In August of last year, Warren Buffett's investment firm Berkshire Hathaway revealed that it had accumulated a stake of 17.8 million shares, then worth more than $500 million, in Canadian oil and gas company Suncor Energy.
Given Buffett's exceptional long-term track record of investing success, his moves deserve close attention. While he probably purchased Suncor because it was extremely undervalued at the time, the company is also very attractive from a dividend perspective, featuring a very stable business model, and exceptional cash-flow generation abilities that should continue to support strong dividend growth.
Stable and growing dividend
Calgary-based Suncor is an integrated energy company that sports a current dividend yield of 2%. While that yield may not sound all that enticing, the company's dividend growth history and prospects -- I'll get to that later -- are impressive. During the past five years, Suncor's dividend has grown at a compound annual rate of more than 35%. And since 2010, its dividend has more than doubled.
The company has also repurchased some $4 billion worth of its own shares since September 2011, which amounted to more than 8% of its outstanding shares as of April 2014. And it still has $1.4 billion more worth of shares that it plans to buy back under its current authorization. The main reason why Suncor can afford to return so much cash to its shareholders is because of its exceptional cash-generation capabilities.
The company has produced operating cash flow of more than $2.25 billion for 10 consecutive quarters, and delivered record cash flow of $2.88 billion during the 2014 first quarter. Suncor generates so much cash mainly because of its integrated business model, which has been further revamped during Steve Williams' tenure as CEO.
Benefits of integrated model
Its integrated model means the company is involved not only in exploring for and producing oil, but also in upgrading, refining, and marketing petroleum products through its Petro-Canada brand. Crucially, this model greatly reduces the company's vulnerability to lower Canadian crude prices and, therefore, provides it with a major competitive advantage over peers focused exclusively on upstream operations.
Here's why. Basically, the majority of Suncor's production comes from the oil sands. But, because the company also upgrades most of its oil sands production into more valuable light products, and then refines those products into refined fuels and specialty products, it is able to capture value throughout the value chain.
For instance, when Canadian heavy crude was trading at a massive discount to both North American and global crude benchmarks last year, Suncor's upgrading of operations allowed it to capture value from the spread between Canadian heavy crude and West Texas Intermediate, or WTI, the main U.S.-crude benchmark.
Similarly, its refining operations allowed it to capture value from the spread between WTI and Brent, the primary global crude benchmark, because refined product prices are linked to the price of Brent. Further, production from Suncor's assets along Canada's East Coast, the North Sea, and the Middle East, is also sold into premium markets at Brent-linked prices.
Strong dividend growth outlook
This advantage has allowed the company to sell more than 95% of its upstream crude production at higher, Brent-linked prices during the past few years, allowing it to generate industry-leading cash flow from upstream operations of $55.14 per BOE. Going forward, Suncor plans to ramp up oil sands production from 360,000 barrels per day (b/d) in 2013 to an expected more than 550,000 b/d by 2017.
Coupled with only a modest expected increase in capital spending, and major improvements in operating costs that have seen its cash costs per barrel decline from $39.05 in 2011 to $37.00 last year, this production growth should allow it to comfortably grow its cash flows and dividend at an annual rate of around 8% or better during the next few years.
Investors seeking a very stable source of income should seriously consider following Buffett's move into Suncor. The company's control over the entire crude oil value chain allows it to maximize value at every stage, and greatly mitigates its exposure to oil price volatility, as well as reduces its dependence on pipelines like the Keystone XL. This provides Suncor with unparalleled stability in earnings and cash flows, which makes the company's strong and growing dividend especially secure.