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!

Alberta Election 2023’s impact on oil and gas companies

I try to avoid politics on this site other than the direct impact of various policies on investment values.

That said, the upcoming Alberta provincial election, scheduled for May 29, 2023, is a significant political event risk for most of the publicly traded Canadian oil and gas companies, especially CNQ, CVE and SU.

Unlike most of the promises that both major provincial parties talk about and will never deliver on, I think it is safe to say that it is universally agreed that it is a near-certainty that the provincial corporate income tax will rise from 8% to 11% if the Alberta NDP is elected.

The oil and gas producers of Alberta continue to deliver a huge amount of corporate profits at the moment. Pretty much all of the large capitalization companies have exhausted their available tax shields. Since oil and gas production is a price-taker industry, the cost of a corporate tax increase gets directly borne by the shareholders (i.e. the companies cannot all unilaterally raise their prices, which is set by an international market).

The present value of four years of a 3% corporate tax increase on a company such as Cenovus, at WTI US$73 and everything else being equal would be about 35 cents per share.

There is other baked in assumptions that come politically (e.g. royalty regime changes, asset retirement obligation changes, regulatory changes and other indirect taxation changes on fossil fuels) which would increase costs to shareholders.

In essence, you can indirectly infer what market participants think about the election through oil and gas stock prices. The May 5, 2015 election result (caused by a significant split in the Progressive Conservative party) led to Alberta-based oil and gas equities to drop around 5-6%.

This time around, there is no significant split in the right wing of the political spectrum, which would be to the detriment of the Alberta NDP. Indeed, this election is looking to be the most polarized election since 1913, where the top two parties received 94.33% of the vote. Needless to say, Alberta has changed a lot since then.

Opinion polling would suggest that the UCP is going to win, but inevitably the makeup of the voter turnout in “swing seats” (i.e. in certain parts of Calgary, and outer fringes of Edmonton) will determine the outcome of this election. Pretty much all the messaging of the two major political parties is geared towards this mostly sub-urban geography.

My political projection has the UCP winning with about 55 seats (44/87 needed for a majority). The NDP will do much better on popular vote because the remnants of the Alberta Liberals and Alberta Party will coalesce into the “not UCP” camp, but even with around 45% of the vote, it will be insufficient due to the extreme polarization this election.

US Regional Banks

Like a moth flying around a campfire, it is easy to fly in and get incinerated. But I can’t resist looking at more of these regional banks. When you have a lot of third parties claiming to be purchasing puts on the next one bound to be FDIC’ed (the earthquake, in my view, appears to be finished), one would suspect that there is going to be a boomerang effect on these entities as shorts get cleaned out.

The one I’ve been looking at is Customers Bankcorp (NYSE: CUBI), notably because it doesn’t pay a common share dividend and is trading well below book value.

By most accounts it is not an atypical regional bank. It does the usual stuff. The borrow, however, has jacked up from 50bps to 800bps over a month.

In many instances, looking at a chart before the 2020 Covid crisis hit should be a reasonable barometer of economic health of these firms. Indeed, CUBI at this era was around $20-25/share, which is its present trading price.

However, 2019 featured something that we do not have today. A positively sloped yield curve.

Playing around with the dynamic yield curve chart, the short term to long term curve has nearly always featured a positive slope for most of the 2010’s decade.

Today that is heavily negative.

So while there is an argument to be made that entities such as CUBI can run off their books and an investor can claim capital appreciation, theoretically speaking the economic environment for a bank (traditionally having a finance model of “lend long and borrow short”) continues to remain incredibly adverse to profitability, especially as more and more customers want to escape zero/low-yield purgatory for idle cash and can do so with a click of a few mouse buttons.

This moth is happy to stay away from the campfire.

TMX – How much does a pipeline cost?

Just reading the revelation that when the government manages a project, it will triple the cost that it should probably otherwise take to complete – the TMX expansion is running now at a $30 billion capital cost.

The government doesn’t care about the price tag – it’s just another reason to hand out the slush to favoured entities that managed to game the system. The government, despite being the owner of the project, actually doesn’t “pay” for these inflated costs! A simple economic analysis suggests that the pipeline will be so valuable as it is an inelastic service – the WCS differential to the USA vs. shipping it out to Asia will be very extreme, and this differential will be captured with pipeline tariffs. It will be the customers of the pipeline that are captive to the final cost – essentially CNQ, SU, CVE, etc. are paying another tax.

So how much does it cost to send oil out on the existing Transmountain? It is captured in the tolls and tariff bulletin.

A cubic meter of heavy oil from Edmonton to Westridge (just northwest of Simon Fraser University at the water) costs CAD$26, or about CAD$4.20 a barrel.

The TMX expansion will be increasing the flow of oil by 590,000 barrels a day. It is a guarantee that 100% of the available capacity of the pipeline will be utilized – there is simply too much demand for heavy oil to fuel the refineries in places like India, and companies will be able to receive near-Brent crude pricing on WCS.

590,000 barrels a day works out to 215 million barrels per year, assuming no pipeline outages (a false assumption – there will be maintenance periods which will eat into this amount). But let’s work with the theoretical maximum.

At the existing tariff, the incremental heavy crude will generate $900 million in revenues.

Now we look back at the TMX expansion. We have $30 billion in capital costs. Let’s assume the cost of capital is at 5% – pricing in a 180bps spread on “A” rated credit. That’s $1.5 billion/year in interest costs alone. (I am simplifying this considerably by ignoring the fact that there is some equity in the project, I am assuming it is entirely debt-funded – if you want to include equity returns, the revenues required goes even higher!).

