1 Reason Warren Buffett Bought Bought Canadian Oil

Warren Buffett's recent entry into the oil sands market through a relatively small (for Buffett) holding of Suncor Energy Inc. (SU 0.31%) has attracted much attention. However, there is still much speculation as to why Buffett acquired this stake, as traditionally the Oracle does not consider commodity companies to be worth the risk. So why Suncor?

But first, some background
Suncor is a vertically integrated oil producer, producing oil from Canadian oil sands (377,000 barrels/day) and offshore fields internationally (134,000 bbls/d). In addition, the company has capacity to refine 89% of its oil production and capacity to move 100+ million barrels of oil around the globe.

Production costs are around $35/barrel for the company. However, Suncor sells 93% of its oil at the Brent benchmark price, so realized prices are less affected by the U.S. oil boom, which has pushed down the price of WTI. Moreover, Suncor has enough oil resources to maintain current levels of production for 47 years, actually more than ExxonMobil, which only has enough reserves to last 16 years.

Cash is king
As Suncor's production costs average $35/bbl and the price of Brent remains steady above $100/bbl, the company was able to pocket a solid 56% gross margin during 2012. The company's EBITDA 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 spending is wholly covered by cash inflows (during 2012 capital expenditure 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.

A comparison of Suncor to its peers on a free cash flow yield per share basis highlights how well the company is performing in relation to Chevron (CVX 0.44%), EOG Resources (EOG 0.59%), and Occidental Petroleum (OXY -0.09%):

Figures in millions except for per share amounts $US

Free cash flow yield per share shows how attractive the investment is compared to its peers based on free cash flow, and here it would appear that Suncor wins

Not just the cash flow
In addition to Suncor's free cash flow, which is among the best in its sector, the company looks cheap. Now when I say cheap, I mean in comparison to the company's oil reserves, which, as I have already mentioned, are enough to last the company at current production rates for nearly 50 years. 

Data from Yahoo! Finance, OXY, EOG. Proved plus probable reserves include both oil and natural gas, per barrel of oil equivalent.

I believe that this is the reason Buffett took a position in Suncor. Suncor is currently trading at a price valuing the company's reserves at just under $9 per barrel, more than half the value of Chevron! This figure indicates that not only does Suncor have stronger free cash flow than one of the world's largest oil companies, but the company is also significantly undervalued on a price per barrel of reserves basis. Nearly 50 years of production is a long-term advantage, and during this period the price of oil is only likely to go up. With such a low valuation on its reserve base and such strong cash generation, Suncor screams value.