Teck Resources (NYSE:TECK), one of Canada's largest and most diversified miners, looked to move into the oil space to further increase its diversification. Although its massive Fort Hills oil sands project managed to stay alive through the last deep energy market downturn, the COVID-19-related oil plunge may be more than Teck and its Fort Hills partners can handle. Here's what's going on at Fort Hills today.

A rough oil market

But first, some background. In the fourth quarter of 2019, Teck's energy business had a gross profit margin of just 1%. There's not much room for adversity in that number -- which helps explain why earlier this year Teck decided to hit the pause button on a second energy investment, known as Frontier. This resulted in a $1.3 billion writedown. That move, however, came in late February, before energy markets really started to go haywire. 

A man looking at a line crashing through the floor beneath him

Image source: Getty Images.

For roughly a decade, oil markets have been trying to adjust to a material increase in onshore U.S. oil production. The new supply was upending the normal supply/demand dynamics in the sector, with OPEC attempting to keep the balance by cutting production. However, OPEC and Russia ended up disagreeing on this approach and a price war broke out. Now add in the demand falloff from the global effort to contain COVID-19, which basically entailed economies around the world shutting down, and oil has fallen to historically low levels. It is brutal, and since supply is materially outstripping demand, oil is piling up in storage. OPEC, Russia, and the United States have gotten back on the same page with production cuts, but all of that stored oil will have to be worked off before oil prices can mount a sustained recovery.

In this environment, nobody wants another oil facility to come online. So Teck's pulling back on its Frontier construction plans was good news all around. However, the market is so bad that Teck is pulling back even more, scalling back at Fort Hills. 

Fort Hills shuts a line

The 1% profit margin noted above was from the fourth quarter of 2019, when oil prices were higher than they are today. When Teck recently released first-quarter earnings, it reported that its profit margin in the energy business had fallen to negative 51%. While oil has been weak all year, the real pain didn't actually start to hit until the later part of the quarter. So Teck's big move into oil, which only started to produce revenue in 2018 after the Fort Hills project was finally complete, has very quickly turned into a negative, and it's highly likely to get worse as the year progresses. Hindsight is 20/20, but the timing of Fort Hills couldn't have been worse. 

And now Teck is pulling back there. In reality, Teck has only a relatively small voice in the matter. It owns roughly 21% of Fort Hills, with Suncor (NYSE:SU) operating the oil sands mine and holding a controlling 54% stake. (France's Total owns the rest.) That's not to say that Teck has no say -- but it is, to some extent, at the mercy of Suncor's decisions. Regardless of who made the call or how it was decided, Fort Hills is going to go from two processing facilities (called "trains" in the industry) to one. Although no timeline has been given for how long the closure will last, highlighting that it depends on market conditions, Teck has made passing reference to the possibility of a full shutdown. That said, Suncor was quick to say that no such discussions were taking place following Teck's remarks. 

This decision to trim back production will have a number of impacts. Fort Hills will produce less oil, with output of between 100,000 and 120,000 barrels per day well below its nameplate capacity of around 200,000. Although the decline is just a drop in the bucket in the global oil market, all production cutbacks will help get supply and demand back into balance. Meanwhile, certain variable costs will fall, which is good for owners Teck, Suncor, and Total. However, there are operating costs that get spread over all of the production, so the cost to produce a barrel of oil at Fort Hills will rise because of this decision. That's bad for profitability, noting that Teck is expecting ongoing operating costs to increase about 15% from the first-quarter level, which itself was up 15% versus the previous year. With oil prices at low levels, that's not a good sign, so investors should brace for Teck's oil bet to be a drag on earnings for at least the second quarter...and likely longer. 

In addition to an operation update on Fort Hills, Teck last week announced that it was taking a roughly $650 million impairment charge on the asset. The reason: "...lower market expectations for future [Western Canadian Select] heavy oil prices over the next two years combined with reduced production at our Fort Hills operation." In other words, the impairment was only partly related to the choice to curtail production, and Teck is expecting at least two years of oil price headwinds. The choice to pull back at Fort Hills is probably an appropriate call, but it comes with a fair amount of pain just the same. 

This story isn't over yet 

Fort Hills is a project with around 40 years of production ahead of it, so there is still plenty of time for it to prove its worth. However, with oil prices at such low levels, there's increasing uncertainty here. Opening and closing an oil sands mine isn't a simple process, so the call to go from two trains down to one was a pretty big deal.

It's too soon to suggest that Fort Hills will shut entirely, but the notion that it could isn't far-fetched if oil prices remain at their recently depressed levels for long enough. Teck investors should keep a close eye on Fort Hills -- the news could still go from bad to worse. For Suncor, this is just one of many oil developments, but Fort Hills makes up the vast majority of Teck's energy business. Thus, this once-promising diversification move could turn into a heavy weight around Teck's neck.