hi, Orest, and thanks for the question. There’s a number of approaches that we’ve been taking to that. The first as you’ve seen overnight is the announced divestments of Fort Hills. Clearly oil sands carbon, an opportunity there to reduce weight in the portfolio through that divestment, something we’re very pleased to have agreed and have gotten away.

Secondly, as you highlight really the key approach for us is the growth around copper with the doubling of copper production as we bring QB2 online next year. And then with the projects I mentioned being new range being San Nicolás being the QB mill expansion all bring more copper units into the portfolio which further swing us towards green metals and away from carbon. As we’ve said before, we’ll always remain very active and thoughtful in reviewing the shape of the portfolio and the composition of our portfolio. But right now those factors I’ve mentioned are the key execution priorities and that’s what the team is focused on. And that’s what we’re gearing up to deliver.

I’m pretty sure reading between the lines that they are, at the minimum, thinking of doing this. But who in their right mind would buy such an operation in a very hostile jurisdiction?

First quarter review of oil and gas – and a look at Suncor

This is a brief review of the companies that have reported their quarterly results to date in the oil and gas space – specifically the ones in the Divestor Canadian Oil and Gas Index. (ARX, CNQ, CVE, MEG, SU, TOU, WCP have reported).

When your spot commodity exposure charts look like this, you know things are looking good:

The amount of bullishness out there in the previous week was a bit nuts and ripe for a correction. When markets ascend for this much time for this duration, there is a natural process where momentum and technical analysis players get cashed out, regardless of any fundamental underpinnings.

The financial market moves much, much, much faster than what goes on at a glacial pace in reality. While the amount that has evaporated out of my portfolio in the past week is impressive, it goes with the nature of finance that things will indeed be volatile, but the intrinsic value of the portfolio remains intact, reflected by real-world economics instead of financial economics.

All of the companies in the oil and gas index have been reporting record free cash flows, but most notably all of the players have been quite tight on growth capital in the sector – the free cash flow for the most part has gone into debt reduction, dividends and share buybacks. Now that most of these companies have reached their leverage targets, they are now continuing to deploy more cash into share buybacks, or (in the case of TOU) special dividends.

The financial mathematics of companies giving off sustained free cash flows (key word being ‘sustained’, noting that fossil fuel extraction is a cyclical industry) is interesting to analyze. I will use Suncor as an example.

Suncor guided in Q1 that their income tax payments will go up from the lower $2 billion range to $4 to $4.3 billion (note that income tax is a function of operating income minus interest expenses and after the removal of royalties, which is another huge layer of money given to the government!). Suncor does not have a material tax shield so they will be fully paying cash corporate income taxes. The Canada and Alberta corporate tax rate combined is 23%, and they have other operations in other provinces and overseas, so we will assume 23.5% as a base rate, which puts Suncor at $17.7 billion in pre-tax income ($13.5 billion after-tax).

Those with an accounting mindset will ask whether net income translates directly into free cash, and Suncor’s capital expenditures are roughly in line with depreciation. My own on-a-paper napkin free cash modelling also corresponds roughly to this $13.5 billion amount in the current commodity price environment.

Suncor has 1.413 billion shares outstanding as of May 6, 2022, so the upcoming year of income is $9.55/share. Suncor trades at $44/share as I write this, and has an indicated quarterly dividend of 47 cents per share ($1.88 annually). Although management has hinted this will go up over time, for now let us assume it is a static variable.

Deciding between debt reduction, dividends and share buybacks usually are a dilemma, but when the math is this skewed it is not.

Suncor’s debt currently costs them about 5.25%, or 4% after-tax. A share buyback not only alleviates the company from paying out the 4.27% dividend, but is also purchasing a 21.7% return on the equity.

This is a no-brainer decision from an optimization standpoint – every penny after regular capital expenditures, should go into a share buyback. The dividend should be brought to zero and shares should be bought back with that amount instead, until such a point where the return on equity goes below a particular threshold (my own personal threshold if I was calling the shots at management would be 12% or anything below $80/share in the current price environment!).

However, there are other variables to consider.

One is that the commodity price environment might not (and indeed is very unlikely to) last forever. There is a pretty good case to made that this particular price environment will last longer than most (instead of spending on capital expenditures like drunk sailors, companies across the grid are shockingly being very disciplined about limiting the amount of growth in production), and also the margin of error of the price level itself is quite high – West Texas Intermediate is at US$100 and even if it goes down to US$75, my models still have Suncor making around $8 billion in free cash. My $80 threshold price for share buybacks would drop to $47/share in this scenario – very close to the current market price.

