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The Globe and Mail: Economics biggest threat to embattled oil sands

By MARTIN MITTELSTAEDT
The Globe and Mail
Alberta’s embattled oil sands face well known risks from foreign radicals, movie stars, environmentalists and stalled pipelines projects. But there may be an even scarier threat: plain old economics.

Alberta’s embattled oil sands face well known risks from foreign radicals, movie stars, environmentalists and stalled pipelines projects. But there may be an even scarier threat: plain old economics.

The lure of the oil sands is that they hold some of the world’s biggest petroleum reserves. The bad news is that getting this resource out of the ground and ready for refining is expensive, by some estimates the planet’s most costly major oil source. Oil prices (CL-FT101.460.870.86%) have to stay lofty to make investments in the sector pay. Any faltering in prices could cause profits to be elusive, or evaporate.

Just how close new oil sands projects are to being a dicey investment proposition is an open question. For competitive reasons, some major companies – such as Imperial Oil Ltd., (IMO-T46.900.481.03%) developer of the mammoth $30-billion Kearl megaproject – aren’t forthcoming on the oil prices needed to earn a decent return.

But the National Energy Board, culling through publicly available data from the industry, recently pegged the minimum price needed for new projects to be commercially viable at $85 to $95 (U.S.) a barrel.

“It’s the world’s most expensive oil,” said Andrew Logan, head of the oil and gas program at Ceres, a Boston-based organization that promotes sustainable investment and corporate governance.

He said prices wouldn’t need to retreat much from current levels around $100 a barrel to sting investors in new projects. “Starting from a point of the economics being sort of relatively marginal … it doesn’t take a lot to slip them into the red,” he said.

The NEB issued the price data in its Canada’s Energy Future report in November. The estimate included the costs of extracting the sticky bitumen from the ground and processing it in upgraders, along with a 10-per-cent to 15-per-cent after-tax profit margin for producers.

The figures were issued before Imperial Oil stunned the industry in late December by raising the total price of its Kearl project by 25 per cent, an increase driven mainly by new environmental requirements.

Imperial declined to release its break-even figures, but said the project is attractive, even with the rise in its price tag, which works out to additional spending of about $6-billion (Canadian).

“We’re firmly committed to the Kearl project. We believe its the best project out there,” said Pius Rolheiser, an Imperial spokesman.

A competitor, Nexen Inc., (NXY-T18.330.070.38%) is struggling with higher costs at its Long Lake oil sands project. The problems are one of the reasons Nexen has seen its stock price slide from a high of more than $27 last March to about $18. The company announced the departure of two senior executives, including its president, last week.

Earlier investments in the oil sands appear to have a better margin of safety than new projects. Back in 2004, the NEB estimated projects getting off the ground then needed only $40 (U.S.) a barrel to be viable. This is good news for long-time producers such as Suncor Energy Inc. (SU-T34.180.240.71%) and Syncrude Canada Ltd.

New developments face a level of volatility “that is well above most industries” and have significant financial and project execution risk, observed James Jung, senior vice-president of energy at credit-rating firm DBRS.

Among his worries are the potential for cost overruns, the long lead times that it takes projects until they are producing revenue from oil sales, and the possibility of expensive environmental regulations.

Higher project costs wouldn’t be a major problem for new plants if oil prices continue to rise. High prices over the long term is an assumption that has been popular among those who believe the world is running out of conventional crude, and often invoked for making investments for the oil sands.

But projects have design lives of 40 years or more, plenty of time for a cyclical commodity such as oil to trade lower. They could face a threat from new methods of extracting conventional crude, such as the Bakken tight oil play in North Dakota, where drillers have managed to unlock large quantities of petroleum that was formerly thought to be inaccessible, from shale deposits. Similar disruptive technology has caused the price of natural gas to crater to near decade lows.

“What happens if shale oil has the same impact on prices as shale gas has?” asked Mr. Logan.

Oil Prices Graph

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