Forget Tech, Suncor Energy Offers Significant Upside In A Beaten-Down Sector (NYSE:SU)

All financial numbers in this article are in Canadian dollars unless noted otherwise. Oil and gas prices are always in US$.

Introduction

The other day, I read a very interesting article on Bloomberg titled “Wall Street Traders Are Too Scared To Fight The AI Rally.”

What fascinated me about the article is that it discussed that tech has almost become the only game in town, with investors being too scared to bet against it.

Interestingly, despite concerns about the ongoing dominance of high-growth stocks and potential risks, the recent performance of NVIDIA (NVDA) has pushed bullish sentiment even higher.

As we can see below, short interest among major tech companies has fallen to historic lows, which perfectly reflects the overwhelming bullish sentiment.

Before the pandemic, short interest was hovering close to 5%. Now, it’s at just 1%.

Note that even before the pandemic, nobody “hated” tech. It was already the best place to be!

What’s interesting is that these developments remind me of a discussion I recently had with one of my readers.

We discussed that we have the benefit of doing whatever we want in the market, as we do not have to beat the market every single year.

I believe that once investors stop trying to beat the market every year, they can build portfolios that beat the market on a long-term basis.

After all, having to beat the market each year (which applies to most money managers) creates the urgency to always buy the “hot stuff.”

Or, as Bloomberg made the case, with tech-focused indexes consistently rising, active managers face increasing pressure to capitalize on this upward momentum – regardless of valuation!

Furthermore, as we can see below, the ratio of the equal-weight S&P 500 (RSP) to the S&P 500 is close to lows not seen since the pandemic and the Great Financial Crisis.

The reason I’m bringing all of this up isn’t to get anyone to short or sell tech stocks.

No, I am doing what I always do. Whenever “everyone” wants to bet on the same theme, I’m looking for opportunities elsewhere. I did it in 2020/2021, and I feel like we’re now in a similar situation – at least when it comes to valuation differences.

See, NVIDIA is now worth more than all stocks in the energy sector ETF (XLE) combined!

Furthermore, we see that value stocks (energy is a big part of this) are trading at a very attractive valuation compared to growth stocks. This is especially true if we assume that interest rates remain higher for longer.

Hence, this article is about one of the most undervalued energy stocks on my radar. A company that has become so cheap that I believe it will provide substantial returns the moment the market starts to look into other areas beyond tech (rotation).

As the title of this article gave away, that company is the Canadian integrated oil and gas giant Suncor Energy (NYSE:SU), the biggest peer of my energy investment, Canadian Natural Resources (CNQ).

My most recent article on this Canadian company was written on November 9, 2023, titled “Suncor Energy’s Shareholder Return Potential Is Impressive – 13% At $80 WTI.”

Since then, shares have returned 5.6%, including dividends.

In this article, I’ll update my bull case, using its just-released earnings and new developments that bode well for the Canadian upstream sector.

So, let’s get right to it!

Suncor’s World-Class Assets Pave The Road For Growth

Suncor Energy is comparable to a company like Exxon Mobil (XOM), as it is an integrated oil and gas company, meaning it also refines (downstream) oil into value-adding products.

It combines upstream and downstream operations instead of solely focusing on upstream like its peer, Canadian Natural.

The company, which has major operations in Canada’s oil sands, has a reserve life of 26 years, giving it one of the biggest reserves in the entire industry.

In general, Canada is home to some of the world’s largest reserves. Using 2020 numbers (that are still up-to-date), we see that Canada is home to 10% of the world’s oil reserves. Most of these reserves are in the Western Canadian Sedimentary Basin (“WCSB”), where SU operates.

This year, the company is expected to produce between 770 and 810 thousand barrels per day. More than half of this is expected to come from its oil sands operations.

On top of that, it is expected to turn between 550 and 580 thousand barrels per day of its production into refined products this year, with a refinery utilization rate of no less than 92%.

In fact, during its 4Q23 earnings call, the company noted that both upstream and downstream segments showed a strong operational performance during the quarter.

