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Should Contrarian Investors Bet on Canadian Oil Sands Ltd.?

As oil prices continue to recover, investors are starting to kick the tires again on some of their favourite names in the energy sector.

Let’s take a look at Canadian Oil Sands Ltd. (TSX:COS) to see if it deserves a spot in your portfolio.

Production challenges

Long-term investors are certainly hoping the recovery continues, but the company still faces some daunting challenges.

Canadian Oil Sands is the largest shareholder of Syncrude, a massive oil sands company that has struggled horribly in the past three years.

Unplanned outages and costly maintenance work have hindered the company’s ability to hit production guidance. In fact, Canadian Oil Sands had to reduce its production outlook three times in 2014 and the final results missed the most conservative projection.

Syncrude has a production capacity of 350,000 barrels of oil per day, but 2014 production averaged just 258,100 barrels per day.

Operating costs

The lower output combined with high maintenance costs resulted in 2014 operating costs of $49 per barrel. In an effort to survive the oil rout, Canadian Oil Sands slashed the dividend and is working hard to get operating costs down to $40 per barrel, but that is still a lot higher than its oil sands peers.

Capital expenditures for 2015 are expected to be about $450 million and the company still plans to pay a quarterly dividend of five cents per share. Production guidance has been set at 95-110 million barrels, with an average expected WTI oil price of $55 per barrel. Cash flow expectations are $368 million based on the above assumptions.

Balance sheet worries

Canadian Oil Sands had $1.9 billion in net debt at the end of 2014. This represented a long-term debt-to-capitalization of about 30%, which was still significantly lower than the 55% it needs to maintain to avoid breaching its lending covenants.

The recent strength in oil prices and an improving Canadian dollar are helping the situation. As long as this trend continues, things should be manageable, but investors should keep a close eye on the covenants. In 2014 the debt-to-capitalization ratio doubled.

Should you buy?

Canadian Oil Sands Ltd. is up more than 100% since late January. The rally has been driven by a rebound in oil prices and rumours about a possible takeover by its Syncrude partners.

Investors shouldn’t buy the stock with the hope that it will be bought out. If a takeover occurs, it would likely happen when the company can’t meet its financial obligations. At that point, the stock won’t be worth much.

The current guidance for cash flow from operations still comes up short, and this is a assuming Syncrude will hit its output targets and not run into any major unplanned outages. The track record on production guidance isn’t great, so investors should be careful.

If crude continues to recover, Canadian Oil Sands will certainly move higher and the company might get the breathing room it needs to sort out all the problems.

At this point, the oil market still looks volatile and there are other names in the space that are more efficient and have much stronger balance sheets. The easy money has already been made, so I would avoid the stock.

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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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