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Petro-Canada's operational struggles

Cost inflation in the oil sands and a mixed performance elsewhere are disappointing Petro-Canada's investors. Derek Brower reports

IT HAS BEEN a rough few months for Petro-Canada. In August, a problem at a catalytic converter in the company's Edmonton refinery shut down the unit. The month before, a problem with the water-boiler reduced output. Now the entire 135,000 barrels a day (b/d) plant is out of action, part of a planned C$2bn ($2bn) upgrade. The run on gasoline that followed the refinery glitches lead to outages at 90 filling stations in British Columbia and Alberta, leaving Western Canadians peeved.

But then Petro-Canada has always been the fall guy of the country's energy sector. When the government of prime minister Pierre Trudeau created Petro-Canada as a national oil company to capitalise on Alberta's riches, the province's public was unconvinced. The firm's name was soon broken down to Pierre Elliott Trudeau Rips Off Canada. By 2004, Petro-Canada had been privatised.

Shareholders losing faith

Now it is the shareholders who are losing faith in the company. Last month, Petro-Canada's problems grew much bigger than a refinery outage during the Canadian driving season. The projected costs of its Fort Hills development in the oil sands, the company said, would rise from C$14.1bn to about C$24bn. The 70% cost increase at the oil sands' most important greenfield development rocked the industry.

Forget the oil-sands' environmental problems, Petro-Canada's thunderbolt announcement raised yet more questions about the financial viability of the projects, just as oil prices began their retreat. The firm's share price, which has been sliding since mid-summer, took another dive. So did the stock of its Fort Hills partners, UTS Energy and Teck Cominco, which each hold 20% of the partnership.

The company blames the usual culprits for the cost overrun: construction materials, labour, project management and engineering. But that does not convince everyone. "Costs have gone up in the industry, that's true," says one analyst, "but not by 70%."

Yet there are some reasons for the firm to be cheerful. Petro-Canada's strong cash-flow, from assets in eastern Canada, the UK's North Sea Buzzard field and elsewhere, should allow the project to go ahead, despite the bulging price. And its ambitious plans for Fort Hills, which envisaged some 140,000 b/d of synthetic output by 2011 and 280,000 b/d by 2015, give the company some wiggle room.

Most likely is that the start-up will be a year later and initial production slightly lower, suggests Terry Peters, an analyst at Canaccord Capital. Petro-Canada may even decide to bring one train of production on stream at a time, which should also help it cope with some of the labour shortage. So will an agreement the company has from the federal government, which allows it – and, so far, none of its oil-sands rivals – to use foreign workers for 100% of its labour force.

Peters also says the cost estimate could yet be revised downwards: the latest one was based on preliminary front-end engineering and design work that was carried out last year. So any softening of international commodity prices could drag costs down.

But weaker oil prices would also negatively affect Petro-Canada's other oil-sands businesses and cash flow. Peters suggests a price of $70-80 a barrel is the likely threshold for the company's tar business. Besides Fort Hills, the company owns 12% of Syncrude, the largest oil-sands developer, and 100% of the MacKay in situ project, where production is 30,000 b/d.

While costs rise, Petro-Canada, like the other oil-sands developers, also faces a green threat. Public opinion in the country is increasingly worried about the development's environmental impact (see p2). New environmental legislation will likely include charges for carbon emissions. "Costs [of carbon] could be anywhere from $15 a tonne to $100/t," says Peters. Petro-Canada says it is pursuing carbon capture and storage as part of its response and has done its own inventories of greenhouse-gas emissions from its operations in northern Alberta. Analysts say it has priced carbon into its cost estimates. "It's as least as green as anyone else in the sands," says one.

Mixed international success

While its downstream position in Canada – where Petro-Canada operates two refineries, supplying 13% of the market – is relatively small, the company has sought a wider international upstream presence, with mixed success. The declining Buzzard field, where it holds a 29.9% stake, yielded 71,000 barrels of oil equivalent a day last year. And profits from gas properties in the US suffered during 2007 because of lower prices. It plans to drill more wells there – part of a total capital expenditure budget of C$5.3bn for 2008 that is 28% higher than last year – but is only targeting reserves replacement of 50-60%.

Its position in Libya, acquired when it bought Veba Oil in 2002, may be more promising. A 49% stake in Harouge Oil Operations, a joint venture with Libya's National Oil Corporation (NOC), gives it a host of exploration assets in the prospective Sirte basin. Producing assets give Petro-Canada about 50,000 b/d net from the country. More important was a 30-year, $7bn agreement signed with NOC last year: the firm says its output in Libya should double in the next five to seven years. Meanwhile, first gas from its 100% owned, Syrian onshore Ebla gas project, should yield 80m cubic feet a day by 2010, and the company says "there is significant upside".

Along with its oil-sands position, the assets could make Petro-Canada a juicy take-over target. But that prospect could depend on the outcome of this month's election in Canada. Despite the state selling its remaining 19% holding in the company in 2004, Canadian laws still stipulate that no foreign shareholder may own more than a 25% stake.

That effectively leaves Petro-Canada with a poisoned pill, says one analyst. It also makes it more expensive for the company to raise capital and prevents a market valuation that would reflect the possibility of a take over. If prime minister Stephen Harper's Conservative government is returned to power this month with a parliamentary majority – as polls suggest it will be – that law could be repealed.

Even so, says Mark Gilman, an analyst at Benchmark, a broker dealer, other problems are the true source of Petro-Canada's weak share performance. "I've got real questions about whether its asset base has any upside," says Gilman. The Veba acquisition gave Petro-Canada a solid platform for international growth that it has failed to capitalise on, he says. "I don't consider what they've done in Syria and Libya to be a satisfactory outcome."

More worrying, however, remain what Gilman says are Petro-Canada's "significant execution issues". Fort Hills may be the most recent example, but the firm was also bruised by a proposed liquefied natural gas (LNG) agreement with Russia's Gazprom. Petro-Canada wanted to bring LNG from a Russian plant to a terminal in Gros Cacouna, Quebec. After years of negotiations, the deal was abandoned last year, much to Petro-Canada's disappointment. "They thought they brought something to the table with Gazprom," says Gilman. "It was an embarrassment."

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