EIS Idea — September 24, 2007: Canadian Oil Sands Trust

Canadian Oil Sands Trust (COS) owns 36.74% of Syncrude, Ltd, one of the largest and most developed oil sands operations in Canada. Sycrude has a record of profitability and has already achieved construction of the bulk of its long term capacity goals, including in July an upgrade that increased output capacity by 40% to approximately 350,000 barrels per day, or about 129,000 for COS. A de-bottlenecking upgrade will add another 50,000 b/d to capacity in five years and a final planned expansion will bring production to 500,000 b/d in about ten years.

There are two distinguishing qualities of Syncrude operations. First, their bitumen deposits are close enough to the surface that they are mined rather than having to be liquified and then pumped to the surface, a more expensive and energy-intensive process pursued by Nexen/Opti and others. Second, Syncrude, in addition to mining bitumen, upgrades it’s bitumen into a superior grade of light, sweet synthetic oil that they call “Syncrude Sweet Blend” (“SSB”). SSB sells at a price that differs from West Texas Intermediate (“WTI”) crude, the most frequently quoted oil price. Sometimes SSB is priced at a discount to WTI, as it was during 2006, but recently SSB enjoyed a premium of about $5 per barrel to the price of WTI.

The business proposition of an oil sands investment is fairly simple. The company owns an enormous supply of bitumen, perhaps 50 years worth or more — nobody knows for sure. As the price of crude oil rises, the profitability of mining and upgrading bitumen is propelled upwards on a leveraged basis, since the marginal return on an extra dollar of price is 100% less delta taxes. If you think (as I do) that over the long term the price of oil will increase substantially as we get closer to and finally pass the onset of Peak Oil, then oil sands plays are a way to profit from that trend. If you think, as most Wall Street analysts do, that the longer term price of oil will not move up dramatically then the value of an oil sands company is much reduced. In sum, it is all a matter of what the price of oil will be in the out years.

What are the risks? If the price of oil does rise past $100 and then past $200 and so on over the next decade, what might stand in the way of vast riches for the COS shareholder? First, of course, there is the difficult problem of managing a huge, sprawling, technologically advanced and advancing enterprise located in an inhospitable environment with severe endemic labor shortages. Assuming the company continues to successfully handle these daily challenges, their task will not be simply a matter of bundling up all the profits and sending them off to shareholders. The public — and their elected representatives — will be increasingly concerned about protecting their environment and securing their “fair share” of the rising corporate profits.

Syncrude, like all oil sands companies, operates under both provincial and federal environmental regulations. Both jurisdictions specify requirements and financial penalties for failing to meet them. COS allocates about $125 million per year to satisfying the environmental specifications laid out by those governmental requirements. It estimates that Alberta’s requirements for continuing reductions in GHG emissions will add 30 cents per barrel or $7 million to its costs in 2H ‘07. National environmental standards are under development and the company estimates that its costs of compliance may be “significant”. Please see the web sites of Syncrude and COS, for further discussion of environmental problems and their remediation. The quarterly reports of COS detail its approach to environmental issues, including costs.

Issues of taxation at both the federal and provincial levels are important for oil sands operators. This year Canada passed a law that impacts trusts, of which COS is one. Recently, a study commission in Alberta released a report suggesting substantial increases be made in provincial oil and gas taxes. Either national or provincial level taxes could impact COS’s profitability in the out years.

Canadian taxation of trusts is similar to U.S. taxation of REITs. Companies must distribute 90% of earnings but are not taxed at the federal level. Trust taxation was initiated in part to encourage extractive industries, but eventually the advantages convinced other types of companies to shift to trust from corporate status. When such large public companies as Bell Canada contemplated becoming trusts the Federal government began to see its entire corporate tax receipts begin to dissolve. Their reaction was to pass a new law taxing dividends of trusts at 30% starting in 2011.

In response to this change, COS (which I think has one of the smartest managements going) has taken a couple of steps to maximize shareholder returns. First it has decided that from the present time through to the time when the new dividend tax takes effect, which is estimated to be 2012 or 2013 for COS given their specific tax credit carryforwards, the company will pay dividends at the maximum feasible level. It will also, during this period, eliminate debt repayments. Prior to passage of the new dividend tax law, COS had been making substantial reductions in its debt.

Secondly , management is contemplating a change of corporate organization if the new law is not changed by the time that the new tax begins to be applicable. Management has indicated that one option is for the company to drop its trust status and become a corporation. Another option would be for it to sell out, presumably to a corporation. If COS were to become a corporation, their enormous free cash flow could be used to buy in shares on a regular basis in lieu of paying dividends and without incurring a tax. Perhaps there are other actions COS could take to enhance shareholder value, which I am convinced is a primary goal of management.

Alberta’s new proposed tax scheme is in its early days of being considered. Currently oil sands operators pay 25% of operating profit to Alberta after they have recouped their initial capital investment, which COS has done. The new tax proposal would increase that rate. However, Syncrude has a separate agreement with the province for a different tax scheme. It is simply not clear what the implications of the current reconsideration of its tax program by Alberta will have on Syncrude.

The question investors must ask is what are the long term intentions of the Alberta governent. Will they honor whatever new tax scheme eventuates on a long term basis or will they impose even greater taxes as time goes on a la Venezuela. Each investor must make that judgement. Based on my sense of the moral fiber of Canadians, I am willing to believe at this point that future judgements will be fair. If the price of oil goes to $200 a barrel will the Alberta government take no action? For that matter will any government anywhere take no action? One cannot presume that. There may be some form of oil price controls or new taxes aimed at mitigating economic damage to the general economy. Such schemes may not be all bad. But that is a long way from a Venezuelan approach.

