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  • "The market can remain irrational longer than you can remain solvent" - John Maynard Keynes

    Sunday, March 14, 2004

    Price of Oil

    There have been three interesting articles on oil this week from the Wall Street Journal (Losing Reserve: At Shell, Strategy And Structure Fueled Troubles), Barron's (Half Empty? World oil supplies, while not running out now) and Financial Sense Online (Energy and the US Dollar). The summary of their consistent main themes are;

  • Oil price futures currently predict a decrease in oil prices
  • A well respected geologist named Colin Campbell, a 72 year old with a doctorate in geology from Oxford and stints at major oil concerns including Texaco, BP and Amoco from 1957 till 1990 and author of The Coming Oil Crisis, believes oil production will peak in 2010
  • OPEC is incented by their internal quote system to misrepresent their total reserves, as quota are based on total reserves
  • OPEC reserves report yearly show the same numbers over and over again even though some of the oil has been drilled, this implies production exactly matches discovery. This pretty much guarantees the OPEC numbers are incorrect.
  • All OPEC countries greatly increased their stated reserves in the mid-80's with no corresponding discoveries, probably to expand their quota
  • Saudi Arabia is further incented to misrepresent reserves to curry favor with the West and to maintain its political stability
  • A coup in Saudia Arabia would have a significant effect on oil prices
  • Oil companies are currently drilling more oil than they are finding; they are not replacing reserves
  • With the increased demand there is only about 1M barrels a day of swing capacity (mostly provided by Saudi Arabia) where there was 6.5M in the past ten years
  • China's oil consumption has doubled since 92 from 2.7M to 6M in January
  • "Demand -- if it continues to rise at about a 1.5% annual rate -- would climb from 77 million barrels a day in 2000 to 80 million barrels in 2005 and 86 million barrels in 2010"
  • With oil prices so high there is a belief that OPEC members will start cheating, there is no evidence that this is starting to happen and the spare capacity may not be there to support cheating this time around
  • The political instability in Venezuela could affect the output from the world's 4th largest oil producer

    The articles make an interesting argument for a coming bull market or at least a sustained $30-$35USD market in oil. Interestingly the contrarian play in oil right now is the bull case. Common perception is a declining price for oil.

    A Free Call Option on Oil
    Canadian Oil Sands ( or COSWF ) essentially provides the unit owner with a free call on the price of oil. In fact the economics are even better than that. You are essentially buying a heavily in the money call with a strike price of oil at $21USD. The investment maintains it's value if oil is at $21USD and increases as oil increases above that amount. And the call has a 35 year life and pays dividends! There are three posts below on Canadian Oil Sands.
  • Saturday, March 06, 2004

    Canadian Oil Sands Value
    I had assumed various values for oil on a going forward basis. None of these had been based on anything other than projecting today's price of $35+ forward or taking the COS planning price of $25 forward. Neither takes advantage of the data available in oil futures. I updated my model to include oil prices based on futures prices which go all the way to December 2010. The price of oil assumed in the futures prices are 34.54 in 04, 30.83 in 05, 28.99 in 06, 28.52 in 07, 27.94 in 08, 27.87 in 09, 28.05 in 10 and 28.2 after that. I'm going to stick with futures oil prices in my model going forward. After all if COS hedged their production for the next 10 years this is the price they could get. It's reasonable to assume that their lack of hedging is only because they see upside (that said mining/drilling operators have been notoriously bad hedgers historically, with their maximum hedges in place at low points and minimum hedges in place at highs!). This leaves an intrinsic value of around $125CAD assuming no dilution.

    In their conference call and announcement regarding the budget overrun, COS indicated some dilution may be necessary. I see a dilution of 3.2% if they fully hedged their next 2 years production at current futures prices. That is 3.2% if oil averages 34.54 this year and 30.83 next year. In fact if oil meets this years estimate and stays above 33.8 next year there will be no dilution. Even with 3.2% dilution the value is well above $100CAD per unit.

    Oil Price 04Oil Price 052004 Cash2005 CashBank FacilityNet DefecitDilution

    Friday, March 05, 2004

    Great Buying Opportunity
    Canadian Oil Sands announced last night that their current expansion project is going to run over budget by at least 2Bn (50% chance of it being higher) and take 6-9 months longer than expected. Aside from being an interesting project management study, there is not much impact on the value of the business. My model estimates around an $8CAD haircut as a result of the announcement. Intrinsic value still sits above $100CAD. At $47.5CAD today it is a great buying opportunity. Interestingly on their conference call last night they talked about capital expenditure going forward and it was lower than my estimates. This is likely to to add a few dollars back.

    Finally and most importantly if oil stays above $30 long term intrinsic value is up around $135CAD after this announcement.

    Wednesday, March 03, 2004

    The least speculative commodity play
    Oil and other commodity related stocks have performed very well over the last 12 months which has left me with very little interest in them. Generally you are not going to find bargains in any sector that has had a fantastic performance up around 35% over the last 12 months with the S&P 500 up 34% (IGE is the iShares Goldman Sachs Natural Resources Index Fund). Additionally Dr Ed Yardeni, an economist with Prudential has identified that Oil and Gas companies outperform the market during interest rate troughs.

    Given that I shouldn’t be looking in Oil and Gas, I just couldn’t resist. After writing about Master Limited Partnerships I started to research some, and after significant analysis I believe that I have identified a stock with 30-40 years of oil reserves and a pretty large and growing market to sell that oil into. This stock is even better than an MLP because there is no master partner taking additional compensation and all of the management team is drawing relatively low compensation.

