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Canadian Natural Resources CNQ
by Elizabeth Collins
Thesis 09-20-2006
By pinning growth to a 40-year investment in Canada's oil-sands resources, Canadian Natural Resources faces a different set of risks than other conventional oil and gas producers.
As Canada's second-largest natural-gas producer, Canadian Natural has profited markedly from recent increases in North American natural-gas demand and prices. Although Canadian Natural expanded to the North Sea and West Africa in recent years, western Canada still represents the lion's share of production and reserves. Conventional oil and gas resources in the mature western Canadian basin do not offer the promise of long-term production growth, and it is becoming an increasingly tough chore to add reserves there. Although the firm has lots of undeveloped land it can still tap, it has turned increasingly toward heavy oil and unconventional oil sands.
Canadian Natural has large reserves of heavy oil, which has lower value and is more expensive to refine than light oil. Management is attempting to enlarge the market for heavy oil through heavy oil pipeline additions, oil-blending strategies, and the encouragement of heavy oil refining capacity growth. While there is significant marketing risk with heavy oil production, the economics are promising.
The company's long-term strategy is anchored in Alberta's oil sands, and the potential for growth there is huge. Oil sands are hydrocarbon-rich deposits of sand from which thick, heavy oil can be extracted and upgraded into higher-quality crude oil. Having received board sanctioning, the Horizon Oil Sands Project--expected to cost C$10.8 billion--is targeted for startup in 2008. Upon completion of all three phases in 2012, the operation is designed to crank out more than 230,000 barrels of high-quality crude per day for upward of 40 years. Estimated reserves are more than 6 billion barrels, and the project involves no exploration risk whatsoever.
However, we can't ignore the other risks, which are significant. Extracting and upgrading oil from sand is expensive, and project economics are highly sensitive to numerous variables, including volatile natural-gas prices, currency movements, labor costs, and environmental liabilities. While today's lofty oil prices make most oil-sands projects look invincible, high overall costs make the projects susceptible to declining oil prices. With enormous up-front capital costs, there is also risk of cost overruns similar to those that have plagued comparable projects. Still, considering these risks in conjunction with our projected energy prices, we think Horizon will generate decent returns.
Valuation
After digesting Canadian Natural's proposed acquisition of Anadarko's APC Canadian subsidiary for $4 billion, we are maintaining our fair value estimate of $53 per ADR share. We assume the transaction receives the necessary approvals and closes during the fourth quarter of 2006. With this acquisition, Canadian Natural is expanding its current natural-gas production rate by about 25%.
We assume benchmark oil prices of $68 in 2006, $57 in 2007, $46 in 2008, $44 in 2009, and $46 in 2010. Further, we assume benchmark natural-gas prices of $6.90 per thousand cubic feet in 2006, $6.50 in 2007, $6.20 in 2008, $6.30 in 2009, and $6.50 in 2010. We are expecting Canadian Natural's oil and gas production to grow by over 6%, compounded annually, over the next decade. Significant boosts to production should come from the Horizon Oil Sands Project. Since Canadian Natural will be investing heavily over the next several years, and significant free cash flows are still far off, our fair value estimate is extremely sensitive to our weighted average cost of capital (WACC) assumption. We use a 10.4% WACC to discount the firm's future cash flows. If we lowered this by 1 percentage point, our fair value estimate would jump to $73 per ADR share. If we increased the WACC by 1 percentage point, our fair value estimate would drop to $40.
Risk
Besides the inherent volatility associated with fluctuating commodity prices, risks include oil spills and other environmental accidents. Investors also bear foreign-currency risk because earnings are reported and dividends paid in Canadian dollars. However, with much of the firm's production sold in U.S. dollars and most of its costs in Canadian dollars, U.S. investors are somewhat hedged to the risk of a falling Canadian dollar.
See Previous Analyst Reports
Close Competitors TTM Sales $Mil Market Cap $Mil
Canadian Natural Resources 7,224 27,971
* Nexen 4,770 13,977
* Talisman Energy 6,650 18,141
* EnCana 14,266 40,806
* Morningstar Analyst Report Available | Compare These Stocks
Data as of 12-31-2005
Strategy
Canadian Natural Resources pursues growth by adding oil and gas reserves and improving production from its existing resource base. As western Canada's conventional oil resources have dwindled, the company has expanded operations overseas and is targeting enormous deposits of Canadian oil sands. Acquisitions are also an integral part of the firm's growth strategy; however, oil-sands project construction costs will eat up the lion's share of spending over the next several years.
Management & Stewardship
Canadian Natural does not have a chief executive officer; leadership responsibilities are shared by John Langille, the vice chairman of the board, and Steve Laut, who is president and chief operating officer of the company. Laut recently joined the board of directors as well. In 2005, Langille took home C$325,000 in base salary and C$443,000 in bonus. Laut received a base salary of C$408,000 plus C$1.1 million in bonus. We believe that this compensation is reasonable given Canadian Natural's position within the oil and gas industry. In addition to Langille and Laut, Allan Markin serves as chairman of the board, and Murray Edwards serves as vice chairman. With directors and officers owning a sizable chunk of the company's stock, the interests of management and shareholders are clearly aligned. In our opinion, Canadian Natural's stewardship is good. The company could improve on this metric by providing more details on how managers' bonus amounts are determined.
Profile
Calgary-based Canadian Natural Resources is the second-largest natural-gas producer in Canada. In recent years, the addition of international properties in the North Sea and West Africa has boosted oil production to 57% of the total. In 2005, the firm produced 553,000 gross barrels of oil equivalent per day and posted approximately 3.7 billion barrels of gross proved reserves, including oil sands resources.
Growth
In the past, Canadian Natural has relied on both exploration and acquisitions to increase reserves and production. The bulk of the firm's growth will come from exploiting its oil-sands and heavy oil reserves in Alberta.
Profitability
The firm's profits jump around with energy prices, but average returns on invested capital have slightly exceeded our estimates for cost of capital. Heavy investment in oil sands implies negative free cash flows for the next several years.
Financial Health
Debt/book capitalization is about 30%, and this could rise over the next several years with borrowings related to the firm's oil sands strategy. Increased use of commodity price hedging helps offset risk here.
