Oil Sands Set to Explode

Rising energy prices are driving oil sands production to new heights. Last week, Canada's National Energy Board (NEB) released a report giving an update on the opportunities and challenges facing Canada's oil sands between now and 2015. (Link opens a PDF.) A follow-up to a 2004 report, the document takes into account current market conditions, such as the doubling of the price of crude oil and natural gas since the original report came out. We've given our own report on Canada's oil sands, but now let's take a revised look, based on the new NEB report.

Oil sands production
Capital expenditures to fund oil sands development have exploded in the past two years. Current investment totals $106 billion ($125 billion Canadian) to develop projects that will be completed between 2006 and 2015. If all of these projects are completed, oil sands production in 2015 will total a high estimate of 4.4 million bpd (barrels per day), up from 1.1 million bpd in 2005. Assuming that even 75% of the high estimate is achieved, production will increase to 3 million bpd.

That much expansion will place Canada among the world's top oil producers and exporters. As things stood in 2004, Canada ranked eighth among world oil producers and didn't even make the list of the top 14 exporting countries. This was back when it produced just in excess of 3.1 million bpd, with 1 million bpd coming from the oil sands. Assuming that conventional production remains near 2 million bpd, Canada will be producing 5 million bpd in 2015 -- enough to place Canada fourth in global oil production.

These estimates assume that Iran is unable to increase production by more than 1 million bpd, but I consider this assumption reasonable, since Iran is having difficulties meeting its OPEC quota, and its government has created an environment inhospitable to the type of foreign investment needed to boost production.

In exports, oil sands production will have a much more significant impact for Canada. In 2004, Canada's oil consumption was 2.3 million bpd, resulting in net exports of only 800,000 bpd. I estimate that Canada will consume around 2.7 million bpd in 2015, assuming annual growth of 1.6%. With 5 million bpd of production, net exports will total 2.3 million bpd. Returning to our table of Top World Net Exporters, we thereby find that Canada will move into the top 10 exporting countries by 2015. If oil sands production meets the high estimate, Canada could move as high as third place among exporters, behind only Russia and Saudi Arabia.

Producers
It should be no surprise that the major oil sands producers have announced the largest expansion projects:

Company

Total Production (bpd)

Year Complete

Suncor (NYSE: SU  )

500,000 to 550,000

2010 to 2012

EnCana (NYSE: ECA  )

500,000

2016

Canadian Natural Resources Limited (NYSE: CNQ  )

800,000

Not announced



Other large projects have been announced at Imperial Oil, Shell Canada, Petro-Canada (in partnership with UTS Energy and Teck Cominco), Husky Energy, and a whole host of other companies, including Shell EP Americas, which recently shocked the oil sands by purchasing 10 properties in northern Alberta.

The future direction of oil prices and production costs will dictate the profitability for these producers. The NEB report estimates profitability at an oil price of $30 to $35 per barrel of West Texas Intermediate (WTI) light sweet crude oil. These prices are up significantly from the 2004 report, mostly because of higher capital costs and higher natural gas prices. So the global commodity boom that has increased oil prices has also increased the cost of expanding oil sands production.

Production methods
There are two methods of converting oil sands into liquid that can be refined into gasoline and other petroleum products -- mining operations and in situ, or "in place," recovery. Both methods will grow through 2015, with in situ production showing the larger increase.

The NEB report estimates that mining operations will account for 52% of total production in 2015. Expansions at Canadian Natural Resources, Imperial Oil, and Petro-Canada all include new mining operations. This prospect for new installations has been partly responsible for creating joy for shareholders of Joy Global (Nasdaq: JOYG  ) and Bucyrus. Mining operations work where the oil sands deposits are close to the surface and have a lower natural gas requirement than do in situ methods. On the downside, environmental groups question the effectiveness of land restoration after mining operations have taken place, and in situ methods allow access to deeper deposits.

The most common in situ production method is Steam Assisted Gravity Drainage, or SAGD. The advantages are that only the bitumen is removed from the ground, and deeper formations can be exploited. But the downside is that SAGD production requires more natural gas. Because it uses traditional drilling methods, growth in SAGD production should create new business for drilling companies. However, this production is so small compared with global oil production that any incremental business is unlikely to have a serious impact on the major players.

New in situ production methods are also being investigated. Petrobank is building a pilot project to demonstrate its toe-to-heel air injection (THAI) technology. Other companies are experimenting with the vapor extraction process, or vapex, which is similar to the SAGD process, but hydrocarbon solvents are injected instead of steam.

Challenges
Environmental concerns pose the greatest challenge to oil sands production growth. Greenhouse gas emissions, land reclamation, and water usage are the most common issues. The combination of issues has led various environmental groups to call for a moratorium on oil sands development and created bureaucratic obstacles to new projects.

These are serious concerns. Oil sands production emits higher greenhouse gas emissions than conventional oil production does. To meet the requirements of the Kyoto Protocol, Canada will need to invest in clean energy to obtain credits to offset the increase in carbon dioxide, or else capture and sequester the carbon dioxide. In part to balance its oil sands production, Suncor has become one of the largest wind power producers in Canada.

Mining operations remove the surface of Canada's boreal forest to expose the oil sands below. While these lands are to be reclaimed after oil sands production is complete, the resulting landscape will be significantly different, with fewer wetlands, more lakes, and no peat lands. Local groups question the impact on the local ecosystem and the effectiveness of reclamation efforts.

Water usage poses both environmental and technical challenges. Mining and in situ operations require huge volumes of water, which is diverted from the Athabasca River. Current licensing approves the withdrawal of 2.3 billion barrels of fresh water per year from the river, but the planned projects will push the requirement to 3.3 billion barrels per year. The environmental concern here is that insufficient flows exist to ensure the river's ecological sustainability. The technical challenge is that the river flow rates are lower in the winter, a reality that could lead to seasonal shortages. It is likely that oil sands producers will need to implement efforts to reduce water usage, increase recycling, and implement on-site storage to avoid seasonal production losses.

Conclusions
There is little doubt that the Canadian oil sands are booming. If the current projects proceed to completion, Canada will be one of the world's leading producers and exporters of petroleum products.

With more than $100 billion in investment planned for the next decade, there should be plenty of profits available for investors. Unfortunately for investors, the opportunity is widely known, and finding discounts is tough. I still prefer investing in the infrastructure -- the picks and shovels. The companies providing these implements benefit from oil sands development and the global oil and commodities boom. Joy Global has dropped quite a bit recently and might begin to entice some investors at current prices. Alternatively, a good portion of that $106 billion in new construction will be paid to engineering contractors such as CB&I (NYSE: CBI  ) and Jacobs Engineering.

Investments in the oil sands are not without risk. As mentioned, a global collapse in oil prices will hurt the oil sands more than it will conventional oil producers because of the higher production cost of oil sands. To date, Canada has managed the environmental concerns to allow development to continue, and with oil above $70 a barrel, I expect this trend to continue. However, environmental concerns could derail specific projects, accelerate a switch away from mining operations, or cause production costs to increase. Finally, because this opportunity is very well known, you should take care to avoid the growth trap and avoid overpaying for oil sands investments.

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Robert Aronen owns shares of Joy Global and welcomes your comments. The Motley Fool has a disclosure policy.


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