Warren Buffett (Trades, Portfolio) only owns two stocks in the energy sector, and they both pay a dividend – Suncor (SU) and Phillips 66 (PSX). Suncor’s dividend yield is 3.7%, and it has increased its dividend for 13 consecutive years.
Buffett first bought into Suncor in 2013, investing around $500 million at the time. He subsequently purchased more shares during the third quarter of 2015, making Suncor 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 Suncor.
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.
Suncor 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 countercyclically (e.g., pursuing attractive acquisitions) when other companies can’t.
While we certainly cannot and will not begin to guess when oil prices will recover, we are very comfortable owning Suncor in our Conservative Retirees dividend portfolio.
Business overview
Suncor 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, Suncor 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 and production activities and 33% from midstream and downstream (refining and marketing) operations, which include four refineries, a lubricants plant, Canada’s largest ethanol plant and more than1,500 Petro-Canada retail gasoline stations.
With the crash in oil, Suncor’s profit mix through the first nine months of 2015 was 6% oil sands, 6% exploration and production and 88% refining and marketing.
Business analysis
Despite its sensitivity to oil prices, Suncor 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 Suncor apart from its peers and have helped it remain the low-cost competitor in its sector.
Suncor’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 Suncor claim ownership over the most attractive territories while also building up meaningful operational expertise to efficiently run complex oil sands projects.
Suncor’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 it take advantage of differentials that may occur between extraction of resources and selling them to the final customer. Suncor 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 Suncor’s trading capabilities and diversifies cash flow sources during times of unexpected commodity swings.
Suncor’s asset base, operational expertise and capital discipline have helped it establish extremely low production costs. Management expects Suncor’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 C$900 million of growth capital in the third quarter, Suncor generated free cash flow. Through the first nine months of 2015, Suncor has generated C$5.5 billion of cash flow and C$875 million of free cash flow after C$2.7 billion of growth capital spending.
Suncor’s balance sheet is another advantage. The company finished last quarter with C$5.4 billion in cash and undrawn lines of credit of C$6.9 billion for total liquidity of over C$12 billion. It also has an investment-grade credit rating from Standard & Poor's 500.
All of these advantages are allowing Suncor 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 C$15 billion project that is set for first oil production at the end of 2017. Suncor recently bought another 10% interest in the project for C$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 C$25 per barrel. The price Suncor paid for the additional 10% interest was about C$56,000 per flowing barrel compared to overall project costs of C$84,000 per flowing barrel, creating potential for a very strong return.
However, Suncor’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. Suncor currently owns 12% of the project.
Suncor 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 Suncor’s 90%-plus 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 Suncor is trying to buy the asset at a distressed level price. Suncor’s offer has been extended through Jan. 27, and we hope it is ultimately accepted.
All things considered, Suncor 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 its 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.
Suncor shouldn’t be one of them due to its low-cost operations, strong cash flow generation, and investment-grade balance sheet.
Suncor’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.
Its oil sands production is also more costly than conventional oil production because of its energy-intensive production methods. However, Suncor’s E&P and refining and marketing segments and extensive logistical network help diversify its cash flow. In its 2014 annual report, Suncor 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, Suncor 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 60 cents on the dollar, but it’s a bet on management to feel comfortable about this opportunistic risk.
Dividend analysis
We analyze 25-plus years of dividend data and 10-plus years of fundamental data to understand the safety and growth prospects of a dividend.
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 good, and 25 or lower is considered weak.
Suncor’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, Suncor paid dividends of C$1.23 billion. Over that same time period, the company generated C$875 million of free cash flow – not enough to cover the dividend at first glance. However, this figure included a whopping C$2.7 billion of growth capital spending, which is ultimately discretionary in nature if things ever got really bad.
If Suncor cut all growth capex, it would have generated about C$3.6 billion of free cash flow compared to its dividends paid of C$1.23 billion – nearly 3x coverage. Additionally, Suncor has C$5.4 billion in cash and undrawn lines of credit of C$6.9 billion. The company also maintains an investment-grade credit rating with Standard & Poor's (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 Suncor’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 Suncor’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 Suncor’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 five to 10-plus years with projects such as Fort Hills and flexibility with growth capex, Suncor’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 good, and 25 or lower is considered weak.
Suncor’s dividend Growth Score is 7, suggesting that the company’s dividend growth potential is weak. With the rapid decline in oil prices, this is no surprise. Furthermore, with potential opportunities to purchase competitors at 75 cents on the dollar, we would rather see Suncor 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, Suncor 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, Suncor’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 Suncor’s growth projects start ramping up (end of 2017), dividend growth potential should meaningfully improve.
While Suncor 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
Suncor trades at 25x forward earnings and offers a dividend yield of 3.7%. 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 Suncor’s profits to come in close to where they were during 2009. It is reasonable to assume that the company’s profits could at least double or triple over the next two to four 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 to $40 per share (up from $23.50 today). It’s hard to see how things get worse from here unless Suncor makes a dumb acquisition, and oil falls into the $20s.
Conclusion
Suncor 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 (Trades, Portfolio)’s two holdings in the energy sector.
The dividend is safe and Suncor’s financial health has positioned it extremely well to take advantage of its distressed competitors. Whenever oil prices start to normalize, Suncor will emerge much stronger than it was going into the slump. We are happy to collect Suncor’s 3.7% yield in our Conservative Retirees dividend portfolio and patiently wait for better times ahead.
Disclosure: The author is long Suncor.
