The Sun Peeking Through the Clouds

As crude oil neared its bottom early last year, I chatted with a subscriber who had spent his entire career working in the energy sector. I can still hear his world-weary voice lamenting just how punishing the sector’s boom-and-bust cycle can get.

That’s why we favor financially conservative energy players, with the balance-sheet strength to endure just about any operating environment.

To be sure, even a sector’s best companies will still take a beating during a downturn. But their fundamental strength should give investors the confidence to stick with them through thick and thin.

That’s a key consideration when investing in the energy sector, especially given how difficult it is to time commodity cycles.

Suncor Energy Inc. (TSX: SU, NYSE: SU) is one of the highest-quality energy producers in North America. And during the energy sector’s downturn, it did exactly what we expected it to do.

The well-capitalized Canadian oil giant famously entered the energy crash with more than C$5 billion in cash on its balance sheet. A strong cash position not only ensured Suncor would be able to sustain its dividend, it also enabled it to buy top assets on the cheap from troubled competitors.

To that end, last year Suncor acquired Canadian Oil Sands Ltd. for C$7 billion, and it also greatly expanded its interest in the Syncrude joint venture, for a total ownership stake of 53.7% in one of Canada’s top oil-sands projects.

These deals underscore the value of being a relatively conservative player in a sector that’s well known for absolutely brutal downturns.

And now Suncor is leveraged to the rebound.

Cost Discipline

Of course, the energy sector isn’t out of the woods yet. Analysts and industry players alike are starting to worry that prolific U.S. shale production could keep the global oil supply in a glut. But at the very least, it seems reasonable to assume that we’ve already seen the worst of the down cycle.

Fortunately, Suncor is one of the lowest-cost operators in the oil sands, with the average cost to produce  one barrel dropping to just C$22.55 during the first quarter, or about US$17.

Source: Company Presentation

Although Suncor is a truly exceptional operator, these production costs also illustrate a fundamental misunderstanding about the oil sands.

While most financial journalists glibly refer to the oil sands as among the highest-cost crude oil operations in the world, that’s only true of the huge initial investment required to develop a project. Once oil-sands projects are past the development stage, they can remain economically viable even with oil at $50 per barrel.

Indeed, during Suncor’s third-quarter earnings call, CEO Steven Williams said the company can cover its sustaining capital and dividend at $40 per barrel. So when oil trades above that threshold, the company generates significant free cash flow.

Earnings Blowout

Even as the market continues to fret about oil’s supply-demand balance, Suncor’s recent performance shows what we can expect if the rebound in energy commodities continues to gain momentum.  

Suncor reported first-quarter funds from operations per share surged 168.9% year over year, to C$1.21, on revenue growth of 38.7%, to C$7.8 billion.

Although sales fell short of analyst forecasts by 3.4%, earnings per share blew past estimates by 51.7%, for the third consecutive upside surprise.

What a difference a year makes!

Naturally, higher oil prices were the main driver of these results, with an assist from growing production and disciplined cost-cutting.

Total upstream production rose nearly 5%, to more than 725,000 barrels of oil equivalent per day. The increase in production largely came courtesy of Suncor’s bigger stake in Syncrude.

On the cost-management front, Suncor’s customary efficiency helped reduce its cash costs by 7% year over year, despite rising productivity and sharply higher costs for natural gas, a key fuel for extracting crude from oil sands.

During the first quarter, Suncor boosted its quarterly dividend by 10.3%, to C$0.32 per share, or C$1.28 annualized. This was the first increase in its payout since September 2015.

Of course, dividends aren’t the only ways companies return cash to shareholders. In late April, Suncor announced plans to repurchase C$2 billion worth of its own shares over the next 12 months. Based on the company’s current market capitalization of C$72.6 billion, the total buyback would be equivalent to about 2.8% of shares outstanding.

With a forward yield of 2.9%, Suncor is a buy below C$44, or US$33.

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