For example, upstream production reached 808 thousand barrels per day, which is the second-highest in the company’s history.

Furthermore, major achievements included record-breaking production in November and December, successful completion of turnarounds at various facilities, and over 100% utilization at the Syncrude facility.

Moreover, refining utilization stood at an impressive 98% in the quarter, with strong downstream margin capture driven by higher realizations from seasonal diesel differentials.

Adding to that, during the quarter, the company closed the acquisition of Total Energy Canada, which makes it the sole owner of Fort Hills.

This is what the company said when it announced the acquisition of Total Energy Canada last year:

With 100% ownership of Fort Hills we will pursue opportunities to create additional value through regional synergies and basinwide management of our unparalleled, integrated oil sands asset base. This transaction is aligned with our strategy to wholly own and operate long-life strategic assets.

As we can see below, Fort Hills is expected to produce up to 165 thousand barrels per day, roughly a fifth of its total production.

It’s also one of the company’s premier assets, with a 0% decline rate, which is another reason why I like Canadian oil sands.

Essentially, there are two methods to produce oil in the oil sands:

• Surface mining: This method recovers deposits less than 75 meters (82 yards) below the surface.
• In-situ: This method uses steam injection to extract bitumen underground.

Hence, the 0% decline rate refers to the sustained production level.

U.S. shale, for example, has a decline rate of somewhere between 10% and 20%, meaning that existing wells quickly lose productivity, requiring producers to consistently drill new wells.

This is what the EIA wrote in March 2023, including the graph that goes with this comment:

The decline curve converts from a hyperbolic decline to an exponential decline when the monthly decline rate falls to 0.8% (10% annual decline). An example of a production profile using a hyperbolic decline curve is shown in Figure 1.

The overview below shows this comparison as well, including the fact that the majority of Suncor’s production has a very low decline rate.

These numbers also explain why Suncor is able to boost production by 6% this year without having to risk exploiting too much high-quality inventory.

On top of having the “luxury” of not having to worry about elevated decline rates, the company is using its operations to enhance efficiencies (lowering total costs).

For example, the number of trucks operating autonomously has increased from 31 to 45 in the past three months, with plans to reach 91 by the end of this year.

The company aims to transport 100% of ore at the Base Plant autonomously, with potential annual cost savings of $1 million per truck per year.

So, what does this mean for shareholders?

Deep Shareholder Value

One of the most important things to discuss is the company’s ability (and willingness!) to reward its shareholders.

For example, during the fourth quarter, the company showed its commitment to shareholders by returning nearly $1.1 billion, which included a 4.8% dividend hike and $375 million in buybacks.

The 4.8% hike was announced on November 15 and brings the annualized dividend to $2.18 or 4.8% of its stock price. Again, I’m using CAD and Toronto-listed shares here. The same yield applies to U.S. shares as well.

However, dividend growth for investors based in the U.S. and other nations is dependent on the Canadian dollar.

Furthermore, in 2023, the company repurchased $2.2 billion worth of shares, which translates to roughly 4% of its float.

Over the past five years, the company has bought back close to a fifth of its shares, most of it occurring after the pandemic.

Adding to that, despite the aforementioned closing of the acquisition of Total Energy Canada for CAD 1.5 billion, along with closing adjustments and costs, Suncor managed its net debt very effectively, which stood at $13.7 billion at the end of the fourth quarter.

As I wrote in my prior article, the company ended the year with net debt in the target range of $13.5 to $14.0 billion.

Once it lowers net debt to $9 billion, it plans on returning 100% of its free cash flow to shareholders – mainly through buybacks. Below $12 billion, that number is 75%.

Analysts expect the company to lower net debt to $9 billion by the end of this year, which means we will likely see a gradual shift in buybacks in the quarters ahead – in favor of shareholders.

