Canadian Oil Sands Ltd. (TSX:COS) is making progress on its turnaround efforts, but investors are wondering if the company will survive an extended downturn in the oil market.

Syncrude pain

Hard-core fans look at the company’s vast Syncrude reserves and say Canadian Oil Sands is hugely undervalued. They might be right, but oil in the ground isn’t any good to investors if the company can’t get costs down to the point where it generates positive cash flow.

Canadian Oil Sands owns the largest Syncrude stake among the seven partners, meaning the company is on the hook for the biggest part of the expenses. The oil rout came at a very bad time because Syncrude was already battling high operating costs and abysmal production numbers.

How bad was 2014?

Management reduced 2014 production guidance three times and the year-end tally still came in at the bottom of the worst-case projection. Syncrude has the capacity to produce 350,000 barrels per day, but output in 2014 only averaged 258,000 barrels per day.

Operating costs rose to $49 per barrel last year.

Better days ahead

The first quarter of 2015 brought improvements as the company bumped production up to 294,000 barrels per day and operating expenses fell to $35.71 per barrel.

Canadian Oil Sands is also wrapping up two major capital projects at Syncrude, which should translate into capital reductions of $1.7 billion in 2015 and improved operating results.

Cash is king

Cash flow and debt are the two main challenges right now.

Canadian Oil Sands is projecting cash flow of $407 million for 2015 using an average WTI price of US$55 per barrel and a CAD:USD exchange rate of $0.82.

Through the second quarter oil prices rallied above the guidance price and the stock found some support, but the recent pullback in oil prices now has investors worried again that the company is going to run out of time.

Capital costs for the year are expected to be $429 million, just below the target cash flow, so there is already a shortage and that still doesn’t cover the $96 million in dividend payments.

If WTI oil prices move back above $55 for the rest of the year, the company should be okay. If oil is going to stay at the current level of $52 or fall further, the numbers could start to get tight.

The falling Canadian dollar is a double-edged sword. It helps improve margins on oil priced in U.S. dollars, but it has a nasty impact on the company’s U.S. dollar-denominated debt.

As the U.S. dollar gains against the Canadian dollar, the company’s debt-to-capitalization ratio increases. As of March 31 the ratio was 35%, up from 30% at the end of December. The company has to keep it below 55% to avoid breaching lending covenants. Canadian Oil Sands had $2.3 billion in long-term debt at the end of the first quarter and a total capitalization of $6.63 billion.

Takeover rumours

Some pundits believe a white knight will save shareholders if oil prices fall to the point where Canadian Oil Sands can’t meet its obligations on Syncrude.

Suncor and Imperial Oil are both large Syncrude partners with strong balance sheets and either one could easily acquire Canadian Oil Sands. Imperial is the most likely suitor because it owns a 25% stake in the project and has the contract to operate Syncrude.

What about investors?

Suncor and Imperial will likely wait until the last minute before they step in to “help” out, so investors are unlikely to see any benefit from a takeover.

Should you buy Canadian Oil Sands?

If oil prices rebound and Syncrude manages to avoid further operational troubles, Canadian Oil Sands could easily double from the current price of $9 per share. However, the stock could also be cut in half if things don’t go that way.

At this point, it’s a risky play and I would avoid the name.

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Fool contributor Andrew Walker has no position in any stocks mentioned.