The holder of the largest single interest in the Syncrude project, Canadian Oil Sands Ltd. (TSX: COS), remains a favorite among investors because of its juicy dividend yield of 6.3%, coupled with a sustainable payout ratio of 82%. But its share price has pulled back 5% since the end of March 2014 because of disappointing operational and financial results for the first half of the year.
This has some analysts calling the pullback a sterling opportunity to make a bargain investment in one of the oil sands industry’s quality operators. There are, however, a number indicators making me believe Canadian Oil Sands is not exactly a bargain at this time. In fact, I think we will see its performance continue to decline, possibly even threatening that juicy dividend yield.
Crude production continues to decline
A worrying aspect of Canadian Oil Sands’ operations is the continued decline in crude production for the second-quarter 2014, plunging a massive 27% compared to the previous quarter and 23% for first-quarter 2013. This is the lowest level of production in the last eight consecutive quarters and sets a worrying precedent because of its impact on cash flow, particularly with crude prices having peaked during the quarter due to escalating crises in the Middle East.
The significant decline in production can be attributed to unexpected outages of the upgrading machinery (which turns bitumen into light sweet synthetic crude). While the company claims these unexpected outages are rare, I would disagree given the complexity of the machinery and the number of unexpected outages experienced.
Furthermore, the complexity of the machinery required to convert bitumen into light sweet crude requires extensive and ongoing maintenance, which can be quite costly and lead to regular production outages.
Cash flows are declining while operating costs are rising
The significant decline in production had a serious impact on operating cash flow for the second quarter of 2014, with it declining a massive 32% quarter over quarter and 29% year over year to $240 million, or $0.50 per share.
This is of some concern because oil production is a capital-intensive business where cash is king, with any sustained decline in cash flow having a meaningful impact on the capital expenditures required to sustain production. It also has the potential to negatively impact Canadian Oil Sands’ balance sheet with a sustained decline typically leading to the need to boost debt as a means of funding critical capital expenditures and operating costs.
Even more concerning is that operating costs are rising, spiking a very unhealthy 27% quarter over quarter and 38% year over year for the same period, much of which can be attributed to unplanned maintenance on the upgrader.
This points to a disturbing trend: Operating costs have risen on average by 4% per quarter over quarter for the last eight quarters, and I expect this to continue — primarily because costly maintenance is required to keep the complex upgrading machinery functioning efficiently as well as rising transportation costs caused by the pipeline crunch and an overall trend toward higher costs across the oil sands industry. All of this is squeezing Canadian Oil Sands’ margins and ultimately its bottom line.
For the second quarter of 2014, its operating margin per barrel of crude produced, or netback, plunged a whopping 21% quarter over quarter and 15% year over year to $46.62 per barrel. This is quite concerning because for the same period Canadian Oil Sands’ average realized sale price per barrel of Syncrude was $112.04, or 6% higher quarter over quarter and 11% year over year.
Since the price of WTI, against which Canadian Oil Sands’ Syncrude sales are benchmarked, is expected to soften over the near to medium term, I expect this margin to fall, further impacting cash flow and its bottom line.
But what does all of this mean for investors?
Already, Canadian Oil Sands was forced to reissue its 2014 full-year guidance at the end of the first quarter. Annual average daily production was pared back by 5% to 100,000 barrels daily, and operating expenses increased 6% to an average of $46.08 per barrel.
But given the poor second-quarter performance, including a significant plunge in production and an equally significant increase in operating expenses, I find it difficult to see it even achieving the revised guidance. I believe average annual production will be close to around 95,000 barrels of Syncrude daily, while operating expenses may be as high as $48 per barrel, which when coupled with softer WTI prices will have a big impact on cash flow and the bottom line.
All of this makes it likely the share price will soften further and that the dividend payout ratio will increase from 82% of net income and 50% of cash flow. However, unless these is a sustained plunge in WTI to below $80 per barrel, it is unlikely the dividend will be under threat. I do believe, though, that all of this indicates there are better opportunities for investors seeking exposure to the energy patch.
