Personal Finance

CANADAS OIL SANDS BoNANZA

BY ELLIOTT H. GUE AND THE EDITORS OF PERSONAL FINANCE
he two biggest players in Canadas oil sands are Suncor Energy (TSX: SU, NYSE: SU) and Syncrude, a partnership of major oil companies operated by the Canadian unit of ExxonMobil (NYSE: XOM). And both have very big plans. Suncor, which merged last year with the former PetroCanada to become Canadas largest energy player, continues to sell the vast majority of its holdings outside the oil sands. In contrast, it continues to ramp up its oil sands projects. In March 2010 the company won approval from Alberta regulators for a threepart expansion of its Firebag project, which will triple current production of 60,000 barrels of oil equivalent per day (boe/d) by early 2011. The company plans a further expansion to a total of more than 240,000 boe/d by 2012. Syncrudes key players include ExxonMobil (25 percent), Suncor (12 percent) Chinese giant Sinopec (NYSE: SNP, 9 percent) and Canadian Oil Sands (TSX: COS, OTC: COSWF). The venture produced slightly over 300,000 boe/d in June 2010, a tally it expects to more than double over the next ten years as it completes a series of projects slated for 2014, 2016 and 2020. The ventures lands have a projected 100-year life of proven plus probable reserves based on current production rates and an estimated resource of 6.8 billion barrels.

Saudi-Sized Opportunity
This isnt the first rush to oil sands development in Canadas history. Surging oil prices and the desire to find alternatives to politically challenged imports from the Middle East fueled a drilling boom and exploration boom in the late 1970s early 80s. This one, however, figures to have considerably longer legs, in large part due to a dearth of alternatives to feed the worlds ever-increasing appetite for oil. Alberta owns 85 percent of the worlds reserves of bitumenwhich is refined into useable petroleum products in three major areas. Provincial authorities put total economic reservesreserves that can be produced profitably at current energy pricesat some 170.4 billion barrels, with a potential total of 1.75 trillion barrels. And those figures continue to ratchet up as more major

companies get in on the action. Altogether, Canadas tar sands are the largest proven oil reserves outside of Saudi Arabia. Tar sands are already 65 percent of overall Alberta oil output and are expected to hit 88 percent by the end of the decade. Developing in Canada has one other key advantage: the most favorable regulation in the world, both environmental and regarding foreign investment in projects. At a time when countries like Nigeria, Venezuela and the Congo are shaking down resource developers for a greater share of profits, Canada is making things easy for foreign capital to get a piece of its action. Major US companies have long been major investors and are likely to remain the biggest players for the foreseeable future. ExxonMobil, for example, has reached an arrangement with Canadian Oil Sands to develop the companys considerable prospects outside Syncrude. But Canada has also opened up its door to other nations, particularly China, which is a player in other resources such as metallurgical coal and uranium as well. Chinese money to date has generally been in the form of minority investment in projects. But that countrys escalating demand for natural resources means itll continue putting in the money to speed development. Its easy to see the motivation of the Ottawa and Alberta governments for encouraging oil sands production. At a time when many federal and local government entities around the world are nearly bust, the province continues to slash its already light debt load. The national government, meanwhile, expects to be running a budget surplus within the next two to three years. The key is the steady stream of oil royalty revenue thats made possible by rising oil sands production, even as Canadas conventional oil output continues to decline. Thats allowed governments to enact policies that encourage growth in other sectors as well, such as cutting corporate tax rates to the lowest levels of any industrialized nation. And the result is a major spur to the Canadian economy, particularly in energy-rich Alberta. Projects are routinely approved in a timely fashion and

