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Suncor Bids For Canadian Oil Sands: A Good Deal? Or Is Better To Come?

Suncor has made a $4.3 billion share exchange offer for Canadian Oil Sands.

Its shares were valued at $8.84, a 43% premium to its previous closing.

The deal has some clear benefits for Canadian Oil Sands shareholders.

Is an even better deal possible?

Since both Suncor and Canadian Oil Sands report in CAD, all prices quoted are in that currency, unless otherwise noted. Share price quotes are from the TSE, where there is more liquidity for both company's shares.

On October 5, Suncor Energy (NYSE:SU) announced a $4.3 billion offer (prices as of October 2 closing) for the outstanding shares of Canadian Oil Sands (OTCQX:COSWF). Under its terms, a COS shareholder would receive .25 of a Suncor share ($35.37) for each COS share ($6.19). Effectively this would value a COS share at $8.84, a 43% premium. If the deal were completed, Suncor would assume the COS long-term net debt of $2.3 billion, making the total value of the transaction about $6.6 billion. The offer is contingent on at least two-thirds of Canadian Oil Sands' shareholders tendering their shares to Suncor, and, unless withdrawn or extended, closes on December 4, 2015.

Canadian Oil Sands Situation In Brief

Canadian Oil Sands Ltd. is unique among large Canadian energy companies in that it is not a true producer. Its sole asset is a 36.74% stake in the Syncrude oil sands mining/upgrading operation from which it takes its share of the oil produced. Syncrude is, in turn, an operation jointly controlled by seven owners, including also Imperial (NYSEMKT:IMO) (25%) and Suncor (12%). Its operator is Imperial. Unlike most of the partners, Canadian Oil Sands is totally reliant on Syncrude's production for its income. What gives its shares value, however, are the production facilities already in place to deliver high-quality synthetic light crude and the Syncrude long-life reserves. (At 2014 year end, Syncrude held 4.4 billion barrels of proved plus probable reserves, of which the COS share would be 1.6 billion barrels.)

I had previously written of the headwinds Canadian Oil Sands faces currently, in part from the present low levels of crude pricing, in part from regular problems at the Syncrude operation, which is not near nameplate capacity, and in some part at least from the cost overlay that the current management structure creates. These problems are exacerbated by the fact that the Syncrude stake is COS' only holding. Two very recent events - a fire at the Syncrude upgrader and a Moody's downgrade of COS long-term debt - highlighted its current difficulties. So did a recent company presentation which indicated that the company was presently selling oil at a loss of $6.00 per barrel. In its commentary, Moody's was alluding to a cash bleed if current prices persisted, and its downgrade could put pressure on the present dividend. The company last recorded its breakeven costs at C$62.00 (US$50.00) per barrel, which included C$5.00 in costs directly attributable to COS itself.

Canadian Oil Sands long-term debt of $2.3 billion is largely USD-denominated. Although no large principal payment is due before 2019, the current low range of the CAD results in higher than anticipated annual interest payments. The company also has other large liabilities, including at least $1.6 billion in deferred taxes, $356 in future employee benefits, and $1.2 billion in future site reclamation costs (although the last is projected over 70 years).

It must be added that the company also faces possible future headwinds from two reviews currently underway in Alberta. The first is a review of royalties paid on oil extracted from public land. The second, perhaps more problematic for an oil sands miner/upgrader, is a review of potential penalties for greenhouse gas emissions. The results of both reviews would come into effect in 2017 or later.

Over time, the COS share price, especially with dividend cuts, has fallen steeply, even before the more recent drop in crude prices. Near $34.00 in 2011, it reached a bottom of only $5.76 on August 24. Since the company has become a near-proxy for WTI, its NAV has fallen sharply with the decline in forward strip pricing.

What Does the Suncor Deal Offer to COS Shareholders?