[…] our capital allocation structure is pretty clear. When we hit $12 billion net debt, we go to 75, 25 buyback and reduction. And then once we get to $9 billion, and that is a net debt basis, including capitalized leases. We’re focused on that framework. I think to piggyback on Rich’s comments, what we’re trying to do is drive more free cash flow out of the business so we can drive to those targets even more quickly. Now, obviously, it’s all going to be dependent on where commodity price lands, and people will take varying views of when we’re going to hit the $12 billion. But we’re focused on driving that debt down while continuing to return cash to shareholders. – SU 4Q23 Earnings Call

Furthermore, to give you an idea of how much capital the company can spend, it targets roughly $5 in per-share adjusted funds from operations after sustaining capital and dividends at US$78 WTI.

This implies a total potential payout yield of 11%, a number that should be able to increase exponentially if oil prices move higher.

Having said that, normally, I would make the case that Suncor isn’t the best choice for dividend-focused investors.

While it won’t use special dividends – at least not anytime soon – I like that its base dividend is now close to 5%, which brings a fantastic mix of regular quarterly dividends and buybacks to the table.

The valuation isn’t bad, either!

Valuation

Suncor Energy is very cheap.

Using the P/OCF (operating cash flow) metric, the company is trading at a blended multiple of just 4.8x OCF, which is way below its long-term normalized multiple of 10.2x OCF.

As analysts expect the company to generate roughly $11.70 in 2026E OCF, it has a theoretical fair price of $119, based on a 10.2x multiple.

This would imply a 160% upside.

While this is a purely theoretical return, I do believe that SU is way too cheap.

• While I do not disagree that tech/growth has been the better place to be (until now), valuations are favoring energy.
• Despite economic pressures in Europe, China, and other areas, oil prices remain strong.
• Even an 8x OCF multiple would imply roughly 100% stock price upside.

Especially once oil prices get cyclical tailwinds, I expect a rush toward beaten-down oil stocks like SU. There’s just too much value, in my opinion.

On top of that, the Trans Mountain Pipeline expansion is close to being completed.

This expansion could triple the pipeline’s output of currently 300 thousand barrels per day.

Although it will quickly reach its limits again, additional throughput will add significant pricing benefits for Canada’s producers, enhancing margins for most WCSB-based producers.

All things considered, I really like SU and believe it will turn into one of the best-value stocks for the next few years (and likely beyond).

The only reason why I am not long is that I have a position in its peer CNQ.

Takeaway

In a market of lofty valuations where tech dominates, finding value elsewhere is key.

While many are fixated on the soaring tech sector, opportunities lie in undervalued sectors like energy.

In this sector, Suncor Energy stands out as a prime example, with its robust operations and commitment to shareholder value.

Despite its impressive fundamentals and potential for significant upside, SU remains undervalued, trading at a mere fraction of what I believe to be its fair price.

With favorable industry dynamics and upcoming catalysts like the Trans Mountain Pipeline expansion, SU emerges as a compelling investment opportunity.

Pros & Cons

Pros:

• Deep Value: Suncor Energy presents a compelling opportunity for value investors, trading at a significant discount to its fair price.
• Strong Fundamentals: The company has world-class assets and a diversified business model, including upstream and downstream operations.
• Shareholder Friendly: SU has a strong commitment to rewarding shareholders through dividend hikes and substantial buybacks.
• Potential Upside: Analysts anticipate significant upside potential for SU.
• Industry Tailwinds: Favorable industry developments, including potentially elevated oil prices and upcoming pipeline expansions, bode well for Suncor.

Cons:

• Sector Volatility: Investing in the energy sector comes with significant volatility driven by fluctuating oil and gas prices.
• Market Sentiment: Despite its intrinsic value, SU’s stock price may be influenced by broader market sentiment.
• Environmental Risks: As an energy company, SU faces environmental risks and regulatory scrutiny.
• Currency Risks: non-Canadian investors like myself need to be aware that dividend payments are dependent on the Canadian dollar.
• Taxation: Canadian stocks may be taxed differently than, for example, U.S. C-Corps.