Sticky Profits and PerilsSticky Profits and Perils
By Roger Conrad
20 Jun 2006 at 04:26 PM EDT
MCLEAN, Va. (Canadian Edge) - More potential oil than under all of Saudi Arabia; America’s ticket to energy independence; a gold mine for all involved: That’s just a sample of the kind of breathless hype surrounding Canada’s tar sands region.
The bulls certainly do have a point. Unlike corn-based ethanol, shale, switch grass and the other fuels being peddled as the answer to our energy problems, there are companies making good money by producing oil from tar sands. For trust investors, the poster child is Canadian Oil Sands Trust [TSX:COS.UN; OTCPK:COSWF], the trading stock for the Syncrude partnership.
During the past five years, Canadian Oil Sands has risen more than fivefold, adjusted for stocks splits. In the first quarter alone, cash flow per share rose 50% and the trust lifted its payout by the same amount. In addition, Stage 3 of the partnership’s expansion project is well underway, promising even bigger gains when it’s completed.
On a macro level, production from the tar sands is the only area of Canada’s oil and gas industry that’s growing, as the country’s mature conventional oil and gas fields continue to decline. Alberta regulators are squarely behind its development to the point where they’ve been willing to penalize anyone interfering with oil sands’ development, including conventional oil and gas producers.
The oil sands, however, also have a dark side. Syncrude’s operating costs per barrel of oil equivalent (BOE) produced, for example, have more than doubled during the past couple years. That fact has been masked by the even greater rise in oil prices. But it’s a clear sign that there are few real economies of scale when it comes to turning tar into useable oil, other than the fact that small companies just can’t meet the financial commitment.
The soaring operating costs at Syncrude - which have been repeated among the other oil sands players - are also a sign that developers must be big enough to absorb substantial financial burdens. That would seem to rule out the penny oil sands companies now being furiously promoted.
Worse, operating expenses to date haven’t even begun to take into account the environmental costs of extracting oil this way. Syncrude, for example, was forced to suspend its $7.63 billion Stage 3 expansion in mid-May, due to an order by Alberta Environment - the province’s environmental watchdog - to curb odorous emissions.
The problem apparently concerns the operation of a flue gas desulphurizer (FGD) needed to meet clean air requirements, but which apparently emits a powerful smell similar to urine. And unfortunately, as of now, even Syncrude doesn’t know how to fix it, much less what it will cost as its investment languishes.
Then they are the well-chronicled problems of water usage, sludge creation and electricity supplies strain, all of which will only worsen as oil sands production increases. Water problems particularly could wind up restricting development in areas not already under development, even as they ramp up costs for established producers. That makes further enforcement action by Alberta Environment against oil sands companies increasingly likely, pushing costs higher still.
The biggest threat to oil sands producers in mid-2006 is the potential for oil prices to track the recent decline in natural gas prices, which are down some 60% this year. From all reports, oil inventories are more flush than those of gas. Even a modest decline in the political premium now built into oil prices will result in a steep decline in the margins from producing oil from tar.
That’s a possibility oil sands companies haven’t had to face in several years. The risk is why large companies like ConocoPhillips elected to form Syncrude with other giants, rather than take the huge financial risk of developing tar sands on their own. And it’s why any penny oil sands shares you buy are always at risk of a complete wipeout along the lines of the 1980s penny mining shares.
Of course, any severe decline in oil sands production brought on by falling oil prices will sow the seeds of its own reversal. Simply, the more oil that’s produced from tar sands, the more reliant the world becomes on this resource. Any interruption in output for whatever reason will tighten supplies and bring them back into balance with demand, thereby launching a recovery in prices and eventually profits from oil sands production.
As a result, the long-term players in this game are going to be around for a while. And they’re going to make plenty of money for themselves and their investors. It’s certainly not going to be a straight line upward, though. If there’s a reversal in oil prices, much of the profit made in the past few years is going to quickly vanish. And the more direct the play on actual production, the worse the hit.
The upshot: If you want to play the oil sands’ growth, you’ve got to play it smartly. That means being aggressive after prices have come off, rather than when they’re still high. It also means going off the beaten path, particularly to trusts that are linked to the sector’s growth rather than to price points for heavy oil. Below, I look at the oil sands today, with a special focus on the principal players in the trust universe.