To many shareholders at least, the Suncor offer presents an opportunity to take them out of the near-term deterioration and future uncertainty that has hammered the share price for some time. Particularly if the "lower for longer" thesis has some real legs, investors are presented with a way out.

Still, whatever it limitations, the Suncor deal offers not only some form of rescue, but certain positive benefits. Obviously, if the deal goes through, current COS shareholders will retain their interest in Syncrude and garner an additional 12% working interest (an increase of almost one-third). As investors who are presumably convinced of the value of oil sands investment for the future, they will now gain as well exposure to Suncor's much greater and diverse oil sands production, which by 2019 could be something like 630,000 bbls/d or better (presuming the Total and COS deals).

Traditionally, Canadian Oil Sands had appealed to income seeking investors, although dividend cuts have muted that appeal. An acquisition by Suncor would actually increase the annual dividend now received by COS investors from $0.20 to $0.29 per share (some 45%). It would also give current COS shareholders exposure to future SU dividend increases and to share buybacks that are considerably more likely, at least in the near future, with the larger, financially more stable, company.

The Suncor deal also offers some real potential for cost savings on the current Syncrude production. The current operator is Imperial Oil (with many Exxon personnel). There seem to have been improvements. Still, the results have not been spectacular, and there have been suggestions that costs are high. In announcing the COS offer, Suncor has declared its intention of "working with the operator" using key personnel. Suncor has similar mining/upgrading operations nearby and a 48.74% stake would give it clout; more importantly, it has expertise. At the same time, Suncor has denied that it wants to replace Imperial as the Syncrude operator. (IMO's operating contract expires in 2016, but two years notice is required for termination. Even if SU wanted the operatorship, this could not occur before 2018.)

At the same time, even without a reduction in operating costs, Suncor could produce relatively immediate savings on the 100,000 bbl/d or so current COS share of production by a major reduction in the $5.00 per barrel costs directly attributable to COS itself (administrative, insurance interest, taxation). Some have estimated such synergies at $25 million annually.

The further advantage offered by Suncor is that it is an integrated company, offering a measure of protection from its downstream activity in periods of lower pricing, with its downstream also offering the possibility of more profitable marketing for the Syncrude product.

In response to the Suncor offer, the Canadian Oil Sands board has issued a brief statement simply saying for the moment that it is reviewing the proposal and will communicate with shareholders later. It has engaged RBC to advise it on the matter. Nevertheless, the COS board is almost certainly likely to advise rejection and to say that the offer greatly undervalues the company.

The Suncor offer is low. Analysts have called it "opportunistic". One shareholder, Seymour Schulich, a prominent Canadian businessman who may own 5% of the company, has called it "ridiculous," and said he believes the company is worth $20.00. (Schulich bought about 3% of COS as early as 2004. A company of which he is a director, Newmont Mining, sold its own 6.4% stake in COS in 2013.) Suggested prices in this high range seem to be based on current replacement costs for Syncrude, and not NAV, which reflects forward strip prices; nor do they reflect possible cost increases from carbon penalties or increased royalties.

Actually, Suncor made a higher offer for Canadian Oil Sands on April 9, an exchange of each COS share for .32 SU share, which was rejected by the COS board on April16. This would have valued each COS share at $11.84. Still, at that time, everything was higher. On April 8 closing, SU was at $38.84, COS at $10.77, and WTI at $50.44. Most importantly, forward strip pricing was then at much higher levels than it is currently.

The one apparent downside to the current Suncor bid is that because Canadian Oil Sands is not involved directly in production, and has a single product - SCO, or sweet light crude that trades in tandem with WTI - whose quantity is to a certain extent predictable, the COS share has become almost a proxy for the price of crude. If WTI rises sharply, the COS share price should rise sharply also. For those who believe in higher near-term prices, the beaten-down price of COS presented an attractive proposition, and some have bought it for this reason on its recent lows. Were its shares traded for Suncor however, that same immediate traction would be diminished: Suncor has not suffered nearly as much in the downturn, and its holdings are much more diverse than a single product.