companies enjoy numerous tax incentives. In fact, oil and gas companies operating in Alberta now enjoy even more favorable incentives and regulations than they did prior to the 2007 enactment of the Our Fair Share proposals, temporary boosts in royalty rates to capture more revenue for government that have now been completely rolled back and then some. That government support is critical for two reasons. First, producing from oil sands is expensive. Part of the reason is geography. The three main producing regions of Alberta are extremely remote areas and therefore require major investment in transportation and other infrastructure to get the energy to market. Workers must be trained, paid and housed in places that didnt exist in their current form a decade ago. Second, no matter what process is used, getting useable oil from tar sands is basically a mining and chemical refining operation. The bitumen must be separated from other elements and then processed intensively even before it can be shipped to refineries as a variant of heavy oil. The result is a process that requires huge amounts of energy, particularly natural gas. In fact, energy typically accounts for 30 percentplus of overall production costs in the tar sands. Finally, there are environmental costs. In the early years of the boom, producers took their liberties with the environment, particularly when it came to disposing of tailings or waste. The consequences have now come home to roost in the courts. In late June 2010 a provincial court in Alberta ruled in favor of the government and against Syncrude in a case involving so-called settling basins, where water used in oil sands processing is stored and recycled. The judge ruled owners of settling basins must take into account their impact on migrating birds. The case dates back to 2008, and the company has made changes to its practices since. As a result, the ruling isnt expected to have a major financial impact on Syncrude. But it does illustrate the environmental concerns that continue to drive opposition to further oil sands development, including in the US which remains their biggest consumer. US Rep. Harry Waxman (D-CA) registered strong opposition to a planned USD12 billion pipeline that would bring oil from tar sands to US refineries. The Keystone XL pipeline would be a major boon to the economy of several states, particularly Montana. Its projected to double US ability to consume oil from Canadas tar sands. Coupled with two other already approved projects, it could take tar sands to 15 percent of US fuel supply, up from just 4 percent now. The Chairman of the House Committee on Energy and Commerce, however, asserts the pipeline would be a step in the wrong direction by continuing dependence on fossil

fuels. Much of that opposition is due to allegations that oil sands production creates elevated levels of carbon dioxide blamed for global warming, an argument that also resonates heavily in Europe. The Waxman letter, for example, assets tar sands mining emits three times more greenhouse gas pollution than traditional oil. And some have gone so far as to propose that the US governmentparticularly the US Dept of Defenseno longer use petroleum products that are refined from tar sands. In this emotionally and politically charged atmosphere, Alberta and the Canadian national government in Ottawa have had to walk a fine line. As the big investments being made by China show, theres no shortage of markets for the output of the oil sands globally, no matter what the US government does. But being seen as overly permissive in environmental regulation could invite actions that make sales much more expensive and therefore less profitable. Conversely, clamping down hard on what have to date been acceptable industry practices could destroy the economics of oil sands and the boom. The good news is both entities are showing themselves increasingly adept on this score, even as technology advances that promises to eventually make todays concerns moot. Alberta regulators, for example, last month approved plans by Suncor to clean up its tailings ponds over the next several years. The company will spend some CAD1 billion to develop new technology to do the job. Regulators estimate tailings ponds now contain some 840 million cubic meters of fluid and cover a bit over 100 square miles of northern Alberta. That follows approval in April of a plan by Syncrude to clean up its tailings and another at Fort Hills. Regulators are reviewing similar plans at the Albian Sands mine operated by Royal Dutch Shell (NYSE: RDS/A) and the Horizon project run by Canadian Natural Resources (TSX: CNQ, NYSE: CNQ). As for global warming concerns, governments are subsidizing development of new technologies to reduce emissions, just as electric power producers are. Meanwhile, industry has already cut emissions per barrel of oil equivalent by an estimated 35 percent since 1990. None of this is satisfying industry critics, many of whom remain adamant that the mining process is too destructive and companies are doing too little to fix the problems. 50 members of the US Congress, for example, have joined Waxmans plea urging the US State Department not to rubber stamp the Keystone XL pipeline. But its clear government and industry are on the same page that development can occur and meet environmental safeguards. And even in the European Union, officials have abandoned at least for now plans to bar output of oil sands from the Continent.