    The Canadian Oil Sands
    Canada has recently been recognized as having the world’s second largest supply of Oil. About 175 Billion Barrels, behind Saudi Arabia’s 260 Billion or so. Iraq in turn has 110 Billion. There are two main differences between the Canadian and Saudi oil. In Canada the oil is contained in bitumen like substance in Oil Sands. In Saudi Arabia it’s more or less in underground lakes. The Canadian oil is much more expensive to process than the Saudi Oil but of course Canada has none of the associated political risk. With the growing demand from India and China as well as the lack of stability in the middle east, the days of $22USD oil may well be behind us. It is important to realize that 6 year oil futures are now priced at close to $28USD.

    Canadian Oil Sands Trust (COSWF)
    My analysis leads me to believe that the Canadian Oil Sands Trust is trading at around 50% of its Intrinsic Value. The beauty of a trust that simply processes oil sands is that you are not exposed to management’s whims (for example investing money looking for new properties). The trust has to return all of its cash flow to unit holders after certain investments and expenses. This makes the business extremely easy to model.

    COSWF has posted a 2004 projections document on their website ( This provides a great start for modeling their free cash flow. Their uses of cash are investing in increased production facilities, maintenance capital expenditure, Crown Royalties, costs of extracting the oil, interest and G&A. On the revenue side they get paid for delivering their oil, high quality oil, that generally receives a premium price. The company is currently cash flow negative as they are investing in Phase 3 of their 5 phase expansion plan. By the end of 2005 they should have doubled their yearly production. Phase 4 should lead to a further 16% increase in 2010 and another 35% increase in 2015 associated with Phase 5. Eventually the Synacrude partnership, of which COSWF owns 35%, will be producing 200 Million Barrels per year. Based on these growth numbers their proven reserves have 19 years of life and their undeveloped resources will last until 2048! Throughout my analysis I have assumed a 35 year life (through 2039) which discounts the undeveloped resource.

    The other beauty of analyzing this trust is that you can really do a discounted dividend analysis. I have assumed that they only pay out $2 for the next 11 years to fund their phase 4 & 5 expansions which I estimate will cost 848M and 7.8Bn respectively in future dollar terms. They will also have to borrow and incur interest expenses during these expansions. After that they increase their dividend to 30% of cash flow until Phase 5 is complete. Then they pay out 100% of their free cash flow and they are debt free. This free cash flow is cash after interest payments, crown royalties, maintenance capital expenditure, and G&A. They have publicly stated that they would like to pay out more than $2 in the near future; though I am concerned that it will impact Phase 4 & 5 financing and timing. Importantly more cash earlier raises the present value.

    This model reveals a value of around $110CAD. It is trading at $52.88CAD today. This assumes a $25USD price of oil (below the $28USD 6 year futures price) for the entire analysis period and a 10% discount rate. With a 7% discount rate (the actual cost of equity) the value is closer to $200CAD. With oil at $35USD you would see a value of around $184CAD with the higher discount rate. In fact oil at $16 reveals an NPV of $53CAD, again with the 10% discount rate. Remember there is practically no risk in terms of finding oil; the key risks are around exchange rates and commodity prices.

    Canadian Dollar
    As Canadian Oil Sands is listed in Canada you are exposed to a few problems. Firstly to buy it in the US you have to use the over the counter COSWF tracking stock. In effect when you buy COSWF in the US, a broker buys COS_u.TO in Canada, converts the USD and charges you about .4% for the privilege. Unfortunately the purchase leaves you exposed to movements in the US/Canadian dollar; a much more complex factor than valuing the oil sands. Consider this, you invest in COSWF when Canadian Oil Sands is trading at $50CAD and the exchange rate is $1.35 Canadian for $1USD. You have therefore made your purchase at $37.04US. Now if COS stays at $50 CAD but the US dollar strengthens to say $1.50Canadian for $1 US then your investment is only worth $33.3USD. Of course if the dollar weakens the converse is true. Importantly there is a relationship between the price of oil and the US dollar and they will act in concert to increase the value of the investment if the US dollar depreciates. If the USD and CAD reach parity then your $50CAD investment is worth $50US and oil is probably at $40USD+ further increasing the value of the trust.

    It is relatively cheap to hedge your exposure to a rising US dollar (falling CAD). A 9 month Put on the CAD/USD will cost you between 1.7% to 2.4% of a 100k investment, (depending on how much risk you are willing to take). The puts are priced in terms of US cents required to purchase $1 CAD, this is different to the USD/CAD rates which indicate how many Canadian cents it takes to buy $1USD (they are the inverse). If you bought the Put at today’s price it would be about 2.4% or 3.2% annualized. This compares favorably with the current COS dividend of 3.91%.

    But wait there’s more
    Even better than a half priced stock with massive leverage to the growing demand for commodities and the political instability in the Middle East. COS has a DRIP that allows you to purchase more units at a 5% discount with each of your distributions. If you reinvested your dividends at the 5% bonus until 2015 (by which time the scheme will probably end as they will no longer need additional capital) the intrinsic value of your share of the trust will nearly double.

    About 10% of the dividend is return on capital and therefore not taxed in the US. The other 90% qualifies for the 15% dividend tax treatment.

    The trust is currently valued well below its peers. At first glance their lack of free cash flow and their poor payout ratio make the stock look unattractive. Once they have completed Phase 3 in 2005 they plan to increase their payout. This should move the stock to trade more in line with its peers. Additionally any oil shock or even a prolonged high oil price will lead to a revaluing of these companies.


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    Disclaimer and Disclosure Analyses are prepared from sources and data believed to be reliable, but no representation is made as to their accuracy or completeness. I am not paid by covered companies. Strategies or ideas are presented for informational purposes and should not be used as a basis for any financial decisions.
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