DBRS Confirms Canadian Oil Sands Limited at BBB with a Stable Trend

DBRS has today confirmed the Senior Unsecured Long-Term Debt rating of Canadian Oil Sands Limited (COS or the Company) at BBB with a Stable trend. The Company continues to maintain a solid operating profile, with well defined long-life reserves and relatively low maintenance capex over time. The key to improving the Company’s performance and financial profile is the ability to grow production to design productive levels over time (previously expected by year-end 2010 versus 85% achieved for the six months ended June 30, 2010 (6M 2010)), improving plant reliability and reducing operating costs and, to a lesser extent, managing environmental compliance requirements without incurring undue capital costs.

Given its 100% oil-weighted operation and unhedged volumes, the Company’s financial profile has been restored since Q4 2009, helped by strengthening crude oil prices and higher production volumes (+14%). The debt-to-cash flow ratio stood at 1.02 times in 6M 2010, following very low cash flow coverages for the first three quarters of 2009 in a recessionary environment, although debt-to-capital remained in the low 20% range throughout. Production costs were slightly reduced to $38.51/barrel (b) and are expected to remain at this level for the remainder of 2010 as a result of operational issues, which led to reduced production guidance in October 2010 (-8% on average from April 2010) to 105,500 b/d, gross before royalties (84% of design capacity). The Company’s parent, Canadian Oil Sands Trust (the Trust), plans to convert to a corporate structure on or about December 31, 2010, with all internal and external approvals received to date. The conversion should not affect COS’s operations. Post-conversion, COS intends to maintain the Trust’s approach to dividend payments similar to its distributions, which would vary depending primarily on crude oil prices and market conditions.

DBRS expects the Trust to maintain its current per unit distributions of $0.50 per quarter for the fourth quarter on the expectation that the current favourable commodity pricing environment and production volumes would prevail. This should preserve COS’s tax pools at approximately $2.0 billion by year-end, without incurring excessive debt. However, the current payout ratio (71% in 6M 2010) is high compared to its corporate peers. The Company intends to de-leverage, following corporate conversion, in anticipation of substantial growth capex associated with the mining trains and the upgrader de-bottleneck project (to unlock the value of 50,000 b/d of excess coking capacity, or 18,000 b/d net to the Company). The latter is scheduled to start up post-2016. Post-conversion, distributions in the form of dividends per share will likely decline from current levels.

Based on the October 28 2010 guidance of WTI of US$78/b and AECO natural gas of $4.50/mcf, COS expects operating cash flow of about $1.1 billion, which should largely cover capex of $511 million and distributions of about $850 million. Incremental debt of approximately $200 million is estimated, raising total debt to over $1.3 billion, which is within the Company’s target level of $1.6 billion, pre-conversion. Credit metrics should remain within the current rating category. Pro forma debt-to-capital is estimated at 25%, with debt-to-cash flow of about 1.10 times, should production in 2010 be slightly below the revised planned average of 105,500 b/d. The Company maintains sufficient liquidity through its $940 million of credit facilities ($865 million undrawn at September 30, 2010), with no maturities until 2013.

The upgrader de-bottleneck project mentioned above requires the unanimous consent of all joint-venture partners, including the Company. In addition, sustaining capex, currently estimated at about $15/b, including the Syncrude Emissions Reduction (SER) project, could escalate over the next few years, given spending on environmental and infrastructure projects. This would be partly mitigated by the completion of SER by 2011. Infrastructure projects include the replacement and relocation of four mining trains by 2014.

There are limiting factors that are considered manageable. The Company’s cash flow is highly sensitive to the price of oil, given its 100% oil-weighted operations with unhedged production. In addition, operations are based solely in Alberta, which adds to concentration risk. COS has high operating leverage as a large portion of its total operating costs are fixed, with remaining costs tied mainly to volatile natural gas prices (although lower prices have helped operating costs in 2010). There are potential operating challenges associated with running complex cokers as unplanned outages may occur, the risk of which is partially mitigated by the benefits of having three cokers (as opposed to one), as well as the experienced operations team under a ten-year services agreement with Imperial Oil Limited and ExxonMobil Corporation.

Notes:
All figures are in Canadian dollars unless otherwise noted.

The applicable methodology is Rating Oil and Gas Companies, which can be found on our website under Methodologies.

This rating is based on public information.