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The anatomy of an oil sands deal

If more money is needed to develop the oil sands, you go get it. A leading Canadian advisory analyzes the merger of two oil patch giants.

Not so long ago, Alberta’s oil sands were the envy of the energy world.

Their vast reserves — second only to Saudi Arabia — would pour out to an energy-thirsty world, making stupendous profits for all involved.

Then things got sticky. Provincial royalties and environmental complaints could be fended off while the going was good. But as costs went higher and oil prices went lower, the oil sands started running out of gas, so to speak.

Suddenly projects were looking for money. And how do you find billions in the midst of a credit squeeze?

You get bigger, that’s how. And that’s what two of the biggest names in the business have done.

Last week Petro-Canada (TSX-PCA) and Suncor Energy (TSX-SU) announced a merger. The stock market spent the day celebrating and several big oil sands projects just got a whole lot more affordable.

But what does this merger mean for investors? For the answer, we turn to an advisory that has seen many such deals go down in Canada, The Investment Reporter.

In a nutshell, its answer is this. Hold Petro-Canada and buy Suncor. Here’s why.

Canada’s largest oil company

The merger is due to create Canada’s largest oil company by market value. The shares of both firms jumped on news of the merger. But that prompts different reactions from The Investment Reporter.

Petrocan’s price jump makes it a hold. But Suncor warrants a buy, says the advisory. “It’ll become more diversified, have higher cash flow and stronger finances.” Its name will also be above the door.

But you don’t exactly suffer if you’re a Petro-Canada shareholder. You get to exchange each share you own for 1.28 shares of the new company. When you do the math, that represents a healthy 25 per cent premium for the Petro-Canada shares.

There’s a second advantage, at least as far as Ontario Teachers Pension Plan is concerned. This fund holds a 3.3 per cent stake in Petrocan, and it has been pushing the CEO, Mr. Ron Brenneman, to step up his efforts. In the new firm, Mr. Rick George, president and CEO of Suncor, will be sitting at the head of the boardroom table.

Spruced-up balance sheets

Both companies will spruce up their balance sheets with this merger. Together, they expect to save over $300 million a year by trimming various overlapping operations. That’s good anytime, even better in today’s economic climate.

They also plan to focus their capital budgets on “high-return, near-term projects.” Says The Investment Reporter: “To the extent that the merger can wring out costs and improve returns, all shareholders should end up better off.”

So why is Petro-Canada a hold? Well, there are still regulatory hurdles to clear — with judges, regulators, the government and, lastly, two-thirds of the shareholders of both companies. If the deal stumbles anywhere, the shares of Petro-Canada would give up their gains.

Nor is a better bid for Petrocan likely to come along. Under the rules that turned it into a private company, no one can buy more than a fifth of its shares (that’s why this is a merger, not a takeover).

There’s no premium for Suncor shareholders, so there’s less to lose if the deal somehow fails. Plus the only way rivals can break up the deal is bid for Suncor, which would drive up the shares. But if the deal goes through, those rivals are out of luck, because the same one-fifth rule will almost certainly apply to the new company.

A bigger refiner and retailer

Suncor needs the merger more than Petro-Canada at the moment. More than 86 per cent of its production comes from the oil sands. “The trouble is that Suncor needs high oil prices to cover the high costs of oil sands production,’ says the advisory.

Nearly 53 per cent of Petro-Canada’s production comes from conventional sources. It is also a bigger refiner and retailer. In 2008, its sales of refined products averaged 52.4 thousand cubic metres a day, compared to 31.5 thousand cubic metres for Suncor.

Petrocan has 1,323 retail operations, Suncor just 427. (Petro-Canada will still be the name on the gas stations after the merger, by the way). And Suncor will get the benefit of Petrocan’s projects across Canada (off the east coast, for instance) and overseas.

The cash buffer

There’s more. Petro-Canada has a stronger balance sheet these days. Comparing the ratios of net debt to cash flow, the advisory sees Petrocan at a very comfortable 0.5, while Suncor sits at 1.6.

That doesn’t signal dangerous debt levels, “but with profits and cash flow falling this year, the bigger the cash buffer the better.”

And the new Suncor would see its production jump by more than 400,000 barrels of oil equivalent (boe) a day. That’ll bring in the cash.

It seems unlikely that this merger will fail (no, the BCE transaction wasn’t supposed to fail, either, but that highly-leveraged deal was a very different sort of animal).

A circular to shareholders will make the rounds this month. The Investment Reporter recommends that those shareholders support the merger, which is due to close in the third quarter of 2009.

And when oil prices rise again, as they surely will, Canada will have a new giant reeling in the profits. All of a sudden, the oil patch looks a good deal brighter for Canadian investors.