Suncor's bid may have been strategically set low. If a competing bid emerges, Suncor has the possibility of raising its own offer. Even if there is no competing bid, but if forward crude prices stabilize at higher levels over the next two months, and/or if a significant number major investors show reluctance to take up the Suncor bid, it has the ability to improve the offer. Suncor has said it is in contact with major COS stakeholders; my guess would be that at the moment most are uncommitted, but probably encouraging Suncor to sweeten the pot. A representative for TD Asset Management, Canadian Oil Sands' largest shareholder (just under 5 percent), called the Suncor offer "a little light." Suncor's own reaction was to describe any COS rejection as anticipated, and to call its own offer "full and fair." It is continuing to meet with major shareholders to persuade them of the deal's merits.

At the same time, given Suncor's previous offer, the only known basis for an upside would be to assume that Suncor might be willing to exchange about one-third of a SU share for one COS share. With an October 5 closing of SU at $34.60, that would be an implied COS value of $11.52, about $2.00 to the upside of current COS trading. For Suncor, the deal is likely to be slightly dilutive in the near term; even better forward strip pricing probably would not justify its going much beyond these levels.

An Imperial Oil Bid?

Although a competitive bid for Canadian Oil Sands could possibly come from a third party, such as a pension fund, only its Syncrude partners, Suncor and Imperial Oil, seem poised to reap the immediate synergies of a merger. On whether Imperial will make a competitive bid, however, there can only be speculation. Analysts seem divided on the matter, some anticipating an Imperial bid, some not.

Those who do not see an Imperial bid forthcoming note that Imperial is now very much involved in the further expansion of its Kearl project, and it may have much more interest in developing future in situ steam driven SAGD projects, whose costs - and carbon emissions - are somewhat lower. It may be quite content to have Suncor's greater involvement in resolving Syncrude's perennial difficulties.

For its part, the market is clearly anticipating some upward movement, either in a competing bid from Imperial or from a sweetening of the Suncor offer. Since the Suncor announcement, Canadian Oil Sands shares have jumped to a current $9.25-$9.75 range, which at mid-point would be a 7.5% premium to the implied $8.84 valuation in the original announcement. While a positive sign, that is not a huge mark of confidence that something better will emerge.

What Options Have COS Shareholders?

Canadian Oil Sands shareholders who have held their shares for the past year or more have experienced a roller-coaster ride, and ultimately the share price has been decimated. A total rejection of this or any improved deal would probably mean a large decline in share price, perhaps to new lows, especially given its exposure to debt reclassification, possible dividend reductions, and future added royalty or carbon emissions costs. There would also be the loss of any implied takeout premium. Only those investors with a firm conviction of considerably higher crude prices sooner would probably wish to opt for COS braving it out on its own. Even for those who bought shares at recent lows anticipating higher oil prices, the present market price offers some immediate gain.

On the other hand, investors who have little confidence that either a competitive bid will emerge or that Suncor will improve the deal to better persuade COS shareholders, have the immediate option of selling their shares in the current market at a small premium to the $8.84 now offered by Suncor. This could also appeal to those who wish to put the cash to other uses more immediately.

Still, the current offer is open until December 4, and perhaps the best course is to wait and see how events play out. Forward crude prices could increase substantially in that period, a competitive bid could emerge, and Suncor may have to improve its offer to please major shareholders. Apart from a major bidding war or a huge crude price increase, both of which are possible but unlikely, the most reasonable upside is probably in the $2.00 range from the current market price. The downside is a small loss from the current share price if the current deal is maintained as is.

DISCLAIMER: The information provided above is not a recommendation to buy or sell a stock. It intends to increase investor awareness and to assist investors in making smarter decisions. Prospective investors should always do their own further research, and take into account their own current financial holdings, their risk levels and their shorter or longer-term outlooks.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.