So the argument to reduce debt is not out of financial optimization, but rather reducing the brittleness of the financial structure of the company. Hence the decision to allocate the residual 75% of free cash minus capital expenditures and dividends to debt reduction, and the other quarter to share buybacks. Although it is not financially optimal if you assume the current environment exists, it is a safe decision. They will do this until they go to under a $12 billion net debt position, which will happen at the end of Q3/beginning of Q4. (Note that Suncor introduced a new conservative fudge factor by adding in lease liabilities into this definition which inflates the net debt number).

After they reach the $12 billion net debt figure, then 50% gets allocated to debt and 50% to the share buyback. At the current commodity environment and share price, they will be able to complete nearly the 10% full buyback with this regime. After they get down to $9 billion in net debt, then the debt reduction goes to 25% and share buyback will go to 75%. I just hope that management has the prudence to taper the buyback and increase the dividend if their share price gets too high.

The other variable is the dividend. While the tax inefficiency of dividends are well documented elsewhere, it does provide a “bird in the hand” component to the stock, and also gives the buyback itself some metric to be measured against. While other people consider a dividend to be very important, I am agnostic about a particular dividend level, except in context of alternatives.

Obviously if a company has capital investment opportunities, you do not want to see a dividend. You instead want to see them deploying this capital in productive ventures. However, in the fossil fuel industry, there is a very good argument to be made to just keep things as-is and just go on cruise control – this is exactly what is happening for all of these companies. They are paying down debt and allocating cash to dividend and share buybacks, especially when all of them are giving out 20%+ returns. There is no reason not to.

The ultimate irony here is that in such an environment where cash flows are being sustained, it works incredibly in the favour of investors that the market value of these companies remains as low as possible, to facilitate the execution of cheap share buybacks.

This leads me to my next point, which is that it does not take a CFA to realize that on paper, many of these oil and gas companies are perfect candidates for leveraged buyouts. Only the perceived toxicity of fossil fuels and ESG has prevented this to date, and I am wondering which institution will be making the first step in outright trying to convert a leveraged loan (even in the elevated interest rate environment, they can get cheap debt) to buy out a 25% cash flowing entity. It is inevitable at the current depressed market prices.

The first warning shot on this matter (which is cleverly disguised as a strategic performance improvement scheme) comes from Elliott Investment Management’s Restore Suncor slide deck. They can’t outright say what they’re thinking – let’s LBO the whole $60 billion (market value) firm!

Needless to say, an investor in this space makes most of their money “going to the movies”, as Warren Buffett said about one of his earlier investment mistakes (selling a company too early). I think this will be the case for most of the Canadian oil and gas complex.

The power of reinvestment and compounding returns

This post should not be news for anybody in finance, but it is worth refreshing fundamental principles of compounding and equity.

The most attractive feature of equities vs. debt is the effect of compounding. Stocks can rise infinitely while bonds have an effective price cap at the risk-free rate of interest.

To get on the equity gravy train and make outstanding returns, you need to have capital invested in a business with great prospects for reinvestment.

We will use an example of a debt-free company earning a perpetual $10 per year on a $100 investment, but the investment is of a style that does not scale upwards with further reinvestment. The long-term risk-free rate of interest is 2%. Our dream world also does not have income taxes or management expenses.

In this instance, the company can choose the following policies (or a blend thereof):
1) Give the money back to shareholders.
2) Bank its cash and receive 2% on that capital,
3) Speculate on other (preemptively higher-yielding) ventures.

If the policy option is (1) then in theory the valuation of this firm will be $500 (the risk-free rate of interest). The company will still generate $10/year for its shareholders whether the valuation is $100 or $500. An investor would be indifferent to sell the business for $500 and invest in the risk-free bond or just keep holding onto the business – you have magically created $400 of capital profit and you can clip dividends or bond coupons. With your $10/year you can do what you please, or put it in a risk-free 2% yourself.

This example is a constraint of reinvestment – after the re-valuation, your equity has effectively turned into a bond with no chance of compounding beyond the risk-free rate of interest.

If the policy option is (2) then you will see your returns in the appreciation of equity value. After the first year, your firm will generate $0.20 more in income and this will translate into $10 extra equity value, and this will compound at the rate of 2%.

Policy option (3) introduces the concept of risk – can management pull off the reinvestment? If there was an attractive investment at 5%, they would be able to generate $0.50 extra and this would translate into $50 of extra equity value for its holders, again, capitalized at the 2% risk-free rate.

