The Reckoning
Cooper Langford, Financial Post Business Published: Tuesday, December 04, 2007
"What do you expect from a pig farmer?"
Alberta premier Ed Stelmach had barely finished his brief Oct. 25 televised speech announcing the details of the province's long-awaited new oil and gas royalty regime when the "Sound Off" board at the Calgary Herald website lit up. It was a remarkable moment, not only for the crush of postings, but also for the sheer vitriol. "You've shot Alberta in the foot." "Ed needs to be voted off the island." "This is a black day for Alberta."
The pressure, of course, had been building. In mid-September, a provincial panel that was appointed to make recommendations on overhauling Alberta's royalty system called for a 20% increase in what oil and gas companies should be charged for the right to extract the resources that have made the province Canada's new economic powerhouse. The increase would have amounted to a $2-billion hit annually at current prices, and major energy firms immediately threatened to pull billions of dollars of investment if Stelmach took the advice. Public opinion, meanwhile, was split over whether such changes would punish industry for its success or hand over the province's resource riches on all-too-easy terms.
After several agonizing weeks of consultation and deliberation, Stelmach, an old-school Tory who still lives on the farm his grandparents founded a century ago, opted to split the difference. He announced a plan to hike royalties on a sliding scale tied to energy prices, with the promise of bringing in $1.4 billion in new revenue to the province by 2010. While Stelmach was widely quoted afterward saying his government "got it right," politically it was a no-win decision. As such, the wrath on the Herald website from constituents fearing anything that might slow the pace and profitability of development was a predictable attack.
Lost in the rancour - and in the relentless parsing of revenue figures and royalty percentages that followed - was the fact that Stelmach had effectively marked October 2007 as the official coming of age for the Athabasca oil sands, a resource that today accounts for 50% of the province's petroleum production and, in a few years, will utterly dominate its industry. How so? By including under the new regime oil sands pioneers Syncrude Canada Ltd. and Suncor Inc., which had benefited greatly from special royalty treatment introduced in the 1990s. Incentives were needed a decade ago, when methods were less proven, few players were on the scene and oil prices were low. Amid the hurly-burly of today's oil sands rush - capital investment in 2006 jumped nearly 50%, to $14.3 billion, while industry revenue topped $23 billion - that notion seemed not just costly, but quaint.
By telling the world just how much money his government thinks is a fair return to the province, Stelmach also served notice to everyone with a stake in the oil sands chain - the public, main street investors, labourers, bankers, politicians and multinational oil company CEOs - that the resource does not have an eternal upside. Current estimates peg total reserves at 175 billion barrels of extractable oil, and production volume could increase five-fold by 2020 if all the projects announced or in development come to fruition on schedule. But that doesn't mean there's going to be five times more money for everyone. Growth in the oil sands will be matched by growth in costs, public demands and the number of obstacles that confront oil sands developers.
To some, the latter might seem painfully obvious, but the fact that the reaction to Stelmach's calculus at times bordered on the hysterical is a clear indication that not everyone has caught on. The unfortunate truth is that the global economic boom, which made the oil sands more viable than at any time in history, has at the same time fuelled inflationary pressures that have sent development costs into orbit. Labour shortages in Alberta are reaching crisis levels, while existing pipeline capacity - critical to getting oil sands products to market - is maxing out. The province, meanwhile, has fallen behind as booming growth pushes demand for everything from highways to high schools and health centres ever higher. In the near future, there is also the possibility of tightened environmental regulation, fuelled chiefly by worries about CO2 emissions and climate change, along with fears, rational or otherwise, that the scale of development will scar Alberta massively and irreparably.
What this amounts to, then, is a time of reckoning - not merely for the oil sands, but for everyone and everything with a stake in the outcome. It's a period in which the hype, the dreams and the fears that surround the oil sands are colliding hard with the reality of not only how much development can actually be absorbed, but how much will ultimately be tolerated. "We have a tough transition to manage through," says Eric Newell, an oil sands pioneer and former chief executive of Syncrude, the largest producer in the oil sands. You could frame that thought in blunter terms: The rules of the game have changed. Now deal.
If you could travel back 15 years or so, the oil sands would still look like a problem, but one wholly different from that of today. Back then, the Alberta energy industry was happily on its feet. Oil prices were hovering steadily around $20 a barrel and the memories of the bust that had punished the industry and the province in the 1980s were growing dim.
