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Who's got the biggest upside in the oil sands?

Hedgeye Research ran the numbers and came up with two names, one a long-time heavyweight in Canada's oil sands and one that's early in its life.

Hedgeye is a Connecticut-based research firm that lives on digging up tradeable ideas for subscribers. The firm, which is full of expat Canadians, has long been bullish on the oil sands in this country.

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The firm dug through the numbers and the expansion possibilities for Canadian Natural Resources , Canadian Oil Sands , Suncor Energy , Cenovus Energy , Nexen , and MEG Energy .

The verdict, from Hedgeye managing director of energy Lou Gagliardi? "Our favourites are Suncor on the large cap side and MEG as a growth play."

He said both come out on top when looking at the combination of deep resources, a deep discount to Hedgeye's valuation of the stocks, growth prospects, and strong balance sheets.

The key to the analysis is growth prospects. With growth come economies of scale, and that means that the companies can drive up margins even if oil prices are stagnant (though to be sure, Hedgeye is bullish on oil).

"We'll take higher prices if we can get it, but we want to be driving the profits," Mr. Gagliardi said.

From Suncor, he said "we expect earnings to easily beat consensus" in coming periods as the company ramps up expansion, and MEG is a good operator with big prospects.

"We don't want to look at companies that are in the harvest mode," Mr. Gagliardi said. "Their future is rather dim. We want companies in the early stage of development that can continue to drive costs down."

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The firm estimates that Suncor trades at a 25 per cent discount to its underlying value, while MEG is at a 16 per cent discount.

When Suncor is at such a discount, the stock's track record is good. Since the mid-1990s, 82 per cent of the time that Suncor trades at a discount, its shares have moved higher the following year.

Suncor is now at a forward price-earnings ratio of 15 times 2011 estimates. When the stock has been below 20 times in the last couple of decades, its shares have moved higher the following year 91 per cent of the time.

MEG doesn't have a track record like that, having only gone public last year. But it does have a project that Hedgeye likes, and that's the expansion of its Christina Lake oil sands extraction site.

Mr. Gagliardi estimates that the site, with fast ramp-up and relatively low capital spend, could post an internal rate of return of 25 per cent, generating more than $400-million a year of operating cash flow starting in 2014. That's at the top end of the return curve for oil sands expansion projects.

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