THE OIL SANDS SWEEPSTAKES
Companies are fleeing the overheated economy of Fort McMurray in search of cost-friendly alternatives, PATRICK BRETHOUR finds. But will the great escape just cause another bottleneck?
PATRICK BRETHOUR
CALGARY -- To understand the latest surge in the oil sands boom, break out your favourite Three Stooges flick.
At some point, the Stooges rush to leave a room, only to end up with all three wedged in the door frame. It is the Moe-Curly-Larry dilemma: What might work for one is defeated when everybody follows suit.
The Stooges' dilemma is now hitting the oil sands, as the sector searches for an escape hatch from the escalating cost of building upgraders, those massive industrial complexes that turn low-value bitumen into pricey crude oil. Companies have begun to flee the overheating economy of Fort McMurray, at the heart of northern Alberta's bitumen deposits, for the industrial land north of Edmonton. Some are eyeing Lloydminster to the east, while others are beginning to look at the United States as a refuge.
There are advantages and drawbacks to each, but all have two things in common for the firms involved. One is a determination to avoid the mistakes of the previous rounds of upgrader construction this decade, which were plagued by budget overruns in the billions. The other is the certainty that if a new location confers a competitive edge on one player, other companies are sure to follow, with the resulting pile-up blunting that edge.
Synenco Energy Inc. has been caught up in the Stooges dilemma, although it doesn't quite use that vocabulary to describe the situation. "I don't think anyone would qualify as stooges," laughs Todd Newton, Synenco's president and chief operating officer. "We all went into this with our eyes open."
In December, the company chose Sturgeon County, near Edmonton, as the site of the upgrader for its Northern Lights project, scrapping a strategy to build the facility at its mine hundreds of kilometres to the north. Petro-Canada followed suit three months later, saying it too plans to build an upgrader in the area. And more companies are likely to crowd in shortly, including Total SA, which has bought property in the area as a possible upgrader location for its recently acquired project. "It's keeping that option open so we don't get squeezed out of the market," spokesman Paul Floren says.
The doorway is filling up. Mr. Newton insists that the advantages of Sturgeon County -- including better rail infrastructure and more ready access to skilled workers -- will endure. But he admits that competition for resources will intensify. "It's all happening at once," he says, going on to draw a parallel with a crowded shipping lane. "It will create congestion, when it comes to the owners who are trying to bring their assets on line."
It is that situation that has led oil and gas analyst Tom Ebbern to conclude that the resulting traffic jam is now becoming the main barrier to growth in the oil sands. "The upgrader will become the bottleneck," says Mr. Ebbern, executive managing director of institutional research at Tristone Capital Inc. in Calgary.
It's unlikely that any one approach will be a magic solution, he says. Instead, Mr. Ebbern advises investors to think about the divergent strategies of the oil sands firms as they would their own portfolio: A variety of approaches -- diversification -- reduces the overall risk for the sector. As with stocks, each strategy has its own peculiar combination of risks and benefits.
OUT OF THE FRYING PAN
STURGEON COUNTY & EDMONTON
About 450 kilometres to the southwest of Fort McMurray is Sturgeon County, a swathe of industrial land within an easy drive of Edmonton. This is the first refuge that the oil sands have sought from the heated construction environment of Fort McMurray. Shell Canada Ltd. was the first, when it retooled its Scotford refinery earlier this decade to handle output from the Athabasca Oil Sands Project. Smaller companies, including BA Energy Inc. and North West Upgrading, followed later with plans to construct upgraders to process bitumen purchased from others. More recently, Synenco and Petrocan have joined in.
The hope is that workers will be easier to find in Edmonton than in Fort McMurray, where poaching of skilled hands is rampant. Some of the complex, and enormous, manufactured parts needed to build an upgrader will be put together in Edmonton rather than having to be constructed in the field or shipped over long distances, as is the case with the projects to the north. And the area has better transportation links, most notably railways.
In a recent presentation to investors, Petrocan put a price tag on how much it will save by building its upgrader away from Fort McMurray: a billion dollars, according to Brant Sangster, the executive in charge of its oil sands efforts. Impressive as that number is, it actually understates the size of the savings, since it represents only today's value of a much larger total of avoided future costs. The company says those savings stem from lower capital costs, operating expenses and the expectation of reduced risks.
Synenco is not releasing its figures, but Mr. Newton says the magnitude of the savings is not a surprise. "The Petro-Canada number is not a shocking number," he says
But there are drawbacks, the biggest of which is the need to ship bitumen in a pipeline to the upgrader. That involves either an extra outlay of capital, or higher operating costs if the company opts to use someone else's line. The other debit on the ledger is the prospect of increased competition for resources, specifically labour.
Materials typically make up around two-thirds of a project's cost, but those expenses are largely beyond a firm's control. That makes the remainder -- labour costs -- all the more important to contain. Synenco, for instance, is already steeling itself for this, as it assembles a training program that is predicated on a high turnover of workers and is aimed at putting green tradespeople to work more quickly.
And the hope of big savings might end up being a mirage. Shell Canada, after all, did not escape massive cost overruns, even though its upgrader is in the Edmonton area.
DUE SOUTH
THE UNITED STATES
Faced with the certainty of escalating costs throughout Alberta, some companies are already looking farther afield, to strike partnerships with U.S. companies, including refiners in the American Midwest looking for new sources of supply. The heart of this approach is twofold: escape the bidding war for labour in Alberta, and share the risk of the needed capital investment. Husky Energy Inc. and EnCana Corp. have both said they are interested in this strategy, although neither has yet struck a deal. Any such arrangement is likely to come with a built-in marketing arrangement, an added positive at a time when the oil sands production of bitumen is already depressing prices.