In other words, I believe that life for the oil sands investor is not likely to be perfect. A never ending increase in the price of oil, which I do believe is in the cards, will not necessarily translate into COS investors harvesting 100% of the gains that might be projected based on current regulations and taxation. On the other hand, the returns are still likely to be pretty good, I suspect.

Let me address the dividend issue. Personally, I like dividends. I think they are the sincerest indicator of a company’s success. COS pays a substantial and growing dividend, currently $0.40 per quarter, which is up 33% in 2007. Management has said it intends to increase the dividend to the maximum extent it deems prudent over the next six or seven years, as discussed above. The current dividend is supported by current free cash flow of $0.57/share, which I believe will increase to about $0.70 in the second half if the price of WTI crude stays above $70. Another 33% dividend increase for 2008 would bring the dividend to $0.53 cents. That would not surprise me. Nor would $0.60. One respected analyst (Kurt Wolff) has predicted $0.80, but I doubt that. In any case a dividend of $0.53 for 2008 would bring the yield to about 6.4%. If you believe that the price of oil — and therefore the free cash flow of COS — has much further to go in future years, then COS with a 6.4% yield and the promise of a rising dividend seems attractive to me.

How attractive is COS? Warren Buffett once commented that as a general rule a company may be said to be worth twenty times free cash flow (FCF). The Master might want to adjust this multiple depending on the outlook for future FCF and prevailing interest rate levels. Nonetheless, COS is in fact now selling at a 25% discount to 20 times it’s first half FCF. If FCF runs at $0.70 for Q3 and Q4 this year as I project, the 5% cap rate would give the company a buy-out value of $56 per share. Give the public market equities a 25% discount off private market value and you get $42 a share. That is about 27% more than the current $33 price. Add a 5% dividend and you get a total return of 32% if COS achieves a $42 value within one year. I think that target has a reasonable likelihood of being met unless the price of oil declines substantially.

Finally, let’s talk about the impacts of the falling dollar. There are three impacts: the direct impact on the valuation of COS stock and the COS dividend for an American investor, the impact on the global price of oil in US dollars, and the impact on COS earnings. These three impacts work in somewhat complex and offsetting ways. Given this complexity and the fact that I am not a licensed foreign exchange expert, this discussion is certainly not intended to be definitive. Rather, I want to present the bottom line as I understand it for those who want to consider the issue. Let me address the impacts in the reverse order as presented above.

To Canadian Oil Sands Trust, a lower U.S. dollar (“Dollar”) in relationship to the Canadian dollar (“ Loonie”), means that COS revenue from oil sales is reduced by C$0.04 per share for each penny (roughly 1%) of increased Loonie value to the Dollar. It is a simple one-to-one cause and effect relationship because COS revenue is received in Dollars and then translated into Loonies. While the revenue relationship is direct, the impact on COS operating earnings is magnified because COS expenses are largely in Loonies. This negative impact is slightly offset by the fact that COS debt is denominated in Dollars and therefore is reduced by a falling Dollar.

On the other hand, a falling Dollar tends to support a rising price for oil. It is impossible to discern the direct impact of the Dollar/Loonie ratio on the oil price because supply and demand issues, not foreign exchange, have the primarily impact on the oil price. But in recent weeks as the Dollar has fallen rather quickly, it appears to have been an important cause for the rise in oil. A rise of $C 1.00 (roughly 1.25%) in the price of oil adds C$0.05 cents to the EPS of COS.

To summarize the impact of a falling Dollar on the earnings of COS and thereby its ability to pay dividends, there is a direct and magnified negative impact that is offset to an indeterminate degree by a positive impact on price of oil. Is the net effect zero? That may be a reasonable guess, but it is impossible to know for sure because the precise impact of a falling Dollar on the oil price of is impossible to know.

The American investor, however, is advantaged by the falling dollar in a direct one to one cause and effect relationship. As the US dollar depreciates, assuming no change in COS share price or dividend as stated in Loonies, the value of the shares and the dividend are that much greater in Dollars. To be more specific, COS’s $C 0.40 dividend was worth $US 0.364 to me a few months ago when the Loonie was worth $US 0.91. Now, as the currencies are at par, it is worth the full $US 0.40 to me. That’s the same as if I had gotten a dividend increase of 9.9%.

Putting all this together, a falling dollar has a net positive impact on the value of COS shares for the American investor. That is because the impact of the falling dollar on COS’s operating earnings, given its positive impact on the Dollar price of oil, is some amount that may be close to zero. But the value of the COS shares and dividend are increased to the American investor by the full percentage change in the depreciation of the Dollar. Thus, the expectation of a falling Dollar would be a positive influence on an American’s decision to buy or sell shares of COS, although it is certainly not the most important issue.

So, to summarize, here’s my take on Canadian Oil Sands Trust:

1. It will be an operationally leveraged beneficiary of any future increases in the price of crude oil, regardless of future changes in currency exchange rates.

2. It will benefit from increasing volume of about 43% over the next ten years.

3. It has enough bitumen to operate for the next 50 years or longer.

4. It is operated by an outstanding management team which is shareholder oriented.

5. It is more subject to the vagaries of governmental regulation and taxation than is the average company. Moreover, such regulators have a legitimate interest in protecting their environment, which is inherently harmed by the company’s harvesting of bitumen and conversion into crude oil. Thus, one can assume increasing costs to the company for environmental mitigation. But the good news is that the regulators and tax authorities have not yet totally destroyed a reasonable basis for trust with the investment community. They may yet do so, but it has not happened so far in my judgement.

6. If the price of WTI crude averages $71 in the next 12 months, I estimate the FCF of COS at $0.70. That could support a dividend of $0.53 per quarter and a stock price of $42.