Petro-Canada (PCZ)

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Digging into Canada's Oil Sands
March 27, 2007 | By Eugene Bukoveczky

Long touted as the only secure major source of oil for U.S. consumers, the vast Canadian oil sands deposits in the province of Alberta have attracted a huge wave of investment by companies keen to convert the gooey sludge into top grade crude.


On top of the billions that have already gone into creating the mines and processing infrastructure that is currently responsible for more than one million barrels a day of output, another $100 billion in construction spending is either underway or planned over the next ten years to triple production.

Lower Returns on the Horizon
But this next wave of investment could yield significantly lower rates of return than have been realized to date. While the rise in oil prices over the last few years has done much to cement the fundamental economic viability of the business, there are a number of costs that oil sands producers have managed to avoid to date that are now expected to begin hitting the bottom line in the near future.

Operators like Suncor (NYSE: SU), PetroCanada (NYSE: PCZ), Nexen (NYSE: NXY), Canadian Natural Resources (NYSE: CNQ) and Encana (NYSE: ECA) all stand to take a hit once these charges take hold.

Environmental Charges Could Hurt Operating Profits
With its vast arctic regions, Canada is on the front line of the battle against global warming and the environmental agenda has come to the forefront of policy making on the part of Canada's ruling Conservatives.

One obvious target for any government action to reduce greenhouse gas emissions is the oil sands. They are by far the largest sources of emissions in the country due in part to the vast quantities of natural gas that are burned to produce the hot water that separates the oil from the sand in the production process.

Right now, both the federal and provincial governments are busy drafting industry limits on carbon dioxide. The Alberta government has started asking producers to either cut their emissions per barrel of oil produced by 12 percent or pay into a fund. While this would add about $0.25/bbl to the average $20/bbl direct operating costs, the yet to be disclosed federal government plan is expected to be considerably more burdensome -- possibly adding as much as $2 per barrel to costs.

Royalty Costs Set to Jump Dramatically
The royalty tax break that oil sands producers have been getting could also be set to end. The Alberta government launching a study last month to examine raising the preferential 1% royalty rate that has remained unchanged since the late 1990s. At the time, the low rate was justified as a incentive to kick-start the industry. That rate could now increase to 5%.

Construction and Operating Costs Going Higher
Last July, Shell Canada (TSX: C.SHC) shocked investors when it announced that the cost of expanding its oil sands plant would be 50% higher than expected. This is probably just the tip of the iceberg for the industry. Tight labor markets and construction material shortages are expected to only get worse as the construction cycle moves into high gear over the next five years. Labor costs could go up as much as 20%.

The industry also took a hit in the recent Canadian budget when the federal government announced that they would be would phase out the accelerated write-offs of major equipment. This will also reduce reportable income in future years.


Recent Price Rise Could be a Selling Opportunity
With the recent run-up in the price of crude having provided a nice boost to the shares of the oil sands operators, this might not be a bad time to consider lightening up on your holdings if you're long any of these companies.

If you're a long term bullish on the oil sands (and there's plenty of reasons to be) you might just want to step back from the group at this juncture as the roll-out of adverse news over the next few months might allow for the establishment of better entry points in the future.