Sweetness in the sand

Globe Investor Magazine, Feb. 21, 2008

The Risks

When McConnachie first bought COS units in 2003, they were trading at a 20% to 25% discount to net asset value (NAV) - "a no-brainer," he says. Today, however, some analysts think COS is overpriced. At a recent price of $36, CIBC World Markets estimated COS was trading at a 15% premium to NAV. To arrive at this number, CIBC assumed an oil price of $80 (U.S.) and a Canadian dollar ex--change rate of par with the U.S. dollar (see sensitivity analysis, page 29)-the two biggest risk factors to the trust's profitability and distributions (a $10 change in the price of oil, for example, leads to a 17% change in the NAV).

Although the long-term outlook for oil is robust, there's no shortage of evidence that prices may be ahead of themselves. Economics 101 tells us that the price of a commodity tends to settle near its marginal cost of production-that is, the price of oil will rise to the point that it's worthwhile for producers to crank out more-so it's important to note that the Organization of Petroleum Exporting Countries pegs the marginal cost of oil at between $50 and $60 (U.S.) per barrel.

If not a symptom of exuberance, how, then, can we justify the $100 oil prices of early January? Mike Rothman, an ac-claimed oil analyst at ISI Group, doesn't even try; he sees oil heading down to $50 (U.S.) a barrel for the simple reason that oil consumption is not growing as fast as most investors assumed it would. It's the same old story: When faced with higher product prices, consumers either buy less or find a cheaper substitute. "I have never seen the gap be-tween reality and the perception of reality as big as it is now," Rothman re--cently told the investment journal Barron's. Demand for oil grew at a slower pace in 2007, but fell off even more than expected. These days, for every 10 oil bulls, there's a bear.

But there's another reason to be cautious: speculation. Oil prices are determined by auction-the highest bidder deter-mines the price-but it's not only consumers who bid up the commodity to $100. Open interest in oil futures-that is, the number of contracts traded-has tripled on the New York Mercantile Ex--change in the past three years, suggesting lots of speculative buying. And the over-the-counter market, according to the Bank for International Settlements, is 20 times as big as the Nymex, suggesting hedge funds are investing even more heavily in oil. The OTC market was almost irrele-vant in past oil price crashes. What happens if those hedge funds suddenly liquidate their positions? Worse yet, what if they go short?

As for other risks, many have been dealt with, and are already factored into the current price of oil. The dollar is at par and, according to conventional wisdom, not likely to go much higher. Alberta's new royalty regime hurt-cutting almost $6 from Canadian Oil Sands' NAV, according to CIBC-but it's accounted for in the current unit price. So is the income trust taxation issue, which means Canadian Oil Sands will likely convert back to a corporation in 2011.

The other principal risk is inflation, in both operating costs and capital ex--penditures. The cost of adding production ca-pacity has more than doubled in the past two years, so Syncrude's expansion to 500,000 barrels per day could cost a staggering $10 billion, with 37.4% of the expenditure allocated to COS. That represents almost one-third of the trust's market capitilization. Investors are anticipating higher production when they buy units in COS, but any huge increases in the cost of the expansion, or postponement or even cancellation of the project, would hurt.

On the operating side, costs started coming down in the '70s, but they've been trending higher the past five years be-cause of higher labour and natural gas prices. As an investor, the thing to re--member is that increases in operating costs hurt more as oil prices fall. At $76 (Canadian) a barrel-the trust's estimated average selling price in 2007-a 10% in-crease in operating costs will only cut cash flow by 10%. At $60 per barrel, all else remaining equal, cash flow will drop by 15%.

One wild-card risk is the environment. Syncrude produced more than 12 million tonnes of greenhouse gases in 2006. Investors should also consider the potential impact of tougher rules on water use, since Syncrude uses 1.4 barrels of wa-ter to produce a barrel of oil. While most of this water is recycled, nevertheless, oil sands developers are consuming 10% of the Athabasca River's water flow.

Bottom Line

Whether or not 8% is enough compensation for the risk of owning the units is impossible to say. With high oil prices, there may be some froth in the unit price. But fortunately, with COS, it doesn't matter that much, because the company should be around for decades. If all its expansion plans are carried out, Syncrude will be producing at least half a million barrels a day for 30 years or more. And while it's easy to be swayed by the noise-royalties, foreign exchange, inflation-ultimately, investors who think oil prices are in a long-term bull market should consider investing. As a core hold-ing, investors can spread out their stock purchases and get an average price that's close to fair market value. As the com-pany's CEO Marcel Coutu puts it, "If you believe in what we believe, then you ought to be our shareholder."