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The Cost Question

Rising environmental standards, energy costs, geographic isolation and resource needs, however, do add up to one unavoidable fact: Producing from oil sands is far more expensive than producing conventional oil. The cost of production per barrel of oil equivalent has nearly doubled over the past four years. Thats partly due to surging energy costs. But overall operating expenses have continued to climb even with natural gas prices sinking below USD5 per million British thermal units. One reason is labor costs, which have surged 50 percent since 2002 according to industry sources and are likely to rise a lot more as production expands and further strains the pool of qualified employees. Companies and provincial authorities are working together to promote industry training. But the impact of those efforts will only be felt slowly and in the meantime wages are going to rise. The low cost of debt and equity capital has been a major plus for the industry over the past couple years. Capital costs for developing projects, however, have also continued to soar, nearly tripling over the past decade. Statoil (NYSE: STO) estimates break-even oil prices for new oil sands projects using steam-assisted gravity drainage technology are now as high as USD65 to USD75 a barrel. And whether bitumen is extracted by drilling or mining, the cost for developing new supply is at least USD60. That makes oil sands development essentially a bet on oil prices. Were black gold to slip back to where it was a decade ago in the USD20 to USD30 range, the vast majority of existing projects now in operation would be uneconomic. Plunging oil prices did literally shut down the oil sands rush of the 1970s and 80s. And fear of a reprise was a major reason why oil sands development screeched to a halt during the credit crunch/recession of 2008-09. On the other hand, higher production costs mean considerably more leveraged profits. And with the pool of available projects for major oil development shrinking dramatically in politically stable lands, companies are willing to pony up the money to put the wheels in motion for much higher output in coming years. Those kinds of long-term bets are a luxury only exceptionally large companies with huge pools of capital can afford. Even the likes of ExxonMobil, for example, only entered the oil sands development through a consortium that included other giants, so it could minimize the risk of losses from rising costs and/or falling oil prices. Small players in contrast are constantly at risk to ruin should oil prices fall off a cliff. Thats even in the unlikely event theyre able to scrape up the capital to build the kind of mining and chemical operation needed. This is the hard lesson learned by investors who fell for pitches from small companies that claimed to be sitting on vast oil sands reserves during the 2008 oil price spike. The plain fact is without a whole lot of capital, even the most promising tar sands deposits are going to stay right where they are. Reserves are important. But the real value is in the facilities needed to get them to market in usable form.

That leaves just a handful of oil sands producers that are truly worth investing in.

SUNCOR ENeRGY (TSX: SU, NYSE: SU)

By the end of this decade, Suncor Energy (TSX: SU, NYSE: SU) expects its Canadian oil sands division to account for three-quarters of the firms total cash flows. The remaining third will come from its offshore and international operations. Management has set forth an aggressive plan for production growth, targeting 1 million barrels per day in annual output by the end of the decade. This goal implies annualized production growth of 8 percent over the next decade. Most of the growth will come from its oil sands operations, which management expects to grow its output at a 10 percent annualized rate. Another major advantage for Suncor is that more than 90 percent of its total production is oil, not natural gas or NGLs. Over the past year, the firm has disposed over more than $3.5 billion worth of noncore assets, including a number of gas-producing properties. In the current environment of high international oil prices and weak US gas prices, Suncors oil-heavy portfolio is a winning bet. Management recently finalized an agreement on a strategic joint venture with France-based integrated oil giant Total (NYSE: TOT). Under the terms of the deal, Suncor swapped a 19.2 percent stake in its Fort Hills oil sands production project for a 36.75 percent stake in Totals Joslyn project in Canada. Total, an experienced player in the oil sands in its own right, will continue to operate the Josyln project; Suncor will continue to run the Fort Hills project. Suncor also sold a 49 percent stake (retaining the majority) in its Voyageur upgrader in Canada. Production from oil sands mining projects consists of a product known as bitumen, an extraordinarily heavy, viscous hydrocarbon. Bitumen trades at a sizeable discount to crude oil because its tougher to refine and requires expensive treatment before it can be converted into refined products such as gasoline or jet fuel. An upgrader can convert bitumen into synthetic crude oil, a product that is similar to standard light, sweet crude oil. As you might expect, synthetic oil trades at a substantial premium to bitumen. The Voyageur upgrader will ultimately have capacity of about 200,000 barrels per day (102,000 barrels per day for Suncors share), and is expected to be put into service by 2016. Upgraders are a key part of the oil sands production process, but are also extremely expensive to build. By partnering with Totala company nearly twice Suncors size the firm company reduces its capital commitments. All told, Suncor picked up USD1.75 billion in cash and about 160 million barrels in high-quality oil sands reserves from the joint venture with Total. To meet its ambitious production goals, Suncor has announced eight major projects that will take place in the oil sands. Like any other major mining project, oil sand projects are subject to delays from time to time; however, the addition of

