Deals

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

When two executives announce an agreement to merge their companies, investors have to be careful that the mutual backslapping doesn't drown out the actual reasoning for the deal. The same applies to the mutual backstabbing attendant on hostile bids.

Which brings us to Suncor Energy and its less-than-friendly offer for Canadian Oil Sands.

Suncor spent Tuesday morning reiterating that its reluctant quarry faces disaster if investors don't tender their shares. The offer came a day after businessman Seymour Schulich took out full-page press ads urging his fellow shareholders in Canadian Oil Sands to resist, saying Suncor was "trying to pull a fast one."

Such impolite talk in the usually harmonious oil town of Calgary reflects the descent into survival mode with oil trading at less than $40 a barrel. And it is that oil price on which the whole battle hinges, once you screen out the rhetoric coming from both sides -- and which provides Suncor the edge.

Having failed so far to tempt a white knight, Canadian Oil Sands' appeal to investors now rests largely on emphasizing its leverage to a recovery in oil. The company says that its stock has enjoyed near-perfect correlation with oil prices since January 2014. That makes sense given its main asset is a 36.7 percent stake in the Syncrude oil sands project.

Unfortunately, that close tie to oil enabled Suncor's bid in the first place. Both stocks hit their 2014 peak in June, just before the oil-price crash began. But while Suncor's stock fell by 28 percent between then and October 2015, Canadian Oil Sands' plunged by 75 percent.

Northern Exposure
Canadian Oil Sands' shares have collapsed much more in the face of low oil prices.
Source: Bloomberg
Note: Performance indexed to 100

Suncor's integrated business model, incorporating refining, as well as lower balance sheet leverage provided its stock significant insulation from falling oil prices.

Hence, even though Suncor had proposed privately last spring an exchange ratio of 0.32 of its own shares for every one of its target's, it eventually went public with an offer of just 0.25. This chart shows why.

Chasing Down the Target
Canadian Oil Sands' share price as a ratio of Suncor's has plummeted.
Source: Bloomberg

So Canadian Oil Sands is perfectly justified in saying that Suncor is pouncing when the stock is down. For example, under the terms proposed, Canadian Oil Sands' shareholders would end up owning about 8 percent of the combined company -- even though, using averages for 2012 through 2014, their company would have provided between 10 and 15 percent of pro-forma production, net income and free cash flow, based on data compiled by Bloomberg.

In practical terms, though, that argument only makes sense if you think oil prices are due to recover soon or Canadian Oil Sands can ride out an extended downturn.

Regarding oil prices, no one can predict them. Still, it was unfortunate for Canadian Oil Sands that, on the same day Schulich published his open letter, oil prices failed to hold onto a rally despite Saudi Arabia and Iran squaring off in their worst diplomatic crisis since the 1980s. Barring a big supply shock, the global oil glut looks set to continue through much of 2016.

No Fear Here
Crude oil futures haven't scared easy this week.
Source: Bloomberg

Canadian Oil Sands' finances are acutely sensitive to what happens with oil prices. Last month, it laid out its 2016 budget, projecting cash flow from operations of CAD633 million, assuming WTI crude oil averages $50 a barrel. That would leave free cash flow of CAD241 million after capital expenditure of CAD295 million and dividends of about CAD97 million at the current, recently reduced rate.

Cut the oil price assumption by $5, though, and free cash flow after dividends drops to  just CAD37 million, all else equal. Right now, WTI futures average about $40 for 2016. At that level, Canadian Oil Sands' operating cash flow almost certainly wouldn't cover both its capital spending budget and dividends.

And with net debt already standing at north of 3.7 times trailing Ebitda at the end of September, according to data compiled by Bloomberg, any further borrowing by Canadian Oil Sands would weigh heavily on its stock despite the lack of major debt maturities coming due before 2019.

Canadian Oil Sands' investors are thus in the unenviable position of knowing that they are being low-balled but running a risk of further pain if they don't sell.

The stock currently trades at a 9 percent discount to the implied offer price, but still is 31 percent above where it was just before Suncor went public with the terms. It isn't a given that Canadian Oil Sands' shares would lose all of that ground if the offer lapsed. Equally, though, there is no denying that oil futures have fallen further all along the curve since the bid was announced. And the lack of a white knight thus far doesn't suggest much faith that the bottom is in.

Dead Man's Curve
WTI oil futures have fallen even further since the bid was announced.
Source: Bloomberg

Canadian Oil Sands' shareholders can keep their faith in an eventual recovery by all means, but they should hedge it by swapping some of that exposure for Suncor's strengths.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in San Francisco at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net