Should You Invest in Oil Sands?

The volume of crude-oil production from sand has exploded during the past decade. For the most part, investors have disregarded the sector as too speculative. However, with the recent revelation that Warren Buffett's Berkshire Hathaway has waded into the sector, buying a small stake in Suncor Energy (NYSE: SU  ) , investors have now started to take note; but should you follow suit?

Increasingly attractive
Oil production from sand is a relatively high-cost method of producing oil. For example, industry leader Suncor stated that the cost of extracting oil from sand was around $35 per barrel for the third quarter. In comparison, based on figures from 2008, ExxonMobil (NYSE: XOM  ) and Chevron were able to produce their oil for an average cost of $10.50 and $8.70 per barrel, respectively.

However, technological developments have driven the cost of oil production from sand lower during the past few decades, and this is set to continue.

Indeed back in 1967, when Suncor became the world's first oil sands operation, the company's technology of choice for production was the drag-line and bucket wheel, which allowed to the company to produce 45,000 barrels of oil per day. By 1992, the drag-lines were replaced with trucks and hydraulic shovels, allowing the company to ramp up production to 100,000 barrels per day.

Now Suncor is introducing a new technology, the Autonomous Haulage System, which involves operating autonomous trucks in a continuous fashion. The greatest advantage for using this system is lower costs. Apparently the company won't save on manpower costs, however, as it seems the same number of operators are required in other roles.

Nonetheless, lower costs are expected to be realized from greater fuel efficiency, less wear and tear, and more volume hauled. If you've not seen the Autonomous Haulage System before, check out this video of Rio Tinto's fleet in Australia.

So, falling costs should continue to make Suncor's operations more profitable. It's not just Suncor that's benefiting.

Scale and progress
Imperial Oil (NYSEMKT: IMO  ) , which is 70% owned by ExxonMobil, recently commenced production on its Kearl oil sands project. As an example of how far things have come since Suncor first broke into the industry, it took Suncor from 1967 to 1992 to raise its production from 45,000 barrels per day to 100,000. When Imperial's Kearl comes online this year, the project will produce 110,000 barrels of oil per day. This is expected to rise to 345,000 barrels per day by 2020 -- that's 235,000 barrels of additional capacity in seven years.

Imperial and ExxonMobil are also buying up additional acreage from independent producers such as Conoco, which recently sold a 226,000-acre undeveloped property to the two international producers for $720 million. This reveals some interesting figures, most revealing of which is the fact that ExxonMobil and Imperial paid around $3,186 per acre for the land, about 25% more than the average price of similar deals based on data dating back to 2005.

Scale
Investors also need to consider the scale of these projects and the prospect that many oil-sands projects could produce oil for longer than conventional fields. Suncor, for example, states that it has 6.7 billion barrels of oil reserves from sand. Meanwhile, Imperial's Kearl project has 4.6 billion barrels of recoverable resources.

In comparison, the world's fifth-largest offshore oilfield contains 6.5 billion barrels of recoverable resources. So, we can see what kind of scale these projects offer. Actually, both Suncor and Imperial have enough oil sands reserves to last for more than 30 years at current rates of production; these are very 'long-term' assets.

Cash generation
Aside from all of the above factors, one of the things that really attracts me to Suncor in particular is the company's cash generation.

As Suncor's production costs average $35 per barrel, and the price of Brent remains steady above $100 per barrel, the company was able to pocket a solid 56% gross margin during 2012. The company's earnings before interest, taxes, depreciation, and amortization margin was nearly 30%. This makes Suncor highly cash-generative, and a fiscally prudent management team is making the most of this.

For example, during fiscal 2012, the company generated $8.9 billion in cash, only $1 billion less than beverage behemoth Coca-Cola. Nonetheless, despite this level of cash generation, management is keeping a lid on spending, ensuring that capital expenditures are wholly covered by cash inflows (during 2012 capex totaled $6.7 billion on cash generation of $8.9 billion, and management expects cash flow to cover capex again this year).

Furthermore, Suncor is returning free cash to investors. Since September 2011, the company has completed $2.5 billion in stock buybacks and launched an additional $2 billion share-repurchase plan this year.

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