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Declining Oil Reserves in Canada and China Force New Business Strategies

October 19, 2013 | About:
Several things caught my attention about Suncor Energy (SU) and China Petroleum & Chemical Corporation (SNP). First, the major investing gurus are different for each, and have made clear statements concerning investment preferences. Second, the firms are based in different geographies, and local authorities have different weights over activities. And third, each has developed a distinctive business model with a singular characteristic that sets them apart from other market competitors.

Know-how and large reserves

Suncor Energy is Canada’s largest energy company, it possesses the most extensive oil sands operations, and margins in refining activities are above the average. Currently the firm is looking for new opportunities in mainland and offshore Canada, in the Atlantic region and North Sea. Most importantly to the firm, is the unclogging and expansion of oil sands streaming operations. The business strategy is supported by higher oil prices in the medium term, and should help lower higher than average upstream costs.

On the upside, Suncor Energy holds a highly valuable know-how for the exploration & production of unconventional sands. The principal difference with conventional oil operations is cost. Hence, the company has a greater than average dependence from high oil prices to keep the business running. Additionally, technology improvements will be a key to reducing costs while maintaining the operations safe from operational and environmental risks. Last, because the company holds the second largest oil sands reserves, for production to continue smoothly, it is very important to avoid unnecessary publicity.

The recent merger with Petro-Canada, strengthened Suncor Energy by improving its competitive position and organizational skills. Most importantly, the balance between upstream and downstream operations was greatly improved. On the downside, the transaction meant a considerable higher debt, and the need for high capital investment. This last point is especially relevant since the firm displays one of the weakest returns in capital invested for the industry.

Financially, Suncor Energy is moderate due to debt levels and low teen operating margins. The stock is currently trading at 20.5 times its trailing earnings, doubling the industry average. Warren Buffett made the last important stock purchase. The guru bought more than 17 million shares to become the largest position in the company. Another important transaction is Steven Cohen’s, with whom I share an optimistic feeling about the stock. I trust that large reserves and oil sands E&P know-how give the firm an important advantage over the competition.

Government regulation and declining reserves

The China Petroleum & Chemical Corp., known as Sinopec, is the second largest oil & gas integrated Chinese company. Started as a refining operation, today, the firm participates in E&P and marketing of oil & gas products. Additionally, the firm has an important operation for the production of industrial chemicals. Due to declining reserves, and with the aid of Chinese authorities, the firm is actively pursuing an international strategy to increase reserves. This is especially important, since production is expected to rise during the current year in the back of favorable oil and gas prices.

For Sinopec, there is one intervening variable that deserves greater attention than all others: government regulation. In other words, the company is not able to set retail prices for fuel. The issue with dissociating oil from fuel prices is that adjustment is not always a response to market forces. I mean, government may set fuel prices in response to things other than oil price swings. For example, at this point in time analysts point that Chinese regulators have adjusted fuel prices to fight inflation. Although short-term effects may be negative, in the long-run can be devastating for the company´s economics.

Sinopec looks to expand international operations for two reasons: oil imports, and declining domestic reserves. The firm wants to switch from light sweet oil to lower-grade heavy oil, because most of the oil has to be imported and they offer better operating margins. Also, like its main Chinese competitor Petrochina, Sinopec is increasing gas production capacities and improving operational organization since domestic authorities continue to incentivize gas production as an alternative to oil based fuels.

Financially, Sinopec is strong but margins are questionably low. The stock currently trades at 7.9 times its trailing earnings, packing a 17% discount to the industry average. The discount however, is not attracting many gurus. Ken Fisher left the company last year, and Jim Simmons has greatly reduced his position. Only Sarah Ketterer made an interesting stock purchase. I do not share her optimism because the firm is carrying important changes over its business strategy and structure. Since margins are thin and consequences uncertain, I prefer to remain on the sidelines.

Intervention

I prefer Suncor Energy over Sinopec because strict Chinese regulation limits the profits generated by the second. Also, declining reserves have pushed for a risky business strategy that implies important structural changes. More, Suncor Energy has already secured an important reserve and medium-term oil prices are guaranteed to accompany E&P costs. However, I understand that many investors are not friendly of high premium, and may prefer to remain on the side until it declines.

Disclosure: Vanina Egea holds no stock in any of the mentioned stocks.


Rating: 3.5/5 (6 votes)

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