Oil's Shrinking Sandbox Leads to Northern Alberta
Making sense of a complex source of energy.
In recent years, the challenges of securing global energy resources for a growing, industrializing world population have been made painfully apparent by soaring prices. Record profits at the world's largest public oil companies can often paint a tempting target in the search for a villain amidst our collective turmoil. But the world of energy isn't a simple one. In the same way that energy is intricately woven into the fabric of our everyday lives, so too is the market for energy affected by the complexities of politics and the environment. Executives at international oil companies (IOCs) can claim limited victory in record profits if they can't efficiently reinvest for the long term. What's stopping them, you ask? Perhaps the most difficult barrier is also one of the great issues of the day: access to resource.
Resource nationalism has resulted in national oil companies (NOCs) controlling most of the world's energy reserves. In many cases, nations dictate terms of investment to IOCs, and IOCs have to play along. That's not to say the IOCs don't have a say; some companies are the size of countries themselves, with commensurate influence, and without their investment and expertise, some energy-hungry nations may not be able to get projects off the ground. But stable partner nations have been hard to come by, and the sandbox in which the IOCs can play has been shrinking.
Cue the oil sands of northern Alberta, Canada. These vast tarry deposits of bitumen can--at great difficulty and expense--be processed into usable end products. Intermediate steps of upgrading the bitumen on-site into synthetic crude oil, blending it with lighter products, or alternate methods are typically undertaken before pipeline transportation to downstream refining markets.
As in most other frontier regions, the challenges of bringing projects to fruition in the oil sands are enormous. But the prize is not insignificant. Whereas most conventional fields constantly battle declines, producing small fractions of original production after 10 or 15 years, oil sands projects can last 40 or 50 years without declines. Instead of drilling deep into land or under water, trying to find and then delineate a reservoir, this resource base is visible and well-defined. Put another way, there's little exploration risk, but major development risk. And therein lies the rub.
In recent weeks, with oil prices plummeting in tandem with more apparent signs of a global slowdown, many oil sands projects are being slowed down or deferred indefinitely. This is because almost no aspect of a project can be easily or accurately predicted. In addition to the broader tightness in capital markets, and the inescapable oil price debate, costs have skyrocketed to unmanageable levels, timelines have been made unpredictable by poor labor productivity, risks of direct environmental costs have increased, and downstream markets have grown less secure with increasing political pressure against the emissions-heavy processing of oil sands bitumen. From international oil companies such as Royal Dutch Shell (RDS.A), Total (TOT), and StatoilHydro (STO) to Canadian locals like Suncor (SU), Petro-Canada (PCZ), Canadian Natural Resources (CNQ), and Nexen (NXY), activity is set to slow down significantly.
But is the end nigh for this region of vast resources? Probably not. Let's take a look at the challenges, and see how they are evolving.
A Highly Uncertain World
Capital is currently scarce and expensive. Small marginal players in the oil sands face near-impossible odds in trying to raise money. Even for larger operators with healthy balance sheets, the cost of debt has shown no signs of abating, with credit spreads soaring and larger syndicates becoming a necessary aggravation. Savaged equity prices clearly communicate how high required returns on investment have become. So oil sands projects find themselves competing for capital against less risky ventures, and it will take time for the slowdown to set a new equilibrium.
Fortunately, the cost of input materials like steel and concrete has already dropped significantly as a result of the global slowdown, so this is less of a concern than it was even a few months ago. As the combination of poor economics and capital constraints claims more victims from competitive big-ticket projects like refineries and LNG terminals, some easing should be felt along the global supply chain. We also think the recent tightness in engineering capacity will improve, providing further relief.
Labor is perhaps the biggest wild card. Labor has been a massive headache for oil sands operators, with the scarcity of skilled labor leading not only to unit cost inflation but a degrading of productivity, which in turn creates delays and also further increases costs. In 2007, we expected construction demand in 2009 and especially 2010 to place a great deal of stress on the supply of skilled labor in northern Alberta. It once appeared that foreign sources of labor would be essential to meeting project demand; with the rash of deferrals, that seems less vital now. How the labor picture shapes up will depend on how the region's operators decide to go forward with their projects.