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Total as a partner increases the chances Suncor will complete projects on schedule. Meanwhile, near-term projectsincluding Firebag 3 and 4appear to be progressing according to managements master plan. In 2011 the company aims to grow its oil sands output to as much as 310,000 barrels of oil per day, up from about 280,000 barrels per day in 2010. Buy Suncor Energy.

PeNN West PetROLeUM (TSX: PWT, NYSE: PWE)

Penn West Petroleum (TSX: PWT, NYSE: PWE) continues to hold the richest oil and gas land base in Canada. Its also proven its ability to arrange financing to develop it, inking a shale gas and oil sands deal with Korean and Chinese investors, respectively. And despite weak production due to weather-related events this year, it looks set for robust oilweighted production growth for years to come. Where the company has proven remarkably tone-deaf is figuring out how to please its shareholder base. For months before it converted to a corporation in 2010, management seemed to relish telling investors it would be cutting dividends to the bone when it did become a corporation. As a result, while new Aggressive Holding Crescent Point Energys shares were zooming higher on its announcement to convert without cuttingcutting its cost of equity capital upwards of 50 percentPenn Wests shares languished. When the company actually converted, it didnt cut as much as some envisioned. But many investors seemed to decide the cash payout was too low to stick around. After a brief uptick in the share price, they sold and Penn West slid again. The companys current approach to retail investors seems to be to try to convince them theyre better off getting a lower dividend for the promise of future growth. Penn Wests strategy, of course, was based on managements belief that institutional investors would pick up the

slack, based on the companys growth story. But months after conversion, individuals are still more than 50 percent of the shareholder base. Institutions, meanwhile, appear to understandably be wary of buying another energy company at a time when so many are worried about a global recession, as most are evaluated by their funds annual returns. From my perspective, Penn Wests reserves make it a value that will sooner or later show up in its share price. One obvious way to accomplish that quickly would be a more shareholder-friendly dividend policy. Barring that, investors are going to have to be patient. Penn West Petroleum is a buy.

BIRD CONstRUCtION (TSX: BDT, OTC: BIRDF)

Expanding oil sands production also means developing the infrastructure in what were previously uninhabited regions, and fast. Here the primary player is Bird Construction (TSX: BDT, OTC: BIRDF). The company has held its leading position in the infrastructure construction and design business throughout Canada in both good times and bad. Most impressively, it was able to counter the drop off in activity in the Alberta Oil Sands region the past couple years by winning a slew of public sector contracts, including most recently a CAD118 million deal with Defense Construction Canada to build a new facility in St. Johns, Newfoundland. Thats kept earnings up and order backlog near the record CAD1 billion peak achieved before the 2008 crash. Now with the oil patch reviving, Birds in the drivers seat to snap up another mother lode of valuable contracts for everything from production facility foundations to government buildings and schools. That should keep earnings rising both before and after the corporate conversion, which occurred on Jan. 1, 2011. Buy Bird Construction.

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