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Economics: Is there a Miracle in the Oil Sands?
New York: October 20, 2004
By John R. Stephenson

For months, the economic headlines have been the same. “Global economic crunch spurred by high oil prices.” “High oil prices cast a shadow over the markets.” Tight oil supply, coupled with strong oil demand growth from rapidly industrializing countries such as China and India, has made oil prices front-page news for some time.

The oil world is sharply divided between those who believe that higher oil prices are here to stay due to a deterioration in reserve quantity and quality of conventional oil fields and those who believe that the high prices are due to short-term fears (terrorism and declines in global inventory stocks) rather than something fundamental. Personally, I believe that the former argument carries more weight. But, with demand surging some 2.2 million barrels per day this year, there is little doubt that unless demand were to drop dramatically (an unlikely possibility) or new oil supplies were to suddenly appear in the marketplace, that higher oil prices will likely persist for some time.

A huge natural resource that Canada has been sitting on for many years is the oil sands which was first discovered by the Indians who used the sticky bitumen to gum their canoes. The first European to see the oil sands was fur trader Peter Pond who discovered the bitumen along the banks of the Athabasca River. The oil sands differ from conventional oil and gas reserves where the oil and gas are trapped in rock formations. With the oil sands, the heavy black oil (bitumen) is mixed in with sand and clay and must be separated from one another to be useful. Between 1906 and 1917, there were 24 commercial wells drilled in search of a huge oil field below the surface of the oil sands. None of these wells was a success. The first truly successful project in the oil sands started in 1962 and was named the Great Canadian Oil Sands Project (“GCOS”). Later the ownership of GCOS rested with the Sun Oil Company (later Suncor Energy) and became the world’s first oil sands operation.

There seems to be a lot of talk lately about Canada as a possible new supplier of crude oil to a thirsty world economy. Certainly, oil in Canada is nothing new, but lately, the focus has been on the oil sands and the vast possibilities for our future energy needs that may be buried there. It might come as a surprise to realize that, despite Canada’s relatively small conventional oil and gas resource base, it was the fourth largest global oil and gas producer in 2003 (behind Russia, the United States and Saudi Arabia). As well, Canada accounted for some 17% of total U.S. petroleum imports last year versus a combined total for all of the Middle Eastern countries of 21%. In natural gas supply, the story is even more remarkable with Canada representing 87% of total U.S. natural gas imports.

With some market forecasters predicting that global oil supply, at least conventional oil output, could peak by as early as 2010, the rush to develop alternative solutions has begun. Alberta’s oil sands, along with Venezuela’s Orinoco extra-heavy oil belt, are leading contenders as alternate suppliers of crude oil. Canada’s current total proven oil reserves stand at 16.9 billion barrels, with conventional oil reserves accounting for approximately 4.5 billion barrels, or less than 27% of the total reserve base. But this proven reserve base represents only a small proportion of Canada’s total resource potential. Various professional organizations such as the Alberta Energy and Utilities Board (“EUB”) and the Canadian Association of Petroleum Producers (“CAPP”) have pegged the recoverable reserves from the oil sands at approximately 175 billion barrels based on current technologies and existing cost structures.

If this estimate of the oil sands resource base turns out to be accurate, then the oil sands could produce as much as 10 million barrels of oil a day (current production is 1.2 million barrels/day), with an estimated production life of fifty years. This would catapult Canada into the big leagues of petroleum production and alongside Saudi Arabia which is currently producing between 10 and 10.5 million barrels a day. The EUB has even gone so far as to estimate that the ultimate recoverable oil reserves from the Alberta oil sands could potentially exceed some 300 billion barrels. There is only one problem. The cost. Lehman Brothers (an investment bank) estimates that the total cost to increase production from the oil sands to this level is $130 billion (US).

The oil sands are a unique resource of the province of Alberta, which is home to all known recoverable reserves. The three major deposits in the region are Athabasca, Peace River, and Cold Lake, which cover a combined total area of approximately 141,000 square kilometers in the province’s central and northern section.

Compared with traditional upstream oil and gas projects, the oil sands are very difficult and expensive to exploit. While conventional crude oil flows naturally or is pumped from the ground, the oil sands consist of oil that has seeped from deep reservoirs over the last hundred million years and has become mixed with sand and clay. Of the total volume of the oil sands, sand and clay account for 80-85% of the volume, water 4-6% and bitumen (heavy black oil) 10-12% by volume. Typically, oil sands projects are developed in stages, with a designated long-term production plateau of at least 30-40 years, which contrasts with the relatively short production peak rates of conventional developments. With oil sands production, the oil is recovered through both mining in situ — meaning “in place” and also through a separation technology which utilizes an upgrader to separate the oil from the sand and clay. The basic techniques for recovering the reserves from the oil sands include open pit mining (for reserve depths up to 250 feet) and steam-assisted gravity drainage for reserves that are buried deeper (approximately 90% of estimated reserves).

Both the open pit mining and the steam assisted gravity drainage methods of recovering and extracting bitumen are heavy users of natural gas. That is because there are vast quantities of oil and sand that need to be recovered in order to produce a barrel of oil. Typically, two tons of oil sands are needed to produce one barrel of synthetic crude. Some estimates put the amount of natural gas needed to help the oil industry unlock the vast potential of the oil sands at some 2,400 mmcf/d which is quadruple the current usage. The amount of natural gas used to process the bitumen is quite substantial and Lehman Brothers estimates that current technologies utilize between 0.4 mcf – 0.5 mcf of gas per one barrel of synthetic oil when utilizing open pit mining and between 1.0 and 1.5 mcf of gas per one barrel of synthetic oil when steam assisted gravity drainage is the production technique employed. The upshot? With declining natural gas production and increasing worldwide demand for petroleum, there should be continued upward price pressure on natural gas.

The combination of tight conventional oil supplies and geopolitical tensions is creating a near perfect storm for the development of the oil sands. Currently, there are a string of oil sands projects worth tens of billions of dollars which are being planned in Alberta over the next ten years. The three biggest integrated oil sands projects operating in Alberta currently include Syncrude (230,000 barrels/day), Suncor (233,000 barrels/day) and the Athabasca Oil Sands Project (a partnership of Shell Canada, Chevron Canada and Western Oil Sands). These massive projects are often subject to cost overruns and their project economics can be impacted by the high cost of natural gas. Suncor’s cash operating costs averaged C$11.50 in 2003 ($0.40 higher than 2002 costs because of higher natural gas prices) which, when compared with US$2.00 to recover oil in Saudi Arabia and Iraq, puts Canadian producers at a cost disadvantage. But with a tight global oil market (high oil prices) and the lack of exploration, risk investments in Alberta oil sands projects and companies make sense.

One way to play the oil sands story without feeling the impact of project delays and cost overruns is to purchase shares in the pipeline companies that take the product from the oil sands to the market. Enbridge (ENB — target price $56.00 ) is the primary pipeline operator in the region, and its system already transports a portion of the output to refiners as far south as the U.S. mid-continent. The company has aggressive plans to extend its routes to the energy starved U.S. market and is planning a C$650 million southern access pipeline that would move Canadian oil to other major U.S. market hubs, extending as far south as the U.S. Gulf Coast. In addition, the company is also looking at taking up to 400 mb/d of oil sands production to the West Coast to access the California or Asian markets.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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