While Canadian Oil Sands Ltd. (TSX:COS) was rightfully shunned by most as a viable way to gain exposure to the oil production sector during the oil price decline, the recent Q1 2015 earnings release, coupled with the apparent firming up of WTI prices, makes Canadian Oil Sands an intriguing option for the first time in months.
Canadian Oil Sands is a pure-play oil company, producing 100% synthetic crude through its 36.74% stake in the Syncrude oil sands mining project. Due to the fact its production is entirely unhedged, it is deeply leveraged to the price of oil—a fact that resulted in the stock falling 60% from September to December 2014, and the dividend being slashed 75%.
While the company did report a loss of $186 million in Q1 2015, there were several extremely positive operating and financial results, which leverage the company even more significantly to a recovery in oil prices, while improving its downside protection should oil prices decline once again.
Canadian Oil Sands is showing success in its cost-cutting initiatives
Canadian Oil Sands responded effectively to declining oil prices by intensifying efforts to achieve a lower cost structure. As part of this plan, Canadian Oil Sands targeted operating cost reductions of between $260-400 million. Lowering operating costs has the potential to significantly increase cash flow from operations in current oil price conditions and allow the company to benefit further from price increases.
The company demonstrated impressive success in moving towards these targets, and its current operating expense per barrel is an extremely low $35.71 for Q1. This is in contrast to $46.91 in Q1 2014, and Canadian Oil Sands has not seen operating costs in this range since 2011-12.
These reductions stem largely from lasting changes to cost structure
There are multiple factors underpinning this decline in operating costs. Approximately 34% of the decline is because of cheaper natural gas and diesel costs. While this is important, it is far more significant to note that the remainder of the difference is due to declines in production and maintenance costs as a result of the company improving its cost structure.
These declines in production and maintenance are attributable partially to increased efficiencies, labour, and supply cost improvements. They are also attributable to the fact that Canadian Oil Sands recently completed four major capital projects, all of which will improve reliability and reduce maintenance costs. For example, the recent completion of the Mildred Lake Mine Train replacement project will not only reduce maintenance expenses, but will also improve reliability since redundancies built into the project can reduce the impact of unplanned outages.
Improved reliability further reduces operating costs since a lower frequency of unplanned outages can improve utilization, which in turn means more production, and therefore lower costs because they are spread over more barrels.
Canadian Oil Sands is now predicting cost reductions in the mid-range of its $260-400 million target, but is targeting the higher end of the range. This has resulted in Canadian Oil Sands guiding $407 million in cash flow from operations, or $0.84 per share, at an estimated oil price of US$55 (below current levels).
This is up from Canadian Oil Sands’ previous $0.74 cash flow guidance for 2015. Given Canadian Oil Sands’ oil price sensitivity should oil prices increase to US$60, this would result in $1.17 per share of cash flow, or $571 million in cash flow from operations, which is well in excess of the company’s $429 million in capital expenses
On the other hand, should oil prices decline to US$50, Canadian Oil Sands would realize a loss of nearly $200 million, but these losses are mitigated by the operating expense reductions and could be further mitigated by Canadian Oil Sands hitting the high end of its operating cost reduction range.
With $1.1 billion of unused credit facility space, a lower cost structure, and oil prices that have possibly stabilized in the US$50-60 range, there is good reason to believe the worst is over for Canadian Oil Sands.
