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Bullish or bearish on Canada's oil sands?

International oil companies are fleeing the oil sands, but the Canadian producers that have plugged the gap have reason to be optimistic

For more than 130 years, sentiment around Canada's oil sands has swung erratically between exuberance and disregard. Just a decade ago, the oil sands was the darling of global investors, supermajors, and national oil companies. A flood of investment lifted output by roughly 2m barrels a day during the 2000-15 boom, with production to surpass 3m b/d in the next few months. A few early movers reaped handsome returns; Canadian Natural Resources (CNRL) and Suncor share prices, for example, each appreciated more than 400% from 2001-06.

However, the frenzied expansion soon became a threat to further growth. Infrastructure bottlenecks threatened to trap production in Alberta, environmental opposition mounted, and exorbitant rent seeking throughout the value chain all hit the economics of producing in the oil sands and sentiments around the region's future. Though many of these headwinds were in full effect by 2008, production growth continued inexorably until 2015.

More recently, the price crash has seen an exodus of international oil companies. ConocoPhillips, Shell, Statoil and Total have all made headline-grabbing deals to sell off major chinks of their oil sands businesses. This has contributed to a sense that the oil sands are in decline. In reality, these majors are leaving more to sure