The province of Alberta in Western Canada is a forbidding place – a desolate landscape of peat bog and sparse boreal forest, where icy winds can gust the temperature to 40 degrees below freezing. Despite the fact that there are estimated to be 1.7 trillion barrels of oil beneath its surface, it wasn’t until 1964 that the oil industry plucked up the courage to drill in the province.
But now that global oil reserves are dwindling, the Alberta oil sands are being tagged as the great white hope of the oil industry. And while Alberta remains a challenging place to source oil, Canadian tar sands developers are sure to be a big part of the oil story over the next 20 years.
It’s not just the cold that makes Alberta such a daunting place for oil groups, though. Canadian oil is a nightmare to exploit – trapped in sand banked beneath the rock surface, the oil is part of a mucky soup of clay, tar and shale. Two tons of this mixture yields just one barrel of oil and it wasn’t until the late 1960s that oil groups had much success with the separation process. It took an age for Canadian oil giant Syncrude to come up with the right kind of heavy machinery as they struggled to drag the tar from beneath the surface in giant buckets.
Tapping the tar sands is nowhere near as painstaking today. But it does require a phenomenal amount of natural resources to get the job done. Tar sands developers rely on natural gas to power their massive extraction facilities, which is an increasingly expensive business. The process also puts serious pressure on local water resources as it takes about 1.4 barrels of water to produce a single barrel of oil – lots of steam is needed to bring the tar sand to the surface.
And while most of this water is recycled, developers are still consuming more than 10% of the local Athabasca River’s water flow. Just as bad, production of tar sands oil generates between two and four times the amount of greenhouse gases per barrel as conventional oil.
This partly explains the uneasy attitude of local officials, who last year imposed a 20% royalty hike on developers tapping the publicly-owned oil fields, a move that led many energy analysts aggressively to mark down tar sands stocks, such as Suncor and the Canadian Oil Sands Trust. That royalty decision was popular in Alberta, where locals felt that they were not getting their fair share of the province’s energy resources.
However, it was much less acceptable to Wall Street, where energy analysts reacted by dismissing the area as ‘Albertistan’, part of ‘Canazuela’. But however uneasy the relationship with local officials is, Alberta ultimately isn’t Russia – there has been no revocation of licences, and Albertans understand that the developers are in there for the long haul.
But the discounts on Canadian oil sands stocks are as much about Wall Street’s mounting concerns over cost overruns as they are about local bureaucracy. In the past ten years, the average cost of finding, developing and producing in Alberta has jumped from just $8 per barrel of oil equivalent per day to around $30. A serious shortage of labour and machinery has also contributed to a run-up in costs. Oil may be over $100 a barrel now, but with the input cost of natural gas escalating, tar sands groups are undoubtedly nervous about just how much their profit margins might be shaved if a recession hits oil prices.
Nonetheless, with global oil consumption still rising by one to two per cent a year, the industry has little choice but to search beneath Alberta. Canada currently produces about one million barrels of oil a day from the tar sands. Expect that to triple in the next two decades.
Suncor is already half way to its target
One of the pioneers in oil sands development, Suncor Energy’s (NYSE:SU) share price has recently taken a bit of a battering. Although the company reported a 13% jump in revenues last year, it made a big investment in extra infrastructure and the stock has fallen with the market since the start of this year.
Already one of the giants among the Canadian oil sands plays, Suncor is ploughing ahead with an aggressive $20.6bn oil sands expansion that will add 200,000 barrels a day of crude oil by 2012. The recent sell-off in shares was partly down to worries about the sheer scale of these ambitions, given the difficulty of stepping up production in the face of labour and machine shortages.
But as Blackmont Capital analyst Menno Hulshof points out, Suncor is already more than half way to achieving its target of 550,000 barrels per day of crude oil by 2012, and is ideally placed to tap the tar sands over the long term. In the short term, Suncor is selling its mix of oil products at around $74 per barrel, while cash costs run at less than $28 a barrel. All in all, the forward p/e of ten looks pretty modest.