Up in the "tar sands," as the oil sands were then more widely known, two companies, Suncor and Syncrude, were collectively producing more than of 400,000 barrels per day. It was a time of quiet progress for the resource's true believers, like Newell, then still in the early stages of his 14-year tenure at Syncrude. But it was also a period of frustration. The prospect of mining dirt or injecting steam deep into the ground to extract bitumen, the bottom-of-the-barrel form of crude that's wrung from oil sands ore, had failed to excite the world.
"What was it going to take to get this thing going?" That was the question Newell and his colleagues kept asking themselves. Their solution: a national task force composed of industry and government representatives that would draft a framework to turn the oil sands - as they would rebrand the resource to make it sound more appealing - from an expensive backwater project to a world-class investment opportunity.
The National Oil Sands Task force released its report in 1995, establishing a vision for the future in which daily oil sands production would double, maybe even triple, to between 800,000 and 1.2 million barrels within 25 years. "I used to shake when I had to say that," Newell recalls. "People would look at you like you were smoking something funny."
But however optimistic those projections seemed, the arguments advanced by Newell and his expert group were persuasive. In 1997, the Alberta government, under Premier Ralph Klein, implemented one of their key recommendations: lowering royalties on oil sands projects to 1% of revenue a year until project costs were fully recovered. After that, a royalty of 25% would kick in. While nobody knew it then, Klein had just laid the foundations for what would become the greatest boom story in Canadian history, and the task force leaders who thought of themselves as radicals would soon look like timid conservatives.
Today, there are 19 new projects and expansions underway, with another 30 that have been announced but not started. If they all go ahead as planned and on schedule, daily production will rise from current levels of around 1.1 million barrels to as much as six million barrels by 2020. Resource experts say actual production growth will almost certainly be lower, more like four million barrels daily and possibly less. But even if six million barrels were achievable, there is still enough recoverable oil in the granular muck that lies beneath northeastern Alberta to keep production going for 80 years, using current technology. If technological advances increase the resource, the sands could be going strong well into the next century.
Even given what analysts call "constrained" development projections, the economic impacts are staggering. According to a 2005 study by the Canadian Energy Research Institute (CERI), an independent Calgary-based economics and policy think tank, oil sands development will, by 2020, add almost $800 billion to Canada's gross domestic product, equivalent to about two-thirds of current annual GDP. Total returns to government in royalties and corporate and income taxes will total more than $120 billion, with some $44 billion accruing to Alberta alone. Job creation is measured in the millions of person years.
The investment scenario, meanwhile, presents an intriguing, but more challenging picture. Right now, with demand from China and India driving oil prices close to US$100 per barrel, the opportunity seems limitless. But the oil sands industry is extremely sensitive to oil prices, and most return projections are based on more conservative outlooks. Oil, after all, only broke the US$40 mark three years ago. Less than a decade ago, it was below US$15.
Given that projects can also take 15 to 20 years from the start of construction to hit payout, it makes sense not to be too optimistic. William Lacey, managing director for institutional investment at First Energy Capital Corp. in Calgary, estimates returns at a modest 9%, assuming US$60 oil and a US85¢ dollar. Returns and prices may be higher now, "but what goes up can also come down," he says. "This isn't a business for the faint of heart."
In other words, no matter how big the resource, the oil sands have vulnerabilities and must compete for investment dollars. The advantage is that once projects are paid out - and assuming oil prices remain strong - they will be stable money-spinners for decades.
Inflationary pressures have already been eating away at potential margins. According to a CERI outlook report published in October, operating costs for producers - not including fuel - have essentially doubled since 2005. Total costs of delivering a barrel of tradeable product, either bitumen or upgraded synthetic crude oil, have risen anywhere from 23% to 86%, depending on the individual project.
Beyond that are issues deriving from Alberta's ability to keep pace with development. Its capacity to accommodate further activity is already strained, quite possibly to the breaking point.
At the most fundamental operational level, pipeline capacity is maxing out. The prospect of periods of rationing access is very real over the next few years. But human costs are mounting, too. This past July, five unions representing 25,000 tradesmen cast near-unanimous strike votes, raising the spectre that development could come to a crashing halt. Some of the issues involved the frustration of workers having to travel for hours to reach project sites and then spend days at a time in construction camps. The major point, however, was rampant inflation. At least one union, the International Brotherhood of Electrical Workers, negotiated successfully for minimum increases of more than 20% over the next four years - and more if the consumer price index outpaces wage growth.