In order to amortize this debt over the course of 30 years, the revenues that need to get applied directly to the debt is $1.9 billion a year. There are also other operating costs to running a pipeline (electricity, administration, maintenance, etc.), but the point is that they will need to collect at least double the rate than they are currently collecting in order to pay the debt on the capital costs.

I’m guessing with other administrative expenses baked in, you are looking at a tariff fee of CAD$9-10/barrel.

Brent is trading at US$75.50/barrel currently, while WTI is US$71.50 and WCS is US$51.

There’s about a US$20-24 differential that can be captured with an increased outlet to the Pacific.

However, at least CAD$5-6/barrel of that is going to get sucked up in pipeline costs due to the astronomical cost increases to construct the TMX expansion.

For comparison, the Enbridge Line 3 expansion cost about CAD$13 billion, and was 1000 miles in length. TMX is about 700 miles in length and is projected to cost CAD$30 billion. While the mountainous terrain is of course more difficult to work with, this is by no means a total mitigating factor the account for the cost differential – it is mostly a function of regulatory compliance, all entirely by design – the government does not have to pay for it.

If TMX was constructed for half as much, the incremental profits would go to the shareholders of the oil producers (minus the various taxes and royalties). However, in this instance, the surplus mostly goes to whoever was awarded the contracts – essentially another form of government spending that is “off balance sheet”. Sadly, this happens all the time, and is another example of how spending (which increases the GDP) does not necessarily generate productivity (the actual value you get by spending).

Losers of the TSX, year to date

Rank ordering year-to-date, losers on the TSX, with a minimum market cap of $50 million:

What strikes out at me?

Canfor Pulp (CFX) – What a miserable industry pulp and paper has been over the past four years. Their profitability last decade has been quite good, and then 2019 hit and that was it. Now they are closing down core assets in British Columbia (their Prince George mill is a considerable producer). Most of their production is destined for export to Asia and the USA, and if there is ever a poster child for how BC is a high-cost jurisdiction to conduct forestry, this one is it. CFP owns 55% of CFX. Contrast this with Cascades (TSX: CAS) which the common stock continues its usual range-bound meandering (remember – they were one of the prime recipients of demand for toilet paper during the onset of Covid-19!). If there is any sense of regression to the mean on CFX, however, it would be a multi-bagger stock. The question would be – when? Solvency is not too particular a concern – they’ve got their lines of credit extended out sufficiently.

Verde Agritech (NPK) – A foreign fertilizer firm, notably one of their board members got cleared out of half of his position in the company on April 24th on a margin call. I have no other comments on this other than my professed non-knowledge about Potash and the fertilizer industry. I note that Nutrien (NTR) has been trending down for over a year.

Corus Entertainment (CJR.b) – They cut their dividend, and are realizing that their degree of financial leverage is really going to hurt their cash generation, especially in an industry that is becoming more and more questionable for advertising revenues (broadcast television). The risk here is obvious.

VerticalScope (FORA) – How they managed to get over a half-billion valuation when they went public is beyond me. Rode the 2021 “web 3.0” bubble for the maximum (right there with Farmer’s Edge and the like). Given the organic business is marginally profitable and unscalable at best, and given their existing debt-load, good luck!

Vintage Wine (VWE) – This is a US/Nasdaq entity, I don’t know why this went on the TSX screen, but I checked it out anyway. Sales issues (declining), cost containment, and a large amount of debt plague this company. However, if you shop around any of their wineries, they do offer a “Platinum Shareholder Passport“, where if you own 1000 shares (which is now US$1.08/share, not too steep), you qualify for “25% discount on any wine purchase made at Vintage wineries and web stores.”, which quite possibly might be even larger than a $1,080 investment, depending on how much wine you end up buying. Now that’s a non-taxable dividend you can drink to!

Autocanada (ACQ) – How the mighty have fallen. After blowing a considerable amount of capital on share buybacks (the latest substantial issuer bid at $28 – stock is now $16) in 2022, they are finally feeling the pinch of margin erosion, especially from their last quarterly report. There are macroeconomic headwinds in place here, in addition to a not inconsiderable amount of debt. On their balance sheet, they did something smart by financing a $350 million senior unsecured note financing in early 2022 at 5.75% at a 7-year maturity, but there is still $1.2 billion in other floating rate debt on the books, which needless to say is getting very expensive. Even worse yet is the impact when you have to pass these costs onto your customers in financing charges, so suddenly your Land Rover that was a low $799 per two week payment is now $999! At some point, customers walk away and then decide they want a Toyota Corolla, which is also inconveniently unavailable everywhere. See: Gibson’s Paradox.

… a bunch of Oil and Gas drilling companies are on the list. No comment – it is pretty obvious why.

Brookfield (BN) – A surprising name to see on the list. I have a “no investment in entities named Brookfield” policy simply because of complexity. There are so many interrelationships between the various Brookfield entities that I do not want to make it my full-time life to keep appraised with it all.

51 on the list was Aritzia (ATZ) – I have long since given up on predicting women’s retail fashion trends. I note that Lululemon (LULU) is still sky-high in valuation (forward P/E of roughly 30). Victoria’s Secret (VSCO) is trading at a projected P/E of 5. Aritzia has kept a relatively decent balance sheet (only material liabilities is the retail leases they have committed to) and the projected multiple is 20. If you can get into the minds of the clientele, you would probably get more visibility on the future sales of this company. How do institutions do it? Should I go stick out like a sore thumb and go outlet mall shopping?

Anything else strike out at you?