Hit the Sands
Oil or tar sands are a mixture of sand, clay, water and bitumen. The latter is a thick, black, asphalt-like hydrocarbon and the principal element in extracting a usable fuel.
The majority of oil sands development is in three major regions of Alberta, with a focal point of Fort McMurray. The climate is inhospitable with little population, making it ideal for resource development.
The first developer of tar sands was a company called Great Canadian Oil Sands, which built a mine in the 1960s in the Fort McMurray area and subsequently changed its name to Suncor [NYSE:SU; TSX:SU]. It was joined by the Syncrude consortium - a joint venture between ConocoPhillips [NYSE:COP], Imperial Oil [AMEX:IMO; TSX:IMO], Murphy Oil [NYSE:MUR], PetroCanada [NYSE:PCZ; TSX:PCA], Nexen [NYSE:NXY; TSX:NXY] and Mocal Energy - which built a facility in the area during the 1970s.
Those facilities have been continually upgraded and have remained cornerstones of tar sands production. They’ve since been joined by new projects from both companies, as well as from a host of other producers - e.g., China, North America and Europe.
Without getting too technical, there are two basic approaches to oil sands development. Mining has been employed in the Athabasca deposits north of Fort McMurray. It exposes and removes the sands by truck and shovel mining methods and then separates the bitumen by adding warm water.
The "in situ" approach removes the bitumen while the sands are still underground. The most common method is to heat up the sand, making the bitumen more fluid and easier to pump to the surface. Some projects use steam pumped in by drilling vertical wells. Others drill horizontal wells and use gravity and steam to get the bitumen out of the ground.
There are also developing technologies involving vaporizing the bitumen, using solvents to supplement or replace the steam. And cold production is employed in reservoirs where oil sands will flow to the surface without being heated up first.
Once the bitumen is removed - either through mining or in situ - it can be used directly to make asphalt. It can also be diluted for transportation by pipeline to refineries for processing into synthetic crude. Further processing can turn the crude into gasoline, aviation fuel and other petroleum products.
The ongoing development of oil sands extraction methods is frequently cited by stock promoters as a reason why even the least-likely penny stock can become a major producer and valuable. What’s nearly always left out of the pitch is that, no matter what method you choose, it’s far more expensive than simply producing oil and gas from conventional wells.
For example, even if in situ bitumen extraction could be accomplished for the same cost as drilling a conventional well - not possible at present - you’d still have the cost of diluting the bitumen for transport and then refining it into a useful product, i.e., fuel. And all those processes require huge amounts of energy - principally electricity - to complete.
In short, no matter what extraction method is used and no matter how far producers get costs down, fuel refined from tar sands is never going to be competitive with conventional oil and gas on a straight-up basis. Instead, the only way producers are going to make money is when conventional oil and gas is expensive enough to keep their margins wide enough to be profitable.
Another complication involves the relationship between the market price of heavy oil - like the synthetic produced from tar sands - and conventional oil. Check out the graph, which plots the price of West Texas Intermediate Crude Oil, a commonly quoted measure for light sweet or more easily refined oil, and West Texas Sour Crude, which is more difficult to refine.
Historically, light sweet crude has traded at a premium to sour crude because of the higher refining costs associated with the latter. In addition, it takes a specially equipped refinery to process heavier oils, i.e., those with greater sulphur content. Since not every refinery is so equipped, there are fewer potential buyers for heavy oil as opposed to light oil.
In recent months, however, the gap between the two grades of oil has widened considerably. That’s likely at least in part due to the greater volumes of heavier oil coming on the market, as sources like tar sands become more important and conventional supplies continue to wane.
The gap could become particularly wide if the price of light oil should happen to fall sharply as many predict. That’s because a lower price of conventional, cheaper-to-process oil would induce refiners and other big buyers to load up at the expense of demand for heavier oils.
That’s another reason why even a relatively minor drop in the widely quoted oil price - a mere pullback in the most bullish energy market since the 1970s - could have a devastating impact on margins for tar sands producers. And it’s why it’s absolutely critical to stick to established players that can weather the potential reversals, particularly at a time when the hype factor is off the chart and share prices are high, even for out and out junk.
