By Fabrice Taylor
Globe Investor Magazine, Feb. 21, 2008
Photographs by Karl B. Staddon
It’s been a bumpy ride, but investors in Canadian Oil Sands Trust (COS.UN-T) have nothing to complain about. For the five-year period ending December, 2007, COS has been one
of the top-performing big-cap energy companies—in--vestors were up 523% over that period (including distributions). That’s almost four times better than the S&P/TSX com-posite and more than double the oil and gas subindex.
What’s amazing about Canadian Oil Sands’ performance is that it happened even while the trust was fending off one debilitating blow after another: massive cost overruns, emergency equity financing, the Kyoto Protocol, the federal govern-ment’s death sentence on income trusts, increases in royalty payments and, most importantly, the amazing surge in the Canadian dollar.
So what about the merits of investing in the trust today? On the one hand, it’s always hard to put your money in a stock that’s done so well for so long. It’s easy to think you’ve missed the boat. You also have to consider that COS units are trading at healthy premiums to other companies, while the yield, for a com-modity stock, looks lower. Still, stocks that go up tend to keep going up. The returns on Canadian Oil Sands, the biggest shareholder in the Syncrude venture and the only producing pure play in oil sands, might not be as spec-tacular for the next five, or 25, years. But you can easily make the case that the trust has come of age, has cleared the major hurdles and is poised to keep cranking out steady returns as the world slowly runs out of oil.
The Opportunity
It weighs 120 tons, but at the Syncrude mines up in Fort McMurray, they call it a garden tool. They don’t use these junior trucks to carry oil sands; they use them to reclaim land and move topsoil—yard work. In the mines, they use real trucks, 90 of them, as big as 400 tons and $5 million a pop—and $50,000 apiece for the tires, which wear out in a year. They use other big machines, like loaders with buckets the size of a small house and wheels that make the hard earth swell like a balloon as they roll over it.
Everything is on a mammoth scale here, like the newest coker vessel, which is used to upgrade tar-like bitumen into oil. It’s nine storeys tall, and as high-tech as a nuclear reactor. And there’s the huge sci-fi tangle of steel pipes, tanks and stacks that hum away, emitting a faintly acrid smell, the drone broken only by the occasional blast of steam escaping from a valve. There’s an eerie emptiness to the place. More than 2,000 people work at Syncrude’s Mildred Lake plant, 50 kilo-metres north of Fort McMurray, but it feels like a ghost town.
They use all this gear to “manufacture” synthetic sweet blend—or SSB, as Syncrude calls its oil (see “How crude is cre-ated,”)—which fetches a premium price over conventional crude because of its consistent quality. Canadian Oil Sands owns 37% of Syncrude; Imperial Oil is the second-largest investor and is in charge of Syncrude’s operations; and Petro-Canada and ConocoPhillips, among others, also own pieces of the company. While the venture was formed in 1964, the first barrel of synthetic oil wasn’t produced until 1978. Altogether, Syncrude has wrung 1.8 billion barrels of oil out of the tar sands—about 110 million barrels in 2007 alone, up from 94 million barrels the year before. This means that every day, Syncrude produces as much as 350,000 barrels of SSB, not to mention thousands of tonnes of waste and byproducts. The oil is piped to refineries, where it fetches a premium price over conventional crude because of its consistent quality.
If 350,000 barrels a day sounds like a lot, it’s not. Every day, human beings go through about 85 million barrels of oil, meaning every three weeks or so we burn as much oil as Syncrude has produced in 30 years. What’s more, global con-sumption is rising by 1% to 2% every year—in other words, 1.7 million more barrels every day. Simple arithmetic points to a problem: We aren’t finding 1.7 million barrels of new conventional oil every day. In fact, a review of oil markets by BP shows that global reserves of crude oil fell in 2006—only by 0.1%, but the 10-year rolling average growth in oil reserves worldwide has also dropped to 1.4% from 4.2% in 1990. Supplies are falling. Demand is going up. It’s pretty easy to be bull-ish on oil prices, and they don’t get much more bullish than the people who run Canadian Oil Sands.
Sitting in the trust’s boardroom, high above downtown Calgary, Marcel Coutu, the easygoing CEO of Canadian Oil Sands, exudes a certain nonchalance, and who can blame him. “We believe that crude oil will outperform all other com-modities and inflation,” he says. “We’re running out and demand is rising faster than all of us can keep up with.”
Coutu isn’t the only one who is bullish on oil. Rob McConnachie, a portfolio manager at Dixon Mitchell Investment Coun-sel, bought units in COS several years ago, and plans to hang on to them for a while—at least a couple of decades. McConnachie, whose long-term returns have tended to trounce the benchmark indexes, likens investing in COS to buying an inflation-linked bond. “Oil prices should go up faster than inflation,” he says, meaning an investment in COS will provide investors with a real return. He points to the trust’s almost infinite reserve life—some nine billion barrels—and its virtually non-existent political risk compared to the Middle East, Russia or Venezuela, adding that “over time, the cost of extraction should come down while the cost of finding conventional oil will go up.”
In a nutshell, Syncrude has upside: With 30 years of expertise in mining the oil sands, and tens of billions of dollars al-ready invested, it can go on producing 350,000 barrels a day for the next 70 years without spending a dime on replacing its reserves—the bane of most conventional oil companies. In fact, the company plans to increase its production to 500,000 barrels a day around 2017. And, while newpaper headlines scream about skyrocketing development costs in the oil sands, Syncrude’s operating costs were lower in 2007 than they were the year before.
If you’re optimistic about rising oil prices, Canadian Oil Sands Trust is still a great investment.
Valuation
When considering an investment in COS, the most obvious factor is its yield. The trust has been increasing distributions substantially so that they are now $3 per unit annually for a yield of 8%. The payout ratio—that is, the proportion of distri-butable cash the trust actually pays out to shareholders—will be about 89% in 2008, according to BMO Capital Markets. If everything else remains equal, COS should be able to start paying corporate taxes without cutting distributions when the income trust holiday ends in three years.
Still, that’s a lower yield compared to yields on other commodity-related trusts. BMO's average for non-energy commod-ity trusts - everything from hardwoods to copper concentrate - is about 13%, although prices for these materials are far more volatile than for oil. Even compared to oil, though, COS looks expensive, since BMO pegs the average yield for en-ergy trusts at 12%. But looks can be deceiving: McConnachie tells the story of a client who tore a strip off him for buying COS. "He said, 'You idiot, why would you buy one with a 5% yield when you could get one with 12%? That client pulled his money out and bought the trust in question, which promptly cut its distributions. Meanwhile, distributions in McConnachie's COS units have risen to the point where the yield on purchase cost is beyond 30%.
The point is that high yields often signify high risks. Arc Energy Trust, for example, has a yield of 11% but a reserve life index of just 12 years, meaning that at its current rate of production, it will run out of oil in a little more than a decade if it doesn't find new reserves. But COS is sitting pretty on reserves that will last three decades, and quite possibly longer. Furthermore, Arc's finding, development and acquisition costs were $27 a barrel in 2006, with a three-year average of $19; operating costs were about $9 a barrel of oil equivalent (the trust produces both oil and gas). All in, that's $36 per barrel compared to about $25 at COS.
Another factor is growth. Syncrude has a small expansion planned that will in--crease capacity from its existing plant by 30,000 to 50,000 barrels by 2012, as well as the big bump of 100,000 barrels per day around 2017. Done right, both expan-sions will add quite a lot of value to the trust. COS looks like a far better long-term choice if you're willing to bet on high prices - hence the much lower yield.
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