Canadian Oil Sands Ltd. (TSX:COS) has risen more than 20% in the past two weeks and investors with an eye on beaten up oil sands stocks are wondering if this is the beginning of a big rally.
Let’s take a look at the current situation to see if you should be adding the company to your portfolio.
Operational challenges
The rout in the oil market over the past six months has been extremely painful for Canadian Oil Sands, but the company has been struggling for much longer.
Canadian Oil Sands is the largest shareholder of Syncrude, a massive oil sands project. For the past three years, Syncrude has been an absolute nightmare. Unplanned outages and expensive maintenance work have driven down the plant’s efficiency to the point where Syncrude’s operating cost per barrel is one of the industry’s highest.
With a 37% ownership in the projects, Canadian Oil Sands is on the hook for the largest part of the expenses to keep Syncrude running.
Syncrude has a design production capacity of 350,000 barrels of oil per day. Last year, production averaged 258,100 barrels per day. To say it was a bad year is an understatement. Canadian Oil Sands had to reduce production guidance three times in 2014 and the final output for the year came in at just 94.2 million barrels, slightly below the bottom end of the third revision.
The lower production levels, combined with the high maintenance expenses, drove 2014 operating costs up to $49 per barrel.
Balance sheet concerns
Canadian Oil Sands finished 2014 with net debt of $1.9 billion, which translated into a long-term debt-to-capitalization of about 30%. In order to avoid breaching its lending covenants, Canadian Oil Sands must keep the debt-to-capitalization ratio below 55%. The weakening of the Canadian dollar against the U.S. dollar could have a large negative impact on the ratio, and the loonie has fallen about 7% since the beginning of 2015.
For the moment, the company should be fine, but investors shouldn’t ignore the covenants. In 2014, Canadian Oil Sands’ debt-to-capitalization ratio doubled.
On the bright side, Syncrude is completing two major upgrade projects that will free up cash flow and significantly reduce some of the financial risks.
2015 guidance
Syncrude production guidance for 2015 is 95-110 million barrels. Canadian Oil Sands expects to bring operating costs down to $40 per barrel this year and capital expenditures are predicted to be about $450 million.
The company now expects WTI oil prices to average US$55 per barrel. Cash flow from operations is targeted to be $368 million. For the moment, Canadian Oil Sands still plans to pay a quarterly dividend of five cents per share.
Should you buy?
The price of oil is still below the new guidance target and expected cash flow from operations will not cover revised capital expenditures or the dividend. Given Syncrude’s track record over the past couple of years, investors should build in a cushion for some extra expenses when crunching the numbers.
If oil rallies the stock will surge, and there is no doubt about the long-term quality of the Syncrude reserves, which is the carrot at the end of the stick. But the ongoing weakness in crude prices and the lofty operational costs suggest there might be some more pain coming before the end of this year.
