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FT.comCanadian oil sands

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rossi   Friday, 05/18/07 06:52:45 AM
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FT.com
Canadian oil sands
Thursday May 17, 6:25 am ET

Canada, sitting on a potential 315bn barrels of recoverable oil, offers a tantalising prospect: a Middle East-sized prize in a reassuringly dull environment. There is just one problem. Canada's peculiar geology means much of its oil is mixed in with sand. These oil sands have to be either mined or heated deep underground to force the oil up to the surface ("in-situ" drilling). The viscous tar that results then has to be processed so that it can be refined.

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That makes oil sands expensive. Citigroup (NYSE:C) reckons they only make sense in a world with long-term crude oil prices of more than $40 a barrel. Fortunately for fans of sands, few expect oil to drop to that level anytime soon. The size of the resources potentially on offer means that, although upfront capital expenditure is huge, output - and hence cashflows - should be steady and long-lasting.

The initial investment phase is, therefore, critical. There are two concerns right now. First, cost inflation, a scourge of oil industry profits the world over. Second, uncertainty over the fiscal regime. Canada charges a royalty of just 1 per cent on oil sands revenues until capex has been recouped, but that is under review. Were it brought into line with the standard rate of 25 per cent, smaller, early-stage projects would be hit hard.

Valuations in the oil sands sub-sector have risen on the back of recent acquisitions by Statoil (NYSE:STO) and Royal Dutch Shell. The latter offers diversified exposure: oil sands will account for less than 5 per cent of Shell's oil production by 2010. With pure plays, investors should favour in-situ drillers - typically less capital-intensive than miners in early development, mitigating sensitivity to any change in royalties. Suncor, in particular, is weighted towards in-situ projects and already pays royalties at the full rate on virtually all its existing output. Uncertainty ought, in theory, to delay projects on the drawing board, easing bottlenecks for those already being developed or producing.

Unlike Arabia's deserts, Canada's sands are at least accessible, but investors still need to tread carefully.

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