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Is Canadian Oil Sands Ltd. Headed Back to $6?

Canadian Oil Sands Ltd. (TSX:COS) had a nice pop after it announced the big cut to its dividend, but the stock has since fallen 20% and investors are wondering if the surge was just a head fake.

Let’s take a look at the situation to see if you should try to catch this falling knife.

Syncrude troubles

The past three years have been difficult for Canadian Oil Sands. The company’s entire existence depends on the success of the massive Syncrude oil sands project, and the performance of that asset has been abysmal.

Canadian Oil Sands owns about 37% of Syncrude, making it the largest shareholder. This means the company is responsible for the largest part of the costs, and Syncrude has been one big money pit.

Operational challenges continue to plague the company and every time it looks like things are getting back to normal, something else goes wrong. Syncrude has a design capacity to produce 350,000 barrel of oil per day. In 2014, the project averaged 258,100 barrels per day.

Canadian Oil Sands reduced 2014 production guidance three times and the final output of 94.2 million barrels came in below the bottom end of the lowest revision.

Lower production coupled with high maintenance costs resulted in operating costs of about $49 per barrel for 2014. When oil prices were trading above $100 per barrel, the company could handle some inefficiency in the operation. Now, the company is hard-pressed to break even.

Debt issues

Canadian Oil Sands finished 2014 with $1.9 billion in net debt. Once you add in the contractual obligations, the commitments jump to about $4 billion. As with a number of its peers, Canadian Oil Sands is at risk of breaching its lending covenants.

The company has to keep its long-term debt-to-total capitalization below 55% to avoid trouble with its lenders. At the end of Q4 2014, that number sat at 29%, which looks manageable, but it doubled during 2014 due to negative movements in the Canadian dollar against its U.S. counterpart.

The dollar has continued to slide since the beginning of the year and that is going to put more pressure on the company and its stock, especially if the whiz-kid traders start to do the math and determine that the 55% limit could be at risk.

Buy out rumours

There has been a lot of talk about Canadian Oil Sands being bought out by its partners. A consolidation of the ownership in Syncrude could happen and both Suncor and Imperial Oil have the means to acquire the assets, but they would only make that move if Canadian Oil Sands could no longer meet its financial obligations on the project. If things get to that point, the stock won’t be worth much.

What should investors do?

There is no doubt that Syncrude is a great long-term asset that should pump out decades worth of free cash flow. Unfortunately, Canadian Oil Sands investors might not get a chance to reap those rewards if oil prices continue to drop and Syncrude can’t get its costs down fast enough.

At this point, the stock is very speculative. A rebound in oil prices would certainly send the shares much higher, but the downside risks given the precarious financial situation might be a bit too much to take on at this point. In the near term, we could see the stock retest its January lows.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

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

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