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While almost half of my portfolio is in oil companies, I've tended to avoid the majors for years because their shares haven't been good performers (and their profits aren't especially sensitive to the oil price). BP's share price is down by 19% over the past decade while Royal Dutch Shell is up by a touch over 10%.
Nowadays the only large oil company in which I still own shares is in Suncor Energy (NYSE: SU ) , the Canadian giant whose share price has increased by more than 580% in the past ten years. I reckon there's more to come from Suncor Energy. Lots more.
Desperate for oil
The world wants more oil and, thanks to countries like China and India developing a thirst for energy as they industrialize, supply is increasingly finding it hard to keep up with demand. This imbalance has caused the oil price to rise above $100 a barrel. My opinion is that high oil prices are here to stay, at least until economically viable alternatives become established in several decades time.
Investors can profit from high oil prices by investing in companies with high production costs. Yes, I did mean expensive to produce! The gearing effect is such that if the oil price jumps from $70 to $110 a barrel, then company A, which has production cost of $35 a barrel, sees its profits increase by 114%. In contrast, company B, whose costs are $10 a barrel, sees its profits jump by just 67%.
Suncor Energy is company A.
More oil than BP
Suncor has a lot of oil -- approximately 27 billion barrels of reserves at the last count. At current rates of production these would last for almost 200 years, so there's plenty of scope to increase its output. In fact, I'm counting on it!
Suncor is one of the three biggest Canadian companies, with a market value of about $64 billion. Let's make a quick comparison with BP. BP's market capitalization is about $145 billion and as of the end of 2009 its oil and gas reserves were roughly 18 billion barrels. So Suncor has 50% more reserves but BP is worth $80 billion more.
The main reason for this discrepancy is that most of Suncor's reserves, some 23 billion barrels, are contained in the Athabasca tar sands of Alberta. The process by which tar is turned into oil has much more in common with open-cast mining. So turning the tar sands into oil is more expensive than conventional oil, which means that your profit per barrel is far lower.
To compound matters the tar sands get a bad press. But I think a lot of these fears are exaggerated, and the Albertan government and the tar sands operators have started hitting back in the propaganda war. Thankfully for shareholders, those who work in the industry and Alberta's taxpayers, the rest of the oil business is an easy target.
Most oil-producing countries don't use their oil wealth to improve the lives of their people. The political elites treat the oil revenues as their private piggy bank. In contrast, if you buy Canadian tar sands oil, you're not funding any undesirable regimes. If you're going to make an ethical stance, you should first boycott conventional oil!
Suncor published its results for 2010 last week, with diluted earnings per share rising by 71% (139% if we include its discontinued operations). Suncor's shares aren't particularly cheap, lying on a P/E ratio of 24 for its continuing operations (18 with the discontinued operations), but I reckon that they are still fair value for anyone who is prepared to bet that oil prices will stay above $70 for most of the next decade.
I wrote about Suncor, and its strong position in tar sands oil, in this article just under a year ago. If anything, Suncor's position has strengthened since then and this has been reflected in its share price, up 38% over the past 12 months.
The biggest risk for an oil company, particularly those with high-cost production like Suncor, is that oil prices fall over the long term. I consider this to be an unlikely scenario as demand looks set to continue to increase while there is a lack of cost-effective alternatives.
Suncor has to cope with an additional environmental risk, though as mentioned earlier I believe this is overblown. Most people, despite what they say when polled about the environment, won't want their living standards to fall by 50% because the demand for energy can't be met.
Suncor currently produces about 625,600 barrels per day, 52% of which is tar sands oil. It's on course to expand tar sands production by 10% to 12% per annum up until 2020, by which time it could be producing over 1 million barrels of tar sands oil a day. By then Suncor's shares should be well above the current price of $41.
If the U.S. imposes restrictions on the sale and importation of tar sands oil, the oil will still be sold elsewhere. All that's needed is a pipeline to the west coast (one is being planned) and you have access to several billion Asian consumers.
More from Tony Luckett:
- The Boardwalk Empire Way of Doing Business
- When Past Performance Is a Guide
- Why the FTSE Isn't British