The case to buy Suncor Energy Inc. (TSX:SU)(NYSE:SU) today seems compelling. Oil prices are currently sitting around US$30/bbl, yet Canadian oil sands projects have estimated breakeven costs around the US$33/bbl range, and U.S. producers are estimated to break even in the $25-30/bbl range. This means that $30/bbl over the long term simply does not work, and the vast majority of analysts are expecting some recovery from these levels. With this in mind, Suncor seems like a win-win opportunity. If prices continue to hover in the low $30’s range, Suncor has a rock-solid balance sheet to protect it as well as…
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The case to buy Suncor Energy Inc. (TSX:SU)(NYSE:SU) today seems compelling. Oil prices are currently sitting around US$30/bbl, yet Canadian oil sands projects have estimated breakeven costs around the US$33/bbl range, and U.S. producers are estimated to break even in the $25-30/bbl range.
This means that $30/bbl over the long term simply does not work, and the vast majority of analysts are expecting some recovery from these levels. With this in mind, Suncor seems like a win-win opportunity. If prices continue to hover in the low $30’s range, Suncor has a rock-solid balance sheet to protect it as well as refining operations that act as a hedge.
Suncor has 81% of its production from oil sands operations, which gives the company strong leverage to rising prices. Before jumping in, however, there are some big risks to know about.
1. Suncor’s refining segment will likely weaken going forward
Suncor has one of the best refining operations in North America with utilization rates well above average and profitability considerably above average. In 2015 Suncor’s refining segment’s cash flow from operations grew an impressive 31%, while oil sands’ cash flows dropped in half.
This is because oil is the feed stock for refining operations, and as oil prices plunge, so do refining costs. At the same time, refined products—like gasoline and diesel—typically lag oil prices in the decline and have been supported by strong gasoline demand.
This advantage is set to ease. Firstly, the recent decision by the U.S. government to eliminate their export ban on crude means that U.S. crude can now access global markets. The result is that the spread between West Texas Intermediate crude (North American crude) and Brent crude (global crude) is set to narrow. In fact, the two crudes are nearly trading at the same price.
This is a problem because refining feed stocks are based off WTI crude, but refining products typically trade off the global Brent pricing. The result is that in a recent conference call, Suncor’s CEO admitted that refining will earn less going forward.
2. Suncor could have a big funding gap if oil prices stay low
At Suncor’s recent fourth-quarter conference call, an analyst at Barclay’s suggested that Suncor could end the year with a $4 billion funding gap. That is to say, the company’s capital expenditures and dividend could exceed their cash flow by $4 billion. TD Bank analysts also suggested the same number as a possibility for 2016.
In 2015 Suncor had a funding gap of $1.5 billion. In order to fund gaps like this, Suncor is required to burn through its cash reserves (which currently sit at about $4 billion) and then use its available lines of credit (Suncor currently has about $7 billion of available room).
This means that Suncor would burn through its entire cash supply to fund a shortfall in 2016, which would increase Suncor’s net debt and put it at potential risk of ratings downgrades.
TD estimates that such a funding gap would occur if oil prices were to average US$36/bbl in 2016.
3. Suncor’s recent acquisition of Canadian Oil Sands Ltd. could be a negative for shareholders
Suncor is close to concluding their $6.6 billion acquisition of Canadian Oil Sands Ltd. (TSX:COS), and there is a chance this acquisition could reduce earnings per share. Suncor is paying for Canadian Oil Sands by issuing shares, and if prices stay under $40 per barrel, it is unlikely that the earnings from Canadian Oil Sands will offset the amount of shares issued to pay for it.
This means that the Canadian Oil Sands transaction could actually cost Suncor shareholders in 2016, not benefit them. In addition, Suncor’s capital expenditures and dividend payments will grow because of the acquisition, so if oil prices remain weak, the Canadian Oil Sands deal could both hurt earnings and increase a funding gap.
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Fool contributor Adam Mancini has no position in any stocks mentioned.