DBRS Confirms Canadian Oil Sands at BBB, Trend Now Positive; Confirms Stability Rating at STA-4 (high)

DBRS has today confirmed the Senior Unsecured Long-Term Debt rating of Canadian Oil Sands Limited (COS or the Trust) at BBB and has changed the trend to Positive from Stable. Concurrently, DBRS has also confirmed the stability rating of Canadian Oil Sands Trust at STA-4 (high).

The confirmation and trend change for the debt rating reflect the Trust’s improved operating and financial profile two years after the completion of the Stage 3 Expansion (Stage 3) and DBRS’s belief that the start-up challenges of Stage 3 are behind the Trust. A potential debt rating upgrade is contingent on continued progress towards reaching Stage 3 design capacity (production before royalties of 129,000 barrels of oil (b/d) net to COS or 30% higher than 98,500 b/d in H1 2008) over time, as well as no material deterioration in credit metrics from current levels.

The stability rating is concurrently confirmed based on positive developments mentioned above. As a result, the Trust has substantially higher cash flow to pay distributions. However, future distribution levels could be impacted by the Trust’s exposure to volatile crude oil prices due to its lack of diversification as a pure play Canadian oil sands producer. Further, there are no hedging arrangements in place. Potential increased variability associated with the considerably higher per unit payout is expected, compared to prior periods, as publicly stated by the Trust. The Trust intends to supplement operating cash flow with incremental debt of up to $600 million by 2010, if required, to sustain the current payout. Any moderate reduction in per unit distributions consistent with crude price movements should not have rating implications in the context of maintaining an acceptable financial profile within the parameters of the current stability rating.

Although the Trust has historically been significantly more conservative in its distribution policy than its peers, distributions have ramped up in the first half of 2008 (quarterly distribution has more than quadrupled from $0.30 in Q1 2007 to $1.25 per unit in August 2008) due to substantially lower capex requirements post completion of Stage 3 in 2006, as well as the Trust’s plan to distribute a higher proportion of cash flow (85% of operating cash flow in H1 2008 versus 51% in 2007) in order to preserve tax pools. Existing tax pools of approximately $2 billion are expected to shelter cash taxes for an estimated one or two years beyond 2011. In addition, the Trust has increased its net debt target to $1.6 billion by 2010 from $1.2 billion to expedite fuller payout of free cash flow. COS would have to issue an incremental $600 million of debt to reach this target.

The Trust’s increased payout ratio has somewhat reduced financial flexibility, though mitigated by its low medium-term capex requirements and low balance sheet leverage currently. Strong commodity prices and near-term production growth by achieving the Stage 3 design capacity (+23% from current levels) should improve cash flow to support the targeted incremental net debt. The pro forma effect of the new debt would be to increase debt-to-capital to 29% (from 21%) and debt-to-cash flow to 0.85 times (from 0.55 times), both of which are still moderate for the rating, although based on strong crude oil prices.

DBRS expects COS to continue towards a fuller payout of free cash flow before 2011 when the proposed trust taxation commences, while keeping credit metrics at relatively strong levels. Further, while the Trust has indicated that it may convert to a corporate structure post-2010, final implementation and information details concerning capitalization and payout ratios are not yet available and will be reviewed as additional details surface. In the near term, DBRS believes that this should not impact the Trust’s credit rating.

The positive attributes of the Trust include the following: (1) The Trust’s 36.74% share in Syncrude Canada’s (Syncrude) long life reserves (28 years based on proven reserves) are well defined with no exploration risk, compared to conventional royalty trusts or E&P companies, with depleting reserves and much shorter reserve lives. (2) The Trust’s financial profile has improved, achieving the best credit metrics since 2003 (debt-to-cash flow of 0.55 times for the 12 months ended June 30, 2008 and debt-to-capital of 21%, compared with 5.27 times and 41%, respectively, in 2003) as a result of strong commodity prices coupled with substantially higher production volumes (up 37% from 2003 to 2007) and low maintenance capex. However, leverage will likely creep up due to the aforementioned increase in debt to reach the Trust’s $1.6 billion net debt target by 2010, although pro forma credit metrics are still consistent with the current rating. (3) About 40% additional production capacity (approximately 37,000 b/d net to the Trust for total gross productive capacity of 129,000 b/d, or 350,000 b/d for Syncrude) associated with the completion of Stage 3 enhances cash flow, offering good growth prospects. Medium- to long-term prospects include de-bottlenecking for incremental production volumes of 30,000 to 50,000 b/d (up to 18,400 b/d net to COS, or 14% of current design capacity) with sanctioning expected by 2010, and Stage 4 developments post 2015. All major expansions, such as these, will require unanimous consent of all seven joint venture participants with COS being the largest partner. (4) Strong sponsors/partners in Syncrude, including executives seconded from Imperial Oil/ExxonMobil under a ten-year management services agreement expiring in 2017, provide project management experience and operational expertise. In addition, the Trust retains sufficient liquidity as a result of an $800 million credit facility to 2012 that currently has minimal usage.

The Trust faces the following challenges: (1) With 100% of production weighted towards oil (albeit high quality, light sweet crude), cash flow is highly sensitive to the price of oil. There are no hedges planned for 2008 and beyond, although the high capital spending years are now over with the completion of Stage 3. In addition, operations are concentrated in one area in Alberta, which adds to operational risk. (2) COS has high operating leverage, as a large portion of total operating costs are fixed, with the remaining costs tied mainly to volatile natural gas prices (20% of operating costs in 2007). (3) There are potential operating challenges associated with running complex cokers as unplanned outages may occur, partially mitigated by the benefits of having three cokers (as opposed to one). Teething problems associated with integration of the third coker have largely been addressed, as it has been operating for two years. In addition, these challenges are partly mitigated by the experienced operations team helped by the strong partners in Syncrude. (4) There is continued uncertainty about the details of the planned tax legislation affecting income trusts, although COS has indicated that it would likely convert to a corporate structure in 2011.

Notes:
All figures are in Canadian dollars unless otherwise noted.
This rating is based on public information.