However, Stephen Paget, an energy research analyst at FirstEnergy Capital Corp., says the hope of companies that they can reduce cost pressures by heading south flies in the face of some statistics, including from Imperial Oil Ltd., that show that the capital expenses for refineries in the Midwest are not significantly different than in Edmonton. Another pressure comes from the drain of workers to the U.S. Gulf Coast oil industry, still recovering from last year's devastating hurricane season.
Even if there are enough workers, there remains a question of whether they are experienced enough in the industry. Suncor Energy Inc. discovered this painful fact first hand after maintenance work on its refinery in Denver dragged on longer than expected, crimping its profit. President and chief executive officer Rick George said his company has come to the realization that the local work force is not as well suited to extensive industrial projects as is the case in Alberta.
EYE OF THE STORM
FORT McMURRAY
Despite the concerns over mounting costs, some companies are continuing to move forward with plans to build new upgraders in the middle of the oil sands. Suncor, for one, plans to do so with the third upgrader that will be at the heart of its Voyageur expansion. To the north, Canadian Natural Resources Ltd. is still on budget with its Horizon project, although it has taken numerous steps to insulate itself from the competition for labour, including flying its workers in and out of the construction site.
However, in the south, Nexen Inc. and partner OPTI Canada Inc. are getting hit by rising labour costs. Two weeks ago, the partners said productivity is 20 per cent below projections. Contingency funds, plus savings in other areas, mean that the Long Lake project is still on budget, but it is clear that Nexen and OPTI have not been able to avoid the results of the bidding war for labour -- even though their construction effort is taking place in a relative lull.
IN THE RAW
NO UPGRADER
When Synenco was debating where to build its upgrader, one option being seriously considered was -- nowhere, with the company instead selling raw bitumen to a third party. Ultimately, the company concluded it was worth risking billions to build.
But others, including giant Imperial Oil, are clearly leaning the other way. Today, Imperial does not own an upgrader in Alberta, although it is a partner in the consortium that owns Syncrude Canada Ltd.
The company ships about two-thirds of the bitumen production from its Cold Lake project to refineries in the United States, including one owned by its parent, Exxon Mobil Corp.
Tim Hearn, Imperial's chairman, president and CEO, was one of the first to give voice to the concern that rising costs in Fort McMurray were undermining long-term profitability.
The first phase of its new project, Kearl, will not include an upgrader. While the company has not made a decision for subsequent phases, Mr. Hearn has made it clear that Imperial's focus is on achieving high rates of return on capital (as opposed to capturing the higher profits from synthetic oil).
Analysts believe that many small companies will follow in Imperial's footsteps, but for different reasons. Small-scale projects are not likely to reach production levels that allow them to justify the massive capital investment. However, the success of this approach depends on other firms building upgraders, and reducing the otherwise enormous glut of bitumen that would result.
So, the do-not-build-it strategy works -- but only if the rest of the industry doesn't rush for the same strategy and, like the Stooges, end up in the same old jam.
The upgrader game
The decision to build an upgrader puts billions in capital at risk, but a call
to not build can prove equally costly, as companies give up billions in future revenue from selling synthetic crude. The following analysis from Scotia Capital Inc. of four theoretical projects of 100,000 barrels of daily production shows the numbers behind those billion-dollar decisions - and why some companies might be better off by staying out of the upgrader game.
A: A costly start
Initial investment costs, or capital per flowing barrel, are much higher for projects that include upgraders, with the spread widest for SAGD* projects ($/barrel)
$55,000 UPGRADED MINING
$23,000 NON-UPGRADED MINING
$47,000 UPGRADED SAGD*
$15,000 NON-UPGRADED SAGD*
B: A richer barrel
But that spending results in a much higher selling price per barrel - more than twice as much - in a world in which the Canadian dollar trades for 75¢ U.S. and oil costs $42 a barrel
$54.23 UPGRADED MINING
$25.07 NON-UPGRADED MINING
$54.23 UPGRADED SAGD*
$25.07 NON-UPGRADED SAGD*
C: Plump profits
And the operating margin spread for projects with upgraders is even greater, three times as much as for those without
$33.14 UPGRADED MINING
$10.36 NON-UPGRADED MINING
$35.17 UPGRADED SAGD*
$12.39 NON-UPGRADED SAGD*
D: Balanced returns
But for the investment criterion that companies use, their internal rate of return, the picture is much more balanced, as the current cost of investment offsets the future benefit of added revenue and profits
17.4% UPGRADED MINING
16.2% NON-UPGRADED MINING
17.0% UPGRADED SAGD*
19.9% NON-UPGRADED SAGD*
Fort McMurray
To date, most upgraders have been built in Fort McMurray,
in the heart of the oil sands sector. Companies with facilities built or under construction
here include: Suncor Energy Inc., Syncrude Canada Ltd., Canadian Natural Resources Ltd., and Nexen Inc. with
OPTI Canada Inc.
Edmonton/Sturgeon County
The industrial lands of Sturgeon County are emerging as the next investment hot spot for the oil sands, with nearby Edmonton offering access to a larger work force. Companies that have built or are looking at building
in this area include:
Petro-Canada, Synenco Energy Inc., Shell Canada Ltd., BA Energy Inc., North West Upgrading Inc., and Total SA
Lloydminster
Husky Energy Inc. is contemplating an expansion of its Lloydminster upgrader, saying it could benefit from by adding capacity outside of Fort McMurray.
United States
Some companies are looking at striking partnerships with U.S. firms, including existing refiners, to build upgrading capacity south of the border. On the hunt: Husky
and EnCana Corp.
*SAGD is steam-assisted gravity drainage, in which bitumen is melted underground and pumped to the surface
SOURCE: SCOTIA CAPITAL INC.
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