Why Warren Buffett invested in Suncor Energy, a company in the traditional oil and gas industry.
These days we hear a lot of hypes in clean energy and electric vehicles. Deloitte projects that electric vehicles (EVs) sales will grow at a compounded annual growth rate of 29% over the next ten years. We are expecting a sales growth from 2.5 million in 2020 to 11.2 million in 2025. And then eventually reaching 31.1 million by 2030. Such tremendous growth is no wonder why, valuations of EV companies have been surging lately.
Yes, there is no greenhouse gas emissions from driving EVs. But the electricity used to charge these vehicles are still largely generated from traditional fossil fuels in most parts of the world today. Moreover, manufacturing of EVs and battery use substantial amount of energy as well.
Source: Deloitte Insights / Electric Vehicles – Setting a course for 2030
If you have been following us, you will know that we adopt a value investing approach in our investment analysis. That doesn’t mean that we do not invest in growth. Rather, we advocate to pay only fair to discounted prices for companies.
So, today we want to bring your attention back to the traditional energy sector. Specifically, we want to look at Suncor Energy.
Business Operation Overview
Suncor Energy is an integrated energy company, focused on developing one of the world’s largest resource basins in Canada.
The company’s key oil extraction comes from oil sands. You may not be familiar with this. Because we usually picture oil extraction as those oil rigs drilling for oil in the middle of the sea.
For your understanding, oil sands are also known as tar sands. They are typically made up of a mixture of sand clay, water and bitumen. The company is interested in bitumen, a naturally-occurring extra-heavy crude oil. We can extract oil sands by mining or drilling. For instance, Suncor’s oil sands operations at Fort Hills use the mining process.
In mining operations, the oil sands are scooped up by large shovels and loaded into heavy haul trucks. The company will then bring the oil sands to the plant for further processing.
Through processing and upgrading, the bitumen will now have properties similar to conventional oil. The company will then refine the processed oil into common petroleum products like gasoline and diesel.
Buffett’s Bet on Suncor Energy
Source: Statista / Leading oil and gas companies based on revenue in Canada as of 2020
However, Covid-19 pandemic has turned the oil and gas industry upside down. The drastic reduction in demand has impacted the capital intensive industry dramatically. The crisis has driven many oil producers to a state of financial distress and even bankruptcies.
However, Warren Buffett is placing a bet on Suncor Energy, one of leading oil and gas companies in Canada.
Buffett purchased about 5 million shares of Suncor Energy in Q2 2020, during the initial period of the pandemic outbreak, and the oil price crash episode. His total holdings will add up to a stake of 1.3% or 19.2 million shares.
Just a quick background, Buffett’s Berkshire Hathaway bought into Suncor Energy since Q4 of 2018. Back then, the average trading price was around $34 a share.
The company has been offering dividends, and has been increasing its payout steadily for the past 18 years until 2020. Due to the challenging economic environment because of the rock bottom oil prices, eroding the company’s margin, as well as the drastic fall in demand, the company has cut its dividends by 55% to preserve cash burn. Similarly, management has planned a reduction in capital spending by $1.9 billion and operating cost by $1 billion.
With the rising cases of Covid-19 cases, we expect recovery in oil demand to be slow as countries continue to impose travel restrictions. Accordingly, it may take 3 to 5 years for oil demand to return to pre-Covid levels.
Suncor Energy’s losses has been piling up, recording a $4.14 billion loss in 1H 2020. This will translate to an accumulation of debt in its balance sheet.
Source: Statistia / Daily demand for crude oil 2006 – 2021
According to the International Energy Agency (IEA), oil consumption will flatten over the next 20 years. However, oil consumption is first expected to recover to pre-Covid levels in the next few years. Therefore, we expect business to recover for Suncor Energy, albeit a slow one.
So, the question is, how far can the company sustain the low oil prices and subdued demand without being consumed by its debt burden.
Why Buffett Invested In Suncor Energy?
Buffett invested in Suncor Energy as he seems to believe that oil prices will rise eventually. Furthermore, we think that the company’s share price has been depressed to an attractive price-to-book value of around 0.78.
Source: Yahoo Finance / Suncor Energy Statistics
So we would say that, apart from the higher oil prices in the future, Buffett is engaging in an asset-play. He is well known for investing in great companies at discounted valuation during distressed times.
Not all his investments were successful. However, the additional investment made in Suncor Energy during the pandemic period, implies that Buffett is still positive about its long-term prospect. That’s after accounting for the fact that we are experiencing low demand and prices of oil lately.
Source: U.S Energy Information Administration / Short-Term Energy Outlook Jan 2021
Once travel resumes, the company’s businesses in jet fuel and gas stations will see substantial revenue boost.
In the meantime, while oil prices remain depressed, the company is trying to reduce its losses. They are shifting their product mix to higher-margin synthetic crude.
Other Positive Attributes of Suncor Energy Investment
Suncor Energy’s Huge Reserves
Suncor Energy’s oil sands will not dry out for the next 26 years. This means that the company has ample time to recoup its losses sustained in the near term.
Economic Pillar of Canada
Canada, where Suncor Energy is operating, is the world’s fourth-largest oil producer. The oil sector contributes about 7% to the country’s gross domestic product (GDP).
Yes, there are many challenges, such as environmental concerns and high production costs. However, given its substantial role in the country’s economy, we don’t think that the authority will let the industry suffer too heavily.
This is an asset play and a bet on the recovery in oil prices. Investors entering this stock have to be patient for the full value to be uncovered eventually.
But in the meantime, it may give you a 3 – 5% dividend yield based on the current share price, after accounting for the dividend reduction plan. This can be a nice income while you wait for the market to recover.
Suncor Energy Is A Low Cost Producer
Source: Suncor Energy Q3 2020 Investor Information / Breakeven Sensitivities
Finally, we think that Suncor Energy has some cost advantage over many shale oil producers in the U.S. The company reported a breakeven of around US$35/bbl, after accounting for operating costs, sustaining capital and dividend payouts to its shareholders.
Comparatively, we are looking at breakeven of around US$40-50/bbl for the U.S shale oil producers.
This gives the company the competitive advantage to ride through periods of low oil prices that we saw recently. And allow them to capture higher profit margins when oil prices recover in the future.
So, there you have, some of the key reasons why we think Warren Buffett made a bet in the oil and gas sector, through its additional investment in Suncor Energy in Q2 2020 during the outbreak of the Covid-19 pandemic.
On the whole, other than the bet on the recovery in oil prices and demand, which we think is highly probable, Suncor Energy gives investors a chance for an asset play, given its discount in valuation due to its depressed share prices.
Therefore, once the market recovers, we could potentially see the company’s share price to more than double, when it recovers to pre-Covid levels in the US$40 a share range.
Source: Yahoo Finance / Suncor Energy 5-Year Price Chart
That’s a quick overview of the key stats and figures on the initial findings and our assessment of Suncor Energy and why we think Warren Buffet made a bet on this company.
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