Oil Stocks: Buyer Beware!

Thinking about buying an energy stock? Before you do, make sure that you understand three important risks.

Feb 12, 2014 at 9:01AM

Thinking about buying an energy stock? Before you do, make sure that you understand three important risks – operational, capital and financial. Each company has unique exposure to these risks, so understanding the differences will help you understand your investment. I am going to compare Suncor (NYSE:SU) and Canadian Natural Resources (NYSE:CNQ), two of Canada's largest energy companies, to illustrate the difference in risk exposure.

Source: Company reports

Operational Risk (CNQ > SU)

Suncor has more production from the oil sands, whereas Canadian Natural Resources produces more heavy oil, conventional oil and natural gas. Oil sands production is more costly than heavy or conventional oil, but production levels are more consistent. The table below shows how two generic energy companies make money – the oil price per barrel less the production costs per barrel. Notice how the company with higher production costs loses more money when oil prices decline. Given that Suncor has higher production costs, it may be considered the riskier investment from an operational perspective.

Source: Author's calculations

Capital Risk (SU > CNQ)

Many investors focus on production costs while placing less importance on the other risks. Capital spending is important, because if oil prices fall, a company may be obligated to make payments while having less cash available. As evident in Chart 2 below, Canadian Natural Resources has been spending a higher percentage of its "piggy bank" than Suncor on heavy and conventional oil projects. This is somewhat expected, given that Suncor is an oil sands company. However, notice the continued decline in oil sands spending for Suncor in Chart 3 below, now similar to Canadian Natural Resources' levels, which highlights Suncor's transition into a mature oil sands producer. Overall, the capital intensity ratios are higher for Canadian Natural Resources, which increases risk.

Source: Company reports

Financial Risk (SU > CNQ)

Suncor is an "integrated" company, which means that it has refining assets, whereas Canadian Natural Resources is "non-integrated." Refining assets generated significant amounts of cash over the past few years for Suncor due to the discounts in North American oil prices versus global prices. Not only did Canadian Natural Resources miss out on these refining gains, but weak natural gas prices also hindered cash flow growth. As evident in the chart above, Suncor has been using these cash flow to pay off debt, and return wealth to shareholders. Overall, Suncor has less debt and more cash than Canadian Natural Resources.

The Foolish bottom line
Energy companies are riskier investments than most, so knowing what risks you're exposed to is important. Through owning Suncor, an investor is more exposed to oil price risk, but should take some comfort in the company's disciplined capital spending program and relatively stronger balance sheet. Through owning Canadian Natural Resources, an investor is less exposed to oil price risk, but may not benefit as much if oil prices are strong.

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Matthew Stephenson has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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