We've heard the story a thousand times: The world's oil is all located in politically unstable countries whose interests are opposed to those of the United States. Yet we have continued to increase imports for more than three decades, creating a dependence on foreign oil that is not easily broken.
Of course, we all know who has the oil. One country boasts the largest reserves on earth. Within the coming decades, its production will likely stand head and shoulders above every other nation's. Our unfavorable trade balance with this country could politically destabilize and humiliate the U.S. No, I am not talking about Saudi Arabia. Rather, I ask my countrymen: What are we going to do about Canada?
A bit of background
According to the Oil Sands Discovery Centre, Alberta's oil sands are the largest known reserve of oil on earth, with between 1.7 and 2.5 trillion barrels of non-conventional oil (yes, that was trillion with a "t"). To put this in perspective, Saudi Arabia has "only" 261.9 billion barrels of proven reserves. In fact, all OPEC nations combined have only 885 billion barrels of reserves. Also, unlike many OPEC nations, output in Canada is on the rise and will continue to increase for many decades. The Canadian Association of Petroleum Producers (CAPP) estimates total Canadian production will grow to 3.9 million bpd by 2015, with oil sands production increasing from 1 million bpd to 2.7 million bpd. If the world is approaching Peak Oil, we can't blame Canada.
How does such a grand divide in public perception exist? The main culprit is the slippery definition for "proven reserves." The U.S. Energy Information Administration (based on data from Oil & Gas Journal) recently updated its estimate for proven Canadian reserves from 5 billion to 178.8 billion barrels (to account for the oil sands). Even with the revision, that figure represents only about 10% of the estimated oil in Canada's sandy ground, because the other 90% cannot be profitably produced with current technology. Even so, 178.8 billion barrels places Canada in the No. 2 spot in proven oil reserves, behind Saudi Arabia.
Before we look at the investment opportunities, it's important to understand that oil sands aren't produced in the same way as conventional hydrocarbons. The "oil sands" are heavy hydrocarbon deposits that mix bitumen, sand, water, and clay. Bitumen is a heavy, carbon-rich, hydrogen-poor hydrocarbon. The bitumen is removed from the oil sands and upgraded by removing carbon and adding hydrogen. The upgraded product is generally referred to as "syncrude."
The production companies
Several North American oil companies are involved in the development of the oil sands. SuncorEnergy (NYSE:SU) has been developing the oil sands since 1967 and currently leads production with a capacity of 260,000 bpd, which is projected to increase to 350,000 bpd in 2008 and up to 550,000 bpd by 2012.
The second major player is Syncrude Canada Ltd., a joint venture primarily owned by Canadian Oil Sands Limited, Imperial Oil (AMEX:IMO), and Petro-Canada (NYSE:PCZ). It currently produces 247,000 bpd, which is projected to increase to 350,000 bpd in 2006. Imperial Oil also independently runs the Cold Lake project, which produces about 140,000 bpd.
The Athabasca Oil Sands Project is majority-owned by Shell Canada (NYSE:RD) and currently produces about 154,000 bpd, with the potential for up to 500,000 bpd in the future.
For the closest thing to a "pure play" on production, investors can look at Suncor or the Canadian Oil Sands Trust (with an ownership stake in Syncrude Canada Ltd.), which trades on the Toronto Stock Exchange and in the pink sheets. Before you invest, be aware of pink-sheet illiquidity and foreign ownership restrictions.
Oil sands production costs are currently estimated at just over $15 per barrel, and overall operations are profitable as long as world oil prices remain above $30 a barrel. That seems likely for the foreseeable future, but profits at any of the production companies will depend heavily upon how far above $30 those prices remain. If you want to reduce your sensitivity to world oil prices, consider a "pick and shovel" play instead.
The picks and shovels
More than half of all oil sands are currently recovered using strip-mining operations -- digging up the oil sands and trucking them to upgrading plants. The rest gets recovered "in situ," combining drilling technology with steam injection to pump liquid bitumen directly out of the ground.
The strip-mining operations are a particularly attractive option, since CAPP estimates that mining production will increase from a current rate of 600,000 bpd to 1.2 million bpd by 2010. This is an excellent growth opportunity for the likes of Joy Global (NASDAQ:JOYG) and Bucyrus International, who are already benefiting from a worldwide increase in coal-mining operations. In addition to selling shovels and related equipment, new installations in the oil sands will also drive a long-term aftermarket and maintenance business.
"In situ" production is also projected to grow from a current rate of 380,000 bpd to 700,000 bpd by 2010. This should benefit drilling equipment companies like Hydril (NASDAQ:HYDL) and Grant Prideco.
Similar to the production companies, drilling operations in the oil sands are a very small percentage of worldwide operations. For now, it's tough to find a particularly compelling investment among this group. However, it should be noted that about 80% of the oil sands are located far below the surface and will require "in situ" production. Potential investors should watch closely for technology breakthroughs in this sector.
The hydrogen angle
As mentioned, bitumen is composed of carbon-rich, hydrogen-poor hydrocarbon chains. Upgrading bitumen to syncrude requires hydrogen from air-separation companies like Air Products & Chemicals (NYSE:APD) and BOC Group. There are two reasons why I like this avenue for investment. First, many refiners are using more hydrogen for reasons other than oil sands, since several refining companies have revamped their operations to process heavier, cheaper crude oils. Second, once the hydrogen plant is built, it is integrated into refining operations and continues to make money for the owner for the life of the plant. It should be noted, however, that oil sands will have only a minor impact on Air Products or BOC Group, as they are very large companies with several other businesses.
The risks
While oil sands production appears to be poised for future growth, investing in this area does carry some risks. Because oil sands require much higher production costs than conventional reserves, profits will fall fast for these folks if oil prices plummet. OPEC or Russia could increase production to lower oil prices and make investments in non-conventional oil sources unprofitable. Alternately, high prices could lead to a worldwide reduction in demand. Either scenario would need to be quite extreme to bring oil prices below $30 a barrel.
Environmental concerns pose a greater risk; producing oil sands requires more energy than conventional hydrocarbons. This has created some difficulties for the Canadian government, as they are signatories to the Kyoto Protocol. Increasing oil sands production has increased their carbon dioxide (CO2) emissions. For now, it appears that Canada has arranged its carbon credits to balance Kyoto and continued development, but investors in this area should pay attention to any revisions to current agreements.
Given political problems in other oil-producing areas and weather concerns offshore, risks in the oil sands are moderate. In fact, with much of the currently mined bitumen deposits near the surface, "drilling risk" is basically eliminated -- the companies know the oil is there. Furthermore, Canada can ship syncrude via pipeline directly into the largest market on earth (the U.S.), reducing the total cost of bringing the product to market. All things considered, it appears that oil sands production will increase for many decades into the future.
Investments aside, I worry about the politically destabilizing impact this will have on the United States. How are proud Americans going to respond when we start hearing jokes like, "You eat that belly bacon, eh?" Worse yet, what if the Canadians start calling the United States "the 11th Province?" I just don't know what we'll do, but I fear the flood of Canadian syncrude could be much worse for our pride than the late-'80s flood of hit singles from Bryan Adams and Corey Hart.
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Robert Aronen owns shares of Joy Global, but no other companies mentioned. He swears there are no Bryan Adams albums buried in his closet. Please feel free to share your comments with him. The Motley Fool has an ironclad disclosure policy.
