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What every Canadian Oil Sands shareholder needs to know about Suncor's takeover offer

What every Canadian Oil Sands shareholder needs to know about Suncor's takeover offer

Canadian Oil Sands (COS) is an unique player in Alberta's energy patch.

For one, the company has a single revenue stream - Syncrude, one of the world's largest mines and the largest oil sands operator in the Athabasca basin. COS owns a minority interest in the project, 36.74% to be exact, and for a long time they were the operator of the Syncrude mine. 

But that all changed in 2006 when Imperial Oil, who owns 25% of Syncrude, took over management of the facility. Frustrated with perceived underperformance at Syncrude, Imperial pledged to use ExxonMobil expertise and best practices to boost Syncrude's uptime and improve production. Once Imperial (or more accurately, ExxonMobil) took over Syncrude's management team, COS was left as nothing more than a holding company, collecting free cash flow from the mine, paying out their fraction of the bills to keep the lights on and spitting out a lofty dividend to its shareholders.

When oil prices were high, things were really good at COS. After all, Syncrude doesn't produce the heavy, "raw" bitumen every politician laments about. The Syncrude product is 100% light, sweet crude oil (SCO), sometimes selling at a premium to West Texas Intermediate. Life was good over at COS . . . until the summer of 2014.

After oil prices began rolling over in late 2014, free cash flow at Syncrude dried up, and the operation went into the red. The cost of managing COS, which amounted to a few extra bucks per barrel, no longer made sense. Unlike the other partners at Syncrude, COS has only one revenue stream, leaving it unable to offset Syncrude losses with other parts of its business. COS stock started a downward spiral in late 2014, which accelerated late in the year when they slashed their dividend 85%. From a 2014 high of $24, COS shares ended the year below $10. 

Fast forward to 2015. Sensing blood in the waters, Suncor approached the COS board in April with a friendly takeover offer, which the COS board promptly rejected. After all, COS shares were now trading near $13, substantially higher than the lows of January. And operating costs at Syncrude had been quickly declining in the first half of the year, narrowing the gap on the company's balance sheet. 

But COS share prices (and oil prices) took another turn south only a few months later, hitting a low of $5.75. The sharp recovery in oil prices everyone was expecting didn't materialize. As one of the highest cost oil producers in Canada, COS was left very vulnerable and bleeding cash every quarter. 

Then came the surprise move in early October. Suncor launched a hostile takeover of COS, bypassing the board and going directly to the shareholders. The $6.6 billion all-stock deal would give COS shareholders 0.25 Suncor shares for every COS share they own. The new deal is substantially lower than the original offer presented to the COS board in April. More shockingly, it was far less than what Suncor paid for Total's 10% share of Fort Hills only a few weeks prior. The COS board was deeply insulted given the fact that Fort Hills will produce a heavy diluted bitumen, which trades at a significant discount to Syncrude's SCO product.

❝ Canadian Oil Sands' Board Unanimously Recommends Shareholders Reject Undervalued, Opportunistic and Exploitive Suncor Offer ❞

- Canadian Oil Sands Board of Directors

Given Suncor's 12% interest in Syncrude (which it acquired from the 2009 Petro-Canada takeover), acquiring COS' share would move Suncor's ownership to almost 49%, leap-frogging ahead of Imperial's 25% share. 

But that was early October. Oil prices were hovering near $50 a barrel, giving everyone hope that better times were just around the corner. COS adopted a shareholder rights plan, intended to be in place long after the Suncor offer was set to expire. It looked like the deal was dead. Then oil prices turned south again. And Suncor extended their offer to 4 days past the expiry of COS' poison-pill plan, leaving COS shareholders free to tender their shares without intervention from the board.

❝ COS admitted it has had only two meetings with potential buyers. The simple fact is that COS does not have a robust process underway. How would you feel if you had your house on the market for months and had only two showings? ❞

- Suncor Energy

So where does that leave COS investors? Confused probably. But there are 5 things shareholders should consider:

1. If oil prices do stay lower for longer, you're better off owning Suncor shares

When oil prices are low, there's no question that being diversified and integrated provides more cushion and opportunities for cost savings. Suncor's refining operations significantly benefit from the lucrative crack spread we've seen this past year. COS shareholders will gravely suffer if oil prices remain sub-$40 a barrel for an extended period of time.

