The (Oil) Sands of Time

In the preceding article, we discussed why the concept of peak oil is so bullish for well-positioned oil exploration & production (E&P) companies. As world demand for energy rises, and oil remains the most economically viable source for decades to come, not only will the price of crude oil remain in a long-term bull market but every readily available oil reserve will be tapped and sold. It won’t happen steadily or in a straight line, but it will almost certainly happen.

That’s the basic reason why I’m bullish on companies with exposure to the 170 billion barrels of oil in Canada’s oil sands, the vast Alberta reserves that make Canada second only to Saudi Arabia in oil reserves, with 170 billion barrels. Unlike the Saudi reserves, which have been in production for more than five decades, much of the Alberta oil sands fields – which are about the size of Belgium – have yet to be touched. And of course, they sit in one of the most politically stable nations on Earth. When the world needs oil in the 21st century, Alberta will be one of the prime destinations.

As Fatih Birol, the chief economist of the International Energy Agency, said this week, the world will need “every drop” of the oil sands reserves in the coming decades.

What Are Oil Sands?

In short, oil sands contain a dense form of crude oil (called “bitumen”) mixed with sand. The bitumen is extracted through one of two methods.

If close to the surface, bitumen can sometimes be mined directly through a process like strip-mining, and then separated from the sand through an energy-intensive process. After it’s collected, bitumen is refined into a synthetic oil similar to light sweet crude oil – although it tends to sell for somewhat lower prices.

If the bitumen is far underground, it can be brought up to the surface through a process called “in situ” mining. This process is similar to conventional oil drilling except that it involves first injecting steam into the bitumen to heat it, allowing it to be pumped to the surface. This bitumen is then sold as a form of heavy crude oil.

One of the investment raps against oil sands companies used to be that the production costs are significantly higher than those for conventional oil drilling. However, several trends have made oil sands assets more economically attractive in recent years.

For one, global E&P companies have been forced to turn to harder-to-access and thus more expensive oil – such as deepwater and shale — as production has slowed in the “low-hanging fruit” oil fields that have already been drilled for decades.

Second, technological improvements and economies of scale have lowered the production costs in Alberta in general and for specific types of oil sands operations specifically — a trend likely to continue as production continues to rise in the region.

Third, low natural gas prices have been a boon to the oil sands industry because a significant amount of natural gas is used to produce the steam used in in situ mining as well as in the process by which bitumen is separated from sand and refined into synthetic oil.

The bottom line is that recent and projected crude oil prices more than cover the costs of oil sands production; the rule of thumb is that most oil-sands projects are worthwhile if crude oil is at $70/bbl or above. As crude oil prices rise in the coming years, oil sands production will become even more economically worthwhile – which is why production has doubled in each of the past two decades and is expected to double again between 2010 and 2020.

That rate of production increase is radically higher than the rate of production increases coming from other new drilling projects around the world, giving oil sands E&Ps a much better growth profile than major integrateds (most of whom do have oil-sands exposure) or other E&Ps. No wonder that investment is pouring into Alberta from major E&P companies and nations around the world, thirsty for new sources of oil. There will be no shortage of capital investments to keep building out the oil sands infrastructure.

Downside Risks

The oil sands sector has its critics, who point to not only the high capital and production costs involved with this unique form of oil production but to other problems that could pose downside risks to stocks with heavy exposure to oil sands. Let’s look at each of these in turn.

First, environmentalists call oil sands production among the dirtiest energy sources on Earth, in part because of the need to expend so much energy getting the bitumen out of the Earth and refining it on the spot – not to mention the need for enormous earth-moving equipment and trucks to deal with the two tons of sand needed to produce one barrel of bitumen.

While the environmental concerns are real, Canada and producers have made strides in improving the oil sands carbon footprint, having reduced the greenhouse-gas emissions associated with oil sands production by 29 percent over the past 20 years, with further improvements likely as producers institute carbon-capture technologies. The in situ manufacturing process is actually similar environmentally to conventional oil drilling. And although the oil sands get a lot of negative attention, note that at current production of 1.6 million barrels a day, Canada’s oil sands industry produces only 0.2 percent of global greenhouse gas emissions.

Another problem is transportation. Not enough pipelines currently exist to handle Alberta’s eventual output, and constructing new pipelines to US refineries tends to be politically controversial, as we saw in the Keystone Pipeline controversy. However, the economics are too strong for these hurdles to remain in the way forever. The US will benefit enormously from oil sands production, which reduces our dependence on Middle Eastern oil. Indeed, the Obama Administration is likely to approve the Keystone Pipeline this year.

Canada also is expected to approve the construction of pipelines to carry bitumen-derived products to its own coasts for export around the world, as well as for domestic use.

Unbelievably, many Canadians still use imported oil because there aren’t sufficient pipelines to distribute Albertan oil around the country. It’s likely that will change, easing the pipeline bottlenecks that some fear will develop.

Finally, some critics claim that enormous investment in Albertan oil sands production will prove disastrous if crude oil prices fall below $70 and remain low for years. But for many reasons, we consider that scenario extremely unlikely.

Oil Sands Beneficiaries

Many of the integrated oil giants as well as global E&Ps have exposure to Canadian oil sands, but we’ll focus here on topnotch companies with major high-quality stakes in the oil sands sector.

Our favorite is Growth Portfolio holding Suncor Energy (TSX, NYSE: SU), the oil-sands pioneer that was the first E&P to operate there in 1967 and is now one of Canada’s largest energy companies. Suncor is almost a pure play on oil, with minimal natural-gas operations, and it is one of the nearest pure plays on oil sands available among decent-sized companies. While it also has some offshore and international operations, including in the North Sea and Africa, about 75 percent of Suncor Energy’s total cash flows will come from oil sands by the end of this decade. The company plans to increase its oil sands production growth by 10 percent annualized over the next decade. We are confident it can meet these goals, thanks in part to cost-sharing agreements with well-financed partners like Total SA (NYSE: TOT). Suncor has low debt and pays a modest dividend yield that may rise in the coming years. Buy Suncor Energy below USD 37.

Truly a pure play on the oil sands, MEG Energy Corp. (TSX: MEG, OTC: MEGEF) is an in situ specialist with attractive assets in southern Alberta, stakes in pipeline and storage facilities, production costs lower than many conventional oil producers and a reliable source of capital from its major backer, China National Offshore Oil Corp., or CNOOC (NYSE: CEO) – which holds a minority stake in MEG. The company is still ramping up production – currently at only 24,000 barrels a day – and as a small, pure oil-sands play may be vulnerable to bad news such as an unexpected further delay in Keystone Pipeline approval. But more-aggressive investors looking for a pure oil sands play with a relatively clean environmental profile should consider this one. Buy MEG Energy below USD 38.

Pembina Pipeline Corp. (TSX: PPL, NYSE: PBA) is a longtime recommendation of Roger Conrad, editor of our sister publication Canadian Edge, and for good reason: one of the major Canadian midstream and marketing energy companies, Pembina generates revenue from fees derived from an impressive and diverse network of pipelines, gas gathering and processing facilities and other assets throughout North America. As a major provider of transportation to the gas sands region, Pembina is sure to benefit from rising production there in the coming years. The stock pays a generous dividend yielding 5.8 percent that is amply covered by net income. Buy Pembina Pipeline Corp. below USD 30.


Stock Talk

Myron Ettus

What to you think of the THAI process developed by Petrobank Energy & Resources for oil sands? It uses a combustion process to produce oil at a higher API. Tests are ongoing. It looks promising, but do you think it has a worthwhile future?

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