Suncor's Actions Help Protect Dividend But Balance Sheet Runway Won't Last Forever

Suncor (SU) is an integrated energy company focused on developing Canada’s oil sands. Oil sand is a heavy mixture of bitumen, sand, fine clays, and water. Because it does not flow like conventional crude oil, it must be mined or heated underground before it can be processed.

Oil sands production historically generated around 60% of Suncor's funds from operations, with refining and marketing operations accounting for most of the remainder.

The unprecedented oil-price crash earlier this month has caused virtually all energy companies to evaluate their capital allocation plans.

We believed Suncor would likely maintain its dividend given the firm's solid balance sheet, management's historical commitment to the payout (17 straight years of dividend increases), and the long-life, low-decline nature of oil sands reserves (minimal cost to sustain production compared to conventional oil fields).

On March 23, Suncor announced plans that would help preserve its dividend, though management didn't comment specifically on the payout.

Suncor said this year it expects to reduce capital spending by about 25%, slash operating expenses by more than 10% (saving at least $1 billion), and suspend share repurchases as it hunkers down.

Unfortunately, conditions have since gone from bad to worse for Canadian oil producers. Given this additional stress and uncertainty placed on Suncor's outlook (more on that below), we are downgrading the company's Dividend Safety Score to Borderline Safe.

The price of Western Canada Select (WCS), the benchmark for Canada's heavy oil, plunged 30% on March 26 and tumbled another 28% on March 27 to fall below $5 per barrel. This is uncharted territory.

WCS prices have historically traded at a discount to West Texas Intermediate (WTI) benchmark oil prices in America, which hover near $20 per barrel today.

The discount is due to the further distance Canada's oil has to travel to reach U.S. refineries (compounded by Canada's limited pipeline infrastructure). Additionally, heavier oil can be more difficult for refineries to process.

With the coronavirus pandemic hurting oil demand and forcing oil sands producers to delay maintenance work (rather than temporarily halt production), this dynamic has been amplified.

At current WCS prices, Bloomberg estimates that Canadian heavy crude "has become so cheap that the cost of shipping it to refineries exceeds the value of the oil itself."

Under more normal conditions, Suncor has some insulation from WCS prices thanks to the integrated nature of its business.

The company's refineries, gas stations, and other midstream assets provide logistical flexibility to move production to different markets. As a result, Suncor says it receives "global-based pricing" for the majority of its production.

However, at prices this low, Suncor may need to consider reducing or shutting down some of its operations. After all, Suncor estimates that it requires a WTI oil price a little under $45 per barrel to cover its sustaining capital expenditures (around $3 billion) and dividend ($2.2 billion).

Management has also said that every $1 per barrel change in the price of oil impacts Suncor's funds from operations by about $180 million. If today's prices persist, we estimate Suncor might burn through around $4 billion annually to maintain its business and the dividend.

The good news is that the company still has the liquidity to wait things out for a period of time.

At the end of 2019, Suncor had $6.7 billion of liquidity, and the firm recently secured an additional $2.3 billion of credit facilities. Additionally, no debt is due in 2020, and upcoming maturities in 2021 ($1.4 billion) and 2022 ($225 million) seem manageable.

However, based on today's price environment, we estimate that Suncor's debt-to-capital ratio could rise from 30% today to around 36% after a year of borrowing to plug its cash flow deficit.

This would be above the high end of management's 20% to 35% target range, potentially applying more pressure on the firm to reevaluate its capital allocation priorities.

Of course, oil prices are notoriously volatile (and believed to be unsustainable at today's level), which is one reason why management probably feels comfortable waiting things out for now.

However, a continued slump in prices reduces the runway Suncor has to cover all of its commitments without jeopardizing its financial flexibility. In fact, on March 26 the company's credit rating was downgraded one notch to BBB+ by S&P.

Overall, Suncor appears to remain one of the best houses in an increasingly distressed neighborhood. Canadian oil producers are under some of the most pressure following last week's price shock, and few energy companies can make money, much less cover their dividends, in this environment.

It's hard to say how long today's oil prices could persist (see our take here) as the market continues grappling with an unprecedented demand shock from the coronavirus outbreak and an escalating battle for market share between Saudi Arabia and Russia.

Suncor has taken actions that improve its financial buffer to weather this storm for a while, but higher commodity prices seem necessary within a year or so to keep the company's dividend and balance sheet on solid ground. 

We will continue monitoring the situation and provide updates as necessary.