Promising expansion

To say the oil industry has benefited from high oil prices is pretty obvious. However, there are other factors that are impeding many of the sectors constituents' ability to take full advantage of buoyant market conditions. In particular, industry wide inflation means costs are also on the rise whilst production growth is an on going battle. In 2007, Suncor Energy (NYSE:SU) was on the receiving end of both of these.

"...an expansion project (is) set to increase capacity to 350,000 bpd. ...when complete (it) will result in a 35 percent increase in production capacity."

As a quick reminder, Suncor is a pioneer in the oil sands industry. With extensive operations in Canada, the company is a major producer from the country's vast oil sands deposits. In addition, the company also produces natural gas, operates refineries, generates nearly 150 megawatts of wind energy and operates one of Canada's largest ethanol plants.

Now returning to 2007, full year results released this week show average oil sands production fell nearly 25,000 barrels per day (bpd) to 235,600 bpd. On the other hand, natural gas output grew a modest 3 percent to 215 million cubic feet equivalent (mmcfe) per day. Overall, combined production was 271,400 barrels of oil equivalent per day (boepd) a fall of around 8 percent.

Meanwhile costs were also substantially higher at C$27.80 per barrel, up from C$21.70, due primarily to fixed costs being spread over lower production and higher maintenance charges.

Although higher oil prices helped to offset some of the impact of lower production and increased costs, adjusted net earnings for the year were C$2.24 billion, down from C$2.35 billion. Clearly not the type of performance you would expect from an oil company in a year when prices were so robust.

A look behind the falling production figures however gives us reason for optimism. Downtime at Suncor's oil sands operations, which contributed to both lower production and higher maintenance costs, was related to an expansion project set to increase capacity to 350,000 bpd. This project is now 95 percent complete and will result in a 35 percent increase in production capacity.

In addition, another capacity enhancing project at the group's Sarnia refinery was another large contributor to the cost line. Work to bring the refinery up to full production is continuing after some operational difficulties were encountered following the planned shutdown. We anticipate these problems being resolved in the near future.

So although production and costs were problematic last year, in 2008, oil sands production is now set to increase to between 275,000 and 300,000 bpd due to the work undertaken in 2007. We believe fourth quarter production of over 252,000 bpd is a good indicator that this target is achievable as addition capacity is brought on line. Longer term plans are already in the works to expand capacity beyond 500,000 barrels per day by 2012.

As for this year, cash costs are set to fall as low as C$25 per barrel. While not wildly less than this year, the improvement is taking place within an environment where cost increases are a constant threat.

Meanwhile, natural gas production will be steady in 2008 at around 210 mmcfe. Given these operational enhancements and our bullish view on oil prices, we concur with CEO Rick George when he says, "we plan on establishing new milestones for our company in 2008 and anticipate a record setting year for production." We share that optimism.

Although operations last year were down on 2006, cash flow from operations was still a healthy C$3.8 billion. Just as well because capital spending on projects such as those mentioned above increased C$1.9 billion to C$5.4 billion.

Net debt also rose from the prior year, however gearing still remains manageable at 33 percent and net earnings comfortably cover interest on long term debt 17.7 times. As such we believe that Suncor's financial foundations are solid.

From a charting perspective, despite a recent correction we believe the longer-term outlook remains positive. The share price has recently corrected to touch a low of $79.34, which as evident on the daily chart follows a new record high for the stock of $117.89 in November.

With many technical indicators currently in oversold territory, there is a high probability of a rebound in the share price in the near term. Encouragingly, this would see prices move back above support in the range between $85 and $82.37.

We cannot deny that the recent correction in the share price has been significant. However, considering the broader market volatility we believe the recent reaction by investors is not purely stock specific. In addition, considering the resilience of the longer-term trend, we believe that upward momentum will return in the months ahead.

Helping to get things started will be the production uplift we anticipate from last year's investment. Add in the robust energy markets we expect throughout the year and we believe the group's prospective price to earnings multiple of around 13 times is undemanding.

Accordingly, SU will remain firmly held in the Fat Prophets Portfolio.