How Can Suncor Energy Continue to Improve Its Balance Sheet?

By Markets Fool.com

IMAGE SOURCE: SUNCOR ENERGY.

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By any number of measures, Suncor Energy (NYSE: SU) has maintained a rock solid balance sheet over the past year in the face of persistently low oil prices. Even when the Canadian wildfires shut down a majority of its oil sands production and knocked its second quarter earnings into the red, the company managed to improve its debt-to-capitalization ratio. At first glance, this seems to be unsustainable since an oil company can only fight off the adverse impacts of low prices for so long. Here's what to look for in the second half of 2016 to determine if the trendwill continue.

Cash flows

Suncor has not generated necessary cash flows from operations for the past three quarters in order to cover its capital expenditures (capex). To cover the gap in funding, the company has had toutilize cash on hand or take on more debt. The main culprit of this gap is the subpar performance of Suncor's oil sands operations. While refining cash flows have remained robust at C$885 million in the second quarter, oil sands operations posted negative cash flows of C$202 million.

In the second half of 2016, Suncor needs to showthat it can continue to find ways to improve its cash flow generation. The alternative is to significantly cut back on capex. Suncor has maintained a capital budget of about C$6.5 billion since 2012. In 2016, the company has managed to significantly reduce its sustaining capex, but development capital for its Fort Hills and Hebron ventures has replaced the reductions. Those development expenditures, though, will drop by half in 2017.

Unless oil prices increase, don't expect cash flowsto recover in 2016. In 2017, though, if oil prices do recover and Suncor's capex drops as expected, the company could return to positive cash flow generation.

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Making transactions

Despite its recent cash flow troubles, Suncor has managed to maintain a stellar balance sheet because it has managed to keep its debt at reasonable levels. In addition to making a stock issuance worth C$2.8 billion in the second quarter, it also repurchased C$1.5 billion worth of long-term notes.

Diluting its shares to the tune of C$2.8 billion initially raised some eyebrows . But Suncor utilized the cash to fund its second quarter purchase of a 5% share in the Syncrude oil consortium that gave it a majority working interest in the venture. It was also able to pay off long-term debt and retain additional flexibility for future investments. Through the issuance, Suncor managed to strengthen its balance sheet while adding assets that can boost future production.

In its latest earnings report, Suncor does not disclose its intentions to make further stock issuances or note purchases. However, it has stated that it is looking to divest of up to C$1.5 billion of noncore assets. Don't be surprised if the company utilizes any of the three options during the second half to further drive down its debt-to-capitalization ratio closer to the mid-point of its 20% to 30% target range.

Costs of production

Additionally, Suncor has been striving to lower overall production costs, which helps to boost cash flows and bolster its balance sheet. It has been quite successful in its attempts, dropping its oil sands cash operating costs by nearly 35% since 2013. Unfortunately, the second quarter was a hard lesson in how fickle these numbers can be.

Because of the Canadian wildfires, Suncor had to shut down a majority of its oil sands production for nearly two months. This caused overall production to drop from 560,000 barrels of oil equivalent per day (BOE/D) to 330,000 BOE/D. In direct correlation, cash operating costs spiked over 50%, higher than even its 2013 costs.

Suncor expects these costs to settle back into its four-year trajectory, with annualized costs under C$30 per barrel. Save another catastrophic event such as a large wildfire, there's no reason to believe these expectations aren't realistic for the remainder of 2016 and beyond.

Foolish bottom line

Suncor has felt the pain of both low oil prices and freak natural disasters. Regardless, its debt-to-capitalization remains within its target rangeand it has considerable flexibility with its cash and credit lines. Suncor has achieved this by lowering production costs and finding ways to pay off debt, such as share issuances. Don't expect oil sands cash flows to dramatically increase in the second half, but operational costs should remain low and the company could make further transactions to work off debt and build cash.

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David Lettis has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.