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Think Oil Will Recover? Then Canadian Oil Sands Ltd. Could Soar

There are two ways for investors to bet on crude’s recovery. One is a pretty cautious, while the other is a little risky.

Let’s look at the cautious scenario first. By buying a stock like Imperial Oil or Canadian Natural Resources, investors are preparing for the worst. If crude continues to be weak for a few years, there’s little doubt that both of these companies will survive. They have pristine balance sheets, low-cost production, and management teams with a history of making prudent decisions.

But there’s one big disadvantage in that plan, and that’s a lack of potential upside. Look at it from this perspective—over the last year, Canadian Natural Resources is only down 3%, while Imperial Oil’s shares have eked out a tiny gain. Considering the price of crude was down about 50% during that time, how exactly does that make sense?

The other way to play the recovery is to get a little risky. There are plenty of producers with high-cost assets that have been crushed by the market. Essentially, these companies have become a levered way to bet on an increase in the price of crude. As oil goes up, so does the probability that these companies will survive.

Perhaps the most well-known example of this is Canadian Oil Sands Ltd. (TSX:COS), the 37% owner of  the Syncrude oil sands project. Its share of production is about 100,000 barrels per day, with a cost of about $48 per barrel, not including any non-cash items like depreciation or capital expenditures. The decline of the Canadian dollar has helped, but at this point, the company is barely breaking even.

While the company waits for oil to recover, it has taken some prudent steps. The dividend has been slashed twice, first to $0.20 per share on a quarterly basis, and again to a nickel per share once it became obvious this oil recovery wasn’t going to be as fast as the last one. The company also anticipates that its share of cost savings will be between $160-250 million in 2015, which will definitely help.

The kicker

Perhaps the most compelling reason to invest in Canadian Oil Sands is this: there’s a lot of oil still left under the ground at Syncrude, and you’re paying a very low price for it.

The company has a current enterprise value of $6.7 billion. Its share of proved and probable reserves are 1.6 billion barrels. This means that investors buying shares today are paying about $4 per barrel for the reserves that are easy to extract. There’s an additional 2.1 billion barrels of contingent and prospective reserves that are being thrown in for free.

Many investors don’t really understand the scale of those reserves. Based on production of 100,000 barrels per day, those reserves will last another 43 years. And that’s without even touching the other 2.1 billion barrels, which might not be economically feasible production today, but sure could be in the future.

Why isn’t the market valuing those reserves at a higher price? It’s simple. Investors are guilty of not looking beyond the latest quarter. Right now, those reserves can’t be extracted profitably, so the market prices them accordingly.

The big risk is that Canadian Oil Sands might get into major financial trouble before oil recovers. It’s a risk, but not much of one, at least in my opinion. There are other companies involved in Syncrude that could buy out the company’s share of the project, but I don’t think it’ll even come to that. Canadian Oil Sands has debt of about $1.9 billion and an undrawn credit facility of $1.4 billion. The earliest debt comes due in 2019. In short, there’s a long time to go before investors should start getting worried.

Canadian Oil Sands is likely a long-term winner. Investors who are willing to stomach a little short-term volatility will likely be pretty pleased with that decision a few years from now.

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Fool contributor Nelson Smith owns shares of CANADIAN OIL SANDS LIMITED.

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