Buy, Sell Or Hold: Suncor Energy

Money Morning
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Q: Please tell me about Suncor Energy. Thank you. - Reader Joseph A. Kurtz.

In July 21, when oil was trading at some $125 a barrel and in an apparent freefall, I issued a scaled “Buy” on Chevron Corp. (NYSE:CVX). I based this call on the stock’s ultra-low valuation and the company’s business model, which would enable it to keep posting strong profits even at lower margins. Despite the huge market sell-off – and a whipsaw market for oil that saw prices fall to as low as $90 a barrel before rebounding recently – Chevron’s stock has outperformed both the broader stock market and its oil-sector peers. At Friday’s closing price of $86.95, Chevron’s shares already are up 2.0% from that July 23 recommendation.

With the much-needed opening of offshore drilling in the continental United States, Chevron is positioned uniquely to thrive – as are its shareholders. As I noted back in July, it wasn’t “a question of if, but when” to invest in Chevron.

I bring this analysis to your attention in light of a reader’s question about Suncor Energy Inc. (NYSE:SU), where similar investment logic applies, despite major differences in the companies and in the risk-reward equations of their shares.

Suncor Energy has risen as high as $74.28 earlier this year, before falling to its three-year strong-resistance level of about $39 a share recently (the shares closed Friday at $45.37, down $1.82, or 3.86%, each).

The company disappointed investors in the first half and guided production lower for the second half, telling investors that it faced a much-harsher winter, as well as some operational problems that were subsequently remedied. A new problem – an issue with a processing unit will not affect production, but will lower the product mix quality for a few weeks – only added to investor wariness.

Take these company-specific problems, and add in the panicky markets, the massive liquidation of commodity and commodity-related positions by investment and commercial banks due to their own financial problems, and the impact of that generalized financial stress on global growth expectations, and you can see that Suncor’s stock appears to be heavily distressed relative to the company’sunderlying fundamentals.

Suncor is a riskier – yet potentially much more profitable – stock play than Chevron. Suncor Energy is a pioneer in that it is the second-largest operation exploiting the oil sands in Northern Alberta, Canada.  The Athabasca Oil Sands is the world’s largest petroleum resource, with some 175 billion barrels of crude-oil reserves.  That operation poses major challenges because of the harsh winters, the terrain, unpredictable contents of sulfur, and the fact that major scale extraction of the bitumen mineral and later extraction of oil demands technologies that are relatively new and in constant development.  To these factors, add in the recent major volatility in the price of oil and you get the picture:  Suncor represents an extremely promising stock with a huge potential upside – albeit one that‘s subject to the unpredictable vagaries of both the oil markets and the Canadian climate and some operational challenges.

What about the upside?  We should see major production increases and a lower cost of production per barrel.  Suncor has just launched a major expansion in its production capacity.  Sitting on a 9 billion barrel reservoir, the company is about $7 billion into its $20.6 billion expansion/modernization project, and will be investing between $7 billion and $8 billion a year in 2009 and 2010.  By 2012, Suncor will have boosted production from the current level of 300,000 barrels a day (and 350,000 barrels a day in the year’s second half) to some 500,000 barrels a day. As production ramps up, the company’s average cost per barrel will drop significantly – from the current cash cost of $30 to $31 to as little as $27.

At these low production prices, and with global demand for oil so tight, barring a major global recession, the risk of a profitability reversal is slim to none. And a worldwide recession of that magnitude just isn’t in the cards – even with the U.S. credit markets still under assault.

Truth be told, what we actually see happening is that the price of oil, having stabilized at these lower levels for awhile, will rise again and go through the past peak on its way to new record highs. If that happens – and it appears that this reversal is already under way – the actual risk will be borne by investors who aren’t invested in oil- and other energy-related stocks.

The risks to this upside are mainly unforeseen operational and climatic events, and commodity and labor inflation, which might push up the costs of Suncor’s new expansion projects.  The company’s low leverage ratios and very strong cash flow ensures easy financing, even in these market conditions. The company has been able to manage each one of these challenges very well, given its long operating history, market leadership and sheer size.  This industry leadership imbues Suncor with a competitive advantage, since its proprietary technologies, in constant development, makes them more efficient.

In addition, Suncor has resisted the temptation of acquiring refiners in order to expand upon its partial vertical integration.  Its disciplined acquisition philosophy requires patience for refining margins to keep dropping in order to achieve a lower entry point in any future refinery purchases.

By investing in Suncor today, you are buying into this admittedly volatile stock at a level similar to March 2006, when oil was trading at about $60 a barrel and Suncor’s production capability was but a fraction of its output today. For this “gift” of a bargain-priced stock, we can thank the implosion of the U.S. financial sector and the resulting disarray in the credit markets, which over-penalizes companies with even minor earnings disappointments, or internal project delays. While Suncor’s turnaround won’t be immediate, the magnitude of the ultimate rebound makes this stock a very attractive buy at these valuations – especially given the massive expected increase in production, in oil prices globally, and in the company’s cost-efficiency gains.
Action to Take: Buy Suncor Energy Inc. **

** Disclosure: None

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