The recent declines and dividend cuts of producer trusts weighted toward natural gas production show what can happen if a volatile commodity declines after a massive run-up. All four of the trusts in the graph below - PrimeWest [TSX:PWI.UN; NYSE: PWI], Thunder Energy [TSX:THY.UN; OTCPK:THYFF], Trilogy Energy [TSX:TET.UN; OTCPK:TETFF] and Shiningbank Energy [TSX:SHN.UN; OTCPK:SBKEF] - were all flying high just a few months ago, boosting distributions from abundant cash flow.
Since then, all four have been laid low by dividend cuts in the face of crashing natural gas prices. And that’s despite the fact that they continue to pay competitive dividends.
The Players
The Canadian Association of Petroleum Producers and the Regional Issues Working Group estimate from survey results that the Alberta oil sands industry plans to spend $63.5 billion on new projects through 2010, with an additional $15-$16 billion during the five years following. That’s a considerable leap from the $33.8 billion spent from 1996 through 2004, which is obviously being driven by the huge increase in conventional oil prices.
Obviously, not all these projects will ultimately come to fruition, particularly if conventional oil prices make a meaningful pullback. Other now-contemplated projects may be derailed if the developers’ financial situation diminishes, while still others could be quashed by rising environmental concerns about everything from odors to water pollution.
It’s also a virtual certainty - particularly given the experience of the Syncrude build-out - that development costs will be more than anticipated and very likely far more. That may cause certain projects to be canceled, and again it restricts the field of potentially successful producers to a handful of well-heeled giants.
Finally, there’s always the risk that the Alberta provincial government will become overly addicted to the huge royalties it’s currently raking in. The province’s Finance Ministry, for example, originally budgeted for a C$400 million total royalty based on conventional oil prices of $30. That figure has since been revised to C$700 million.
As history shows, what a government takes in, it usually finds a way to spend. In countries like Saudi Arabia or Nigeria - where the oil-owning elites generally aren’t accountable to the public - that money has a tendency to vanish. But even in countries like Canada, the temptation to spend heavily in good times may be too much to resist. And when times get tough and royalties dip, it will be tempting to try to hit up the developers for a higher percentage.
All these risks notwithstanding, there’s likely to be a big pot of money to go around for those who successfully find a way to tap into it. Obviously, Suncor and the Syncrude venture are the furthest ahead, ranking one and two in output. Suncor had five major projects planned in the Wood Buffalo region by the end of 2005, ranging from mining to in situ, while Syncrude had four all using the mining method. Both are set to be long-term players, and they continue to pursue aggressive growth.
Other major players include the Athabasca Oil Sands Project, a joint venture between units of Royal Dutch Shell [NYSE:RDS-B] and Chevron [NYSE:CVX] with potential for production of 500,000 to 600,000 barrels per day by 2014 to 2015. It has four major projects ongoing in the Wood Buffalo region, all mine- and extraction-based, and a major upgrader development outside the three key regions of Wood Buffalo, Cold Lake and Peace River. The latter is now producing - it’s one of the Wood Buffalo projects.
Of giants now trying to go it alone, PetroCanada has four major in situ and one mining project in Wood Buffalo. Encana [NYSE:ECA; TSX:ECA] has three in situ projects in the Cold Lake Region and another in situ in Pelican Lake, two of which are operating. Imperial Oil has three in situ projects in Cold Lake, one of which is running and the other two in development.
Canadian Natural Resources has two operating in situ - including a cold in situ - projects in the Cold Lake region, as well as one in development for start-up in 2009. It also has four mining projects and an in situ project under development, with regulatory approvals in place for three of the mining projects.
Finally, Total’s [NYSE:TOT] Deer Creek unit has two operating in situ projects and another seeking regulatory approval in the Wood Buffalo region. It also has two mining projects in the region in planning stages. Syncrude partners ConocoPhillips and Nexen have individual projects in planning stages.
Blackrock Ventures [TSX:BVI] has one producing cold in situ project in the Peace River region and two under development in the Cold Lake region. Japan Canada Oil Sands has an in situ project producing in the Wood Buffalo region. And Synenco Energy [TSX:SYN] - China’s entry in the region - has its Northern Lights Project, which plans three mine and extraction facilities.
Copyright © KCI Communications, Inc. 2006
Roger Conrad is Editor of “Canadian Edge.” Come join me today!