So far we have made the assumption that the equity value follows lock-step with the risk-free rate of return. Of course in the real world, it never works that way and there are wildly divergent capitalization percentages used.

What is interesting is in this fictional example, the results you get if the initial equity investment does not trade at the risk-free return rate, but rather it trades at a higher rate, say 5%.

In this instance, the company would trade at an equity value of $200.

We will then consider a fourth policy option with the generated cash returns:
4) Buy back your own stock

This option requires a willing seller to the company (something that isn’t available to a 100% wholly owned firm!). Passing that assumption, an incremental deployment of $10 into the company’s own stock (a 5% reduction in shares) would result in continuing shareholders receiving 5.3% more returns in the future. Shareholders as an aggregate will still receive $10/share in returns, but the return per share will be 5.3% higher than before due to the reduced shares outstanding. This is a far better outcome than policy option (2).

The principle is the following: If a company is earning sustainable, long-lasting cash flows, it is to the benefit of shareholders that either the inherent business of the company has a capital outlay that offers higher returns on capital OR failing that, that the market value of the company’s equity is low to offer another conduit for reinvestment. Barring these two circumstances, returns should be given out as dividends.

This is unintuitive in that sometimes companies engage in really destructive practices with share buybacks. They are not universally good, especially if the future cash generation of the business is spotty. Likewise there are circumstances where buybacks work to massive benefit (a good historical example was Teledyne). However, in all of these cases, investors must possess a crystal ball and be able to forecast that the cash generation of the existing business (in addition to any other potential future capital expenditures) will be sufficiently positive over the required rate of return.

For example, Corvel (Nasdaq: CRVL) has a very extensive history of share buybacks:

The Company’s Board of Directors approved the commencement of a stock repurchase program in the fall of 1996. In May 2021, the Company’s Board of Directors approved a 1,000,000 share expansion to the Company’s existing stock repurchase program, increasing the total number of shares of the Company’s common stock approved for repurchase over the life of the program to 38,000,000 shares. Since the commencement of the stock repurchase program, the Company has spent $604 million on the repurchase of 36,937,900 shares of its common stock, equal to 68% of the outstanding common stock had there been no repurchases. The average price of these repurchases was $16.36 per share. These repurchases were funded primarily by the net earnings of the Company, along with proceeds from the exercise of common stock options. During the three and six months ended September 30, 2021, the Company repurchased 165,455 shares of its common stock for $25.6 million at an average price of $154.48 per share and 284,348 shares of its common stock for $39.8 million at an average price of $139.81, respectively. The Company had 17,763,576 shares of common stock outstanding as of September 30, 2021, net of the 36,937,900 shares in treasury. During the period subsequent to the quarter ended September 30, 2021, the Company repurchased 49,663 shares of its common stock for $8.7 million at an average price of $176.02 per share under the Company’s stock repurchase program.

We look at the financial history of the company over the past 15 years:

This is a textbook example that financial writers should be writing case studies about up there with Teledyne (NYSE: TDY) as this has generated immensely superior returns than if they had not engaged in such a buyback campaign. Share repurchases made over a decade ago are giving off gigantic benefits to present-day shareholders and will continue to do so each and every year as long as the business continues to make money.

The question today is whether this policy is still prudent. The business made $60 million in net income and there stands little reason to believe it will not continue, but should the company continue to buy back stock at what is functionally a present return of 2%? The business itself cannot be scaled that much higher (they primarily rely on internally developed research and development expenses and do not make acquisitions).

It only makes sense if management believes that net income will continue to grow from present levels. One has to make some business judgements at this point whether the company will continue to exhibit pricing power and maintain its competitive advantages (in this respect it looks very good).

Another example we are seeing in real-time is Berkshire (NYSE: BRK.a) using its considerable cash holdings to buy back its own stock. In the first 9 months of this year, they have repurchased just over 3% of the company. There’s more value right now in Berkshire buying its own massively cash-generating options than there would be on the external market – the last major purchase Berkshire made was a huge slab of Apple stock in 2017/2018 which was a wildly profitable trade.

In the Canadian oil and gas industry, right now we are seeing the major Canadian companies deal with the first world problem of excess cash generation. They are all in the process of de-leveraging their balance sheets and paying down (what is already low interest rate) debt, but they are also funneling massive amounts of money into share buybacks.

For example, Suncor (TSE: SU) and Canadian Natural (TSE: CNQ) are buying back stock from the open market at a rate of approximately 0.5% of their shares outstanding each month. Cenovus started their buyback program on November 9th and intends to retire 7% of shares outstanding over the next 12 months. The financial metrics of these companies are quite similar in that with oil at existing prices, an investment in their own stock yields a far greater return than what you can get through the uncertainty of opening up a major project (good luck getting through the environmental assessment!). My estimate at present is around 15% return on equity for these buybacks and needless to say, this will be great for shareholders.