Not long after the Klein government brought in its oil sands royalty regime, both Syncrude and Suncor announced major expansions to their operations. It was big news, nowhere more so than in Fort McMurray, the hub of oil sands operations some 400 kilometres northeast of Edmonton. An easygoing suburban rhythm had become part of the life for this growing community, nestled along the banks of the Athabasca River. But memories of the boom periods remained strong, and tales of those crazier times were often told with nostalgic relish. With the Syncrude and Suncor announcements, people knew another one was on the way.
Today, Fort McMurray is at the sharp end of a very large stick. The population, in the mid-30,000s by the late 1990s, has swollen to 60,000. The housing shortage is acute, and services - from schools to roads to water - are stretched beyond their limits. It's a story that has intrigued the national and international media, which has tramped to the city's doorstep to chronicle its challenges. That many of the reports have portrayed the community as a Wild West irks local leaders. So much so that the Wood Buffalo Regional Municipality, the local government for Fort McMurray and smaller communities in the region, has launched a $400,000 image campaign.
Those leaders also know, better than most, what's needed to keep the region from sinking under the weight of prosperity. In 2005, the Wood Buffalo Municipality released a study detailing the precise cost of the infrastructure it needed to keep up with the pace of development. The final tally: $1.2 billion by 2009. The priority list included more than $370 million for rec centres and urgent upgrades to Fort McMurray's water-treatment system and roads, along with $236 million for schools and health facilities.
In February of this year, the provincial government started to play catch up, committing $396 million over the next three years to infrastructure spending, including more than $200 million for new schools and $100 million for new sewage and waste-water treatment plants. But even with new money flowing to the community, the costs of what it takes to keep up have increased.
"Numbers never stand," says Melissa Blake, a former Syncrude employee who recently won a second term as Wood Buffalo's mayor. "The needs have advanced." Her most pressing concern now? The province must speed up the release of lands that the municipality can zone for housing a population now expected to reach 80,000, maybe more, by 2010. "Everything comes back to land," Blake says. "Once you get yourself a place, you have a world of opportunity."
If Fort McMurray were the province's only problem, coping with the pace of oil sands development might be easier to handle. As the Wood Buffalo costs study argued, after all, meeting costs today would enable orderly development, an investment that would produce multi-billion-dollar returns in royalties and taxes.
But Fort McMurray is only the epicentre for issues that are rattling both government and industry province-wide. The biggest one of all: the environment, a challenge with national ramifications. The issues are complex and widespread, ranging from land reclamation, management of tailings ponds and water withdrawal from the Athabasca River, which critics fear will put habitat at risk, particularly during the low-flow winter season.
Over the past few months, water has come to the forefront, with industry pitting new recycling and reservoir technologies against calls for tighter government regulation and the possibility of requiring companies to pay for usage. But the concern likely to stir the greatest controversy, particularly at the national level, is greenhouse gas emissions.
Evidence of that was abundantly clear a few weeks ago when Peter Lougheed, who presided over Alberta as premier during the oil boom in the 1970s and the subsequent bust in the 1980s, delivered a speech saying the debate for greenhouse gas reduction could lead to a constitutional crisis if federal rules ever start putting limits on provincially regulated industries like the oil sands.
That such comments would come from a politician like Lougheed - once known as the 'blue-eyed sheik' of Alberta - speaks to how deeply climate-change concerns have seeped into public debate. "We're approaching a tipping point in public opinion," says Dan Woynillowicz, an oil sands policy analyst with the Pembina Institute, an Alberta-based sustainable energy research and consulting organization.
That's a worrying prospect from a development perspective, one that's already had measurable impact on oil sands development. This past March, for example, Canadian Natural Resources shelved plans for a multi-billion dollar upgrading project, citing, among its reasons, uncertainty over federal environmental policy. Obviously, Canadian Natural, or any other oil sands player, is not looking for a licence to pollute with abandon. But this example is a clear indicator of how the risk of regulatory change adds new layers of cost insecurity to an industry struggling with budgets.