Traditionally hazy timetables have become even more nebulous. Upgrading makes the least economic sense right now, with costs nowhere near in line with the product quality differentials required to make upgraders a worthwhile endeavor. The narrowing of these quality discounts for Canadian heavy crudes has been a result of increased heavy processing capacity in North American downstream markets, and affords projects an opportunity to be "long" bitumen. Still, for projects that want to manage differential risk, one alternative that may become more attractive is to buy a distressed refinery (perhaps from a U.S. refiner) and refit it to accept bitumen feedstock as necessary--although this in itself would not be a cheap undertaking. Simply keeping the big Alberta upgraders on hold would help ease some of the oil sands' regional constraints. What will also help is slower, phased growth, which means longer time horizons at the benefit of lower expenditures. The question is whether or not--should oil prices suddenly recover--all the players once again decide to stuff themselves through the same narrow door of opportunity.
We think caution will rule for at least a year or two (which admittedly isn't that long). Environmental concerns are numerous, with Canadian emissions legislation a headache of unclear dimensions and the possibility of "dirty oil" rhetoric in the U.S. reducing the size of downstream markets. We don't expect emissions legislation on its own to be a barrier to development, but like Alberta's new royalty framework, it would carry a financial cost that eats into already skinny returns. Nor do we expect the U.S. to reject Canadian oil sands crude, which is offsetting falling Canadian conventional and Mexican production. At least not until the alternative scenarios (more reliance on crude from unstable nations, or a likely costly transition to energy alternatives) can be measured for their palatability.
The Expansion Decision
The decision to move forward amidst these challenges lies in a company's willingness and capability to manage risk. If a company is willing to sanction a project that is economic only at $100 oil over the long term, it'd better be extremely confident about that oil price projection. Alternately, operators might wait and wait for economics that never return. Earlier this decade, new projects could have met their cost of capital at $30 a barrel. In 2007 that number was probably closer to $60, and when recent news out of Petro-Canada's Fort Hills project cited a 2008 increase in costs by 50%, a marginal greenfield project such as Fort Hills would likely have required $100 oil (when the Canadian dollar was much stronger). But that's why the company is deferring its decision on the project. Once the capital is spent, mistakes can't be repaired.
If the global slowdown does not careen into a multiyear catastrophe and instead shows signs of recovery next year, we think costs will likely have to return to a level of capital intensity that would make projects economic at $80 a barrel before the most aggressive companies bite the bullet on expansion. Even then, upgraders would require an excess margin of safety before that project risk is undertaken. More cautious operators may try to hold out for $60 economics or lower, but even if they don't face lease expiry issues, they run the risk of losing labor, resources, and time to more aggressive peers. It's a prisoner's dilemma, made somewhat less uncomfortable by the pain that everyone is feeling--for now.
In terms of projects already operating, active oil sands projects will consider stopping operations only as a last resort. In a very low price environment, energy inputs like natural gas should also fall in price, and operators will look to lower cost structures, perhaps by negotiating lower wages, before considering a temporary shutdown of production. Correlated weakness in the Canadian dollar also helps alleviate some of the pain of low oil prices. We feel oil prices would have to fall below $30 (CAD 40 at a 1.33 exchange rate) and remain persistently low before the shutdown conversation becomes more frequent in the executive suite. In any case, current operations are of less concern than ill-advised expansion that might result in capital impairment.
What really matters is the future. With limited access to conventional barrels, a permanent halt to oil sands expansion could put global oil prices at greater risk of sudden price spikes when the global economy finds its feet. This is of course barring a serendipitous discovery of huge, easy onshore resources, or a green revolution that may be within sight but outside of our immediate grasp. So we consumers have our own dilemma: We want cheap, clean energy, while the marginal energy that is available right now is neither cheap nor clean. Had forward-looking energy policies been established by nations of all stripes 30 years ago, particularly toward conservation, efficiency, and alternatives, this current dilemma would be of far lesser severity and consequence. Even if we assume that lower energy prices won't breed complacency, and even if we assume real global change can be successfully undertaken and achieved, it will likely take years, if not decades, to reach the other side.
The meantime is what oil sands producers are counting on, and why the companies invested in this region may be a solid investment at an appropriate margin of safety. Companies we cover have varying degrees of exposure to the oil sands, and consequently, varying levels of associated uncertainty and capital flexibility. Please see our reports and valuation sections for more details on long-term investing opportunities in this space.
Kish Patel does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.