How Suncor Energy Inc. Shareholders Benefit From the Canadian Oil Sands Ltd. Purchase

It looks like the long-awaited acquisition of Canadian Oil Sands Ltd. (TSX:COS) by Suncor Energy Inc. (TSX:SU)(NYSE:SU) is finally nearing a close. Suncor announced that 72.9% of Canadian Oil Sands shares have been tendered.

Suncor requires 66.66% of Canadian Oil Sands shares to complete the transaction, which means that Suncor is now in the position to acquire the remaining shares at 0.28 Suncor shares per Canadian Oil Sands share. While the case for why this deal benefits Canadian Oil Sands shareholders has been very clear, the benefit to Suncor has not been made as clear.

Canadian Oil Sands shareholders will see a dividend boost from the deal, receive a huge premium on their shares, and still maintain some upside to oil prices. Suncor, on the other hand, will be acquiring more of Syncrude—an asset with persistent reliability problems.

While this is true, the transaction as a whole is beneficial to Suncor. Here’s why.

The deal fits with Suncor’s strategy and strengths

Suncor is primarily an oil sands business, and in 2015 approximately 80% of its production came from its oil sands segment. After the Canadian Oil Sands acquisition, this should increase to 83%. This is because Suncor will be adding Canadian Oil Sands’s 102,000 barrels per day of production.

Is increasing costly oil sands production at a time when Western Canadian Select prices (the oil sands benchmark) is trading at US$17 per barrel a good thing? For Suncor, it may be.

Firstly, one benefit to oil sands production, and to a mining operation like Syncrude in particular, is that the production sees little to no production declines and has an extremely long life. In contrast, tight-oil production sees rapid production declines in the first year or two, and the result is that large amounts of capital needs to be spent to maintain production.

With oil sands assets, the decline rate is nearly zero, which in turn translates to low amounts of maintenance capital to maintain production. This, in turn, leads to improved free cash flow. The acquisition of Canadian Oil Sands will reduce Suncor’s production-decline rate from the already low 7.3% to 6.2% annually.

In addition to this, because Syncrude has upgrading assets, it is able to upgrade the oil sands it produces into higher-value synthetic crude oil, which trades at roughly the same price as West Texas Intermediate crude. This allows Syncrude to ignore the differential between West Texas Intermediate and Western Canadian Select.

Currently, Syncrude has a cash flow breakeven price of US$31 per barrel, according to analysts at TD Bank—which grows to US$37 per barrel when capital expenditures are added on—making it a lower-cost operation than nearly all of Canada’s in-situ (non-mining) oil sands operations.

The majority of these costs are fixed as well, which means that Syncrude will start to contribute plenty of cash flow to Suncor as oil prices begin to rise above the high $30 level. By increasing its ownership in Syncrude through its acquisition of Canadian Oil Sands, Suncor is improving its leverage to rising oil prices and growing its production in a capital-efficient manner.

Suncor can improve Syncrude’s performance

The Canadian Oil Sands acquisition would see Suncor’s ownership in Syncrude increase to 49% from 12%. As a result, even though Syncrude is technically operated by Imperial Oil under a service agreement, Suncor intends to use its expertise to take on a greater role in improving the reliability of the mine.

Syncrude has had persistent problems with reliability; the mine has suffered from constant operational setbacks and its production has declined for the past five years. Over the past five years the mine has had a utilization rate of only 78% (producing at only 78% capacity) compared to Suncor, which has utilization rates above 90%.

Suncor will use its expertise and the fact that the company is geographically close to Syncrude to cross-connect equipment and realize synergies that will bring utilization rates up to levels closer to Suncor’s average.

The end result is greater production, lower costs per barrel, and better earnings for Suncor shareholders.

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Fool contributor Adam Mancini has no position in any stocks mentioned.

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