With expectations that environmental frameworks will change - and a longer view towards industry sustainability - oil sands developers have succeeded in recent years in reducing the volume of greenhouse gas emissions per barrel of oil. Those efficiencies, however, pale in comparison to net emissions increases. Oil sands companies are already the fastest-growing greenhouse gas emitters in Canada, and some observers forecast that total emissions will increase to 100 megatonnes a year by 2020, up from 40 megatonnes today.
Still, the outlook is not desperately gloomy. In a 2006 report, for instance, the Pembina Institute argued that the oil sands could achieve carbon neutrality within 15 years - using mechanisms ranging from offset purchases to carbon capture and sequestration programs - at costs ranging from about $2 to $13 per barrel, depending on the specifics of individual projects.
New technology, meanwhile, holds out more hope. One of the most promising is a technique known as "gasification." The process involves using so-called low-value fuels, such as coal or biomass, which are broken down in a pressure chamber, without combusting. This releases assorted gases, including carbon dioxide, that can be used to power various components of the oil production process, and produces heat, which can be used to generate steam that is injected into the ground to make bitumen viscous for extraction.
The primary goal of gasification in oil sands production is to decrease the burning of natural gas to power operations, thus reducing a major cost. But because its reactions don't involve combustion, it also makes it easier - and cheaper - to capture carbon dioxide for sequestration. The first oil sands application of gasification technology is now being developed at a two-billion barrel joint-venture project by Nexen Inc. and Opti Canada Inc. called Long Lake, about 40 kilometres south of Fort McMurray. Progress, however, has been slower than projected. Due to labour shortages, Long Lake's expected start date in 2008 has been pushed back by at least six months, maybe a year. Development costs, meanwhile, have spiralled to about $6 billion from initial estimates of $3.4 billion.
So what should we expect to see going forward? More than anything, that depends on the price of oil. For the sake of argument, imagine you have a barrel of oil that you had upgraded to synthetic crude from bitumen and were ready to take to market. According to an October report from CERI - the total operating and capital costs of getting that theoretical barrel to market would be more than $60 under today's conditions, including a 15% return. Given the high level of current oil prices, the additional margins on the sale of that barrel would look pretty good - even when you allow for the fact that oil sands crude trades at a discount to benchmark products of higher grades. The problem is that there's no guarantee oil prices will remain this high. And even if they do, given the rate at which supply costs are increasing, that headroom could start to narrow quickly.
At the third OPEC summit in November, Ali al-Naimi, Saudi Arabia's influential oil minister, cited $60 as a likely long-term benchmark for world prices - precisely because it reflects, in his view, a threshold at which oil sands oil can be worked profitably.
To many in Alberta, hitting that level might be a good thing. At current prices, producers can't get going fast enough. And as we've seen, that crushing demand is pushing up costs across the board. Lower the incentive, and perhaps you moderate the pace of development. (Just don't lower it too much.) The worst case, as far as industry is concerned, would be for government to step in with measures aimed at slowing down development, to keep costs and liabilities contained. In its view, the government's job is to deal with infrastructure and the regulatory environment and let market forces take care of the rest. "Some people think you can sit at a desk, twiddle a few knobs and come up with a perfect rate of development," Newell says. "I don't think you can do that by artificial means." Pierre Alvarez, president of the Canadian Association of Petroleum Producers, agrees. "Markets are much better than government in deciding the nature and pace of development."
In a worst-case scenario, mounting pressures could yet turn the oil sands boom into a bust. That's extremely unlikely, but if it happens, then all bets are off. The 1980s meltdown in Alberta's energy sector - which many blamed on Pierre Trudeau's National Energy Program - altered the balance of power in the country. Resentment over the NEP and other federal policies stoked the fires of "western alienation." That led to the growth of the Reform Party and, after its merger with the Progressive Conservatives, Stephen Harper's election as Prime Minister.
Today's most likely outcome? That industry's appetite for further investment and development in the oil sands will ease off as the realities of cost, timelines and returns sink in. As an indication of that prospect, in a mid-November report, the National Energy Board lowered its estimates for oil sands production to about 2.8 million barrels a day, from three million, by 2015. A trend towards restraint is also evident in the stock charts of major players such as Suncor, Nexen and Canadian Natural Resources. All follow a similar pattern, rising rapidly in early 2006, only to peak and then retreat. Stelmach's October announcement was among the latest events to spark a brief pullback. Whatever else is in store, it's safe to say that it won't be the last.