2. If oil prices do recover, Canadian Oil Sands shares will bounce back much faster.

Suncor shares have treaded water since the 2009 take-over of Petro-Canada, underperforming some of its peers in recent years. That's to be expected to some extent, since large diversified companies are harder to grow than smaller, more leveraged operators. COS shares are much more highly correlated to oil prices. If oil prices go up from here, COS shares could substantially outperform. Since oil prices have fallen so far this year, we're a lot closer to the bottom than the top and there's a very high probability prices will go higher in the mid to long term. The question is whether COS shareholders have the stomach to wait for the recovery.

SUNCOR VERSUS CANADIAN OIL SANDS SHARES, INCLUDING DIVIDENDS (COURTESY STOCKCHARTS.COM)

SUNCOR VERSUS CANADIAN OIL SANDS SHARES, INCLUDING DIVIDENDS (COURTESY STOCKCHARTS.COM)

3. Suncor likely can't afford to go much higher

There's probably a small amount of wiggle room for a better offer, but not hugely better. Suncor is likely saving their pennies to buy out Teck's share of the Fort Hills project, given that Teck's financial situation is also going from bad to worse. Any attempt to raise the offering would be dilutive to Suncor shares and likely decimate the stock price. 

Given that oil prices have fallen substantially since the original offer, Suncor is unlikely to come back with a sweetened deal in the near term. If the Suncor deal is allowed to expire in January, COS shares will likely plummet.

4. The only other logical buyer for Canadian Oil Sands is ExxonMobil

Suncor has duly noted that COS has only had 2 other interested buyers. True, 2 is not a big number. But there aren't many companies out there with the guts to buy a giant oil sands mining operation under the cloud of low oil prices and unstable government regimes. It would have to be someone big, with a lot of free cash, and preferably already in the oil sands business. 

Chinese buyers (such as Sinopec or CNOOC, who already own a piece of the Syncrude pie) would likely get shot down by federal regulators. The probability of an external third party (like Warren Buffett's Berkshire Hathaway) marrying into the Syncrude family with no say in the operation is slim to none.

Big state-funded pension plans might also be candidates (such as the Ontario Teachers' Pension Plan which had a significant stake in Petro-Canada or the California Teachers' Pension Plan, who are major investors in Canadian Natural Resources). However, the likelihood of government subsidiaries taking a foray into the Alberta oil sands might be perceived as bad PR. That makes these pension funds a low probability.

Imperial oil is often touted as the only logical buyer. However, Imperial is unlikely to offer an all-stock deal due to their complicated share structure with parent ExxonMobil owning nearly 70% of the company's shares. And it's very unlikely Imperial would take on more debt at this time, since it just comes off a massive capital spend at Kearl.

Enter ExxonMobil. They've already got a major presence in Canada and the Syncrude facility. Buying out COS shareholders would give them over 60% of Syncrude, making them by far the majority owner. An all cash deal in the order of $10 billion would be a rounding error on their balance sheet. A low Canadian dollar means they could get an additional 1.6 billion barrels of proven reserves for a less than a song.

But it's probably too early for Exxon to step in. Like Suncor, best to wait for COS to get desperate. After all, it's clear that someone will buy out COS at some point. It's just a question of who and when.

5. If you're a Syncrude employee, a Suncor takeover is likely to be bad - very bad

When Suncor initially launched their bid, there was little mention of Imperial Oil, except to say they had informed Imperial of their deal and had no intention of taking over management of the Syncrude operation.

But the rhetoric got uglier as time passed. Suncor now emphasizes they could greatly improve operating efficiencies at Syncrude, which is likely code for we plan to takeover the facility, move our people in and slash and burn our way to profitability. Suncor is quite proficient at mass layoffs, cutting thousands of jobs in 2009 and again earlier this year. Imperial's management style is diametrically opposed, remaining one of the few oil companies not slashing jobs this year. For Syncrude employees, that's another reason to think twice before tendering your shares.

The Suncor offer is set to expire on January 8th, 2016. Canadian Oil Sands is recommending its investors reject the offer, however, its shareholder rights plan expires on January 4th, leaving the fate of the company in the hands of its shareholders.

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