It is why an investor should want low equity market values as long as these buybacks continue and the pricing power of the companies remain high. In the oil patch, this of course requires a commodity price that by all accounts should remain in a profitable range for companies that have had their cost structures streamlined and capital spending requirements that have been curtailed due to a hostile regulatory regime. The returns from these share buybacks are likely to be immense, barring a collapse in the oil price.

Large Cap Canadian Energy

A briefing note. I do not think any of this thinking below is original by any means, but it needs to be said.

On May 26, Suncor (TSX: SU) guided at WTIC US$60 in 2021 and US$55 in 2022 (which is presently US$68 and US$62 for the year-end contracts, respectively) a free cash flow of $7 billion. This is after a $3 billion capital expenditure in 2021.

The guidance was notable in that the 9 megabyte slide deck they provided went through great pains to downplay the amount of cash they actually were going to generate (in typical Canadian fashion, it is like they are embarrassed to admit they are making this much money), but let’s play along.

Suncor’s enterprise value is about CAD$60 billion, about $45 billion market value and $15 billion debt.

Let’s do some basic math. This is grade school finance.

It means if the company can produce cash at the present rate (which, in general, they can given the nature of what they are mining at the present capital expenditure rate), if directed to debt and equity, they will be able to pay off all their debt and repurchase their entire share stack (at current prices – it will rise over time) in 8.5 years.

This doesn’t include changes in the selling price of oil, which the above figure is currently below market.

This is a little more complicated to calculate the sensitivity to commodity pricing. Companies give out sensitivities and for every dollar on Brent (not quite WTIC, but deeply correlated), Suncor changes its funds flow through operations by about CAD$300 million. Very roughly, subtract royalties and taxes (no more tax shield, they made too much money already) and it is about CAD$200 million leftover.

I note that at current pricing, an $8 positive oil price difference over the model (note: do not confuse with the Canada/USA differential) changes the 8.5 years alluded to above into about 7 years.

You just need to make the assumption that oil pricing will stay steady.

If this is the case (or heaven forbid, oil rises even further), Suncor is ridiculously undervalued.

This doesn’t even factor in the WCS/WTIC differential, which is likely to close once Line 3 is completed (end of the year) and TMX is finished (2022?). This will be the freest money for all stakeholders involved. An extra US$5 off the differential (it is now about US$15) on Suncor’s capacity is about US$1.5 billion a year – suddenly 7 years now becomes 6 years.

Not surprisingly, the company is buying back stock like mad, probably because there isn’t anything else they can really do with the excess cash flow.

In the past couple months, they’ve bought back US$375 million in stock, 17.2 million shares (about 1.1% of the outstanding). They should aim to buy back the maximum they can at current pricing.

As this continues, the stock price will rise and make future buybacks less attractive. After the appreciation, they should jack up the dividend.

Normally businesses would also invest in capital expenditures, but in Canada, we are closed for business for any significant natural resource projects. We mine what we have left, which makes the decisions easy – harvest cash.

What is the thesis against this?

The obvious elephant in the room is the sustainability of oil pricing.

I have no doubt in 100 years from today that fossil fuel consumption, one way or another, will be seriously curtailed. It will likely be too expensive to use in most applications that we see today.

But in 8.5 years? Get real. Oil sands reserves are measured in decades.

The other obvious component of “Why are they letting me have it so cheap?” is political correctness in the form of ESG. Much demand is sapped because of this. Many institutions cannot touch oil and gas, including Berkshire Hathaway.

Eventually through buybacks and dividend payments, the market will adjust this.

The margin of safety here is extremely high and nothing comes close in the Canadian marketplace, at least to anything with over a billion dollar market cap.

The same reasoning above also applies to Canadian Natural Resources (TSX: CNQ) and Cenovus (TSX: CVE). They are also in the same boat in terms of their FCF/EV valuation, and also with similarities in their operations. Once they reduce leverage, they will be buying back stock like crazy if it is still at the current price. I don’t know how long this will last.

Sometimes things are so obvious in the markets you really wonder what the trick is, but with this, it is the closest thing I can think of picking up polymer cash notes on the street. Efficient market theory would tell me that those cash notes wouldn’t be there. Perhaps traditional finance theorists might be right, we will see. At least I can take some solace when I am at the gas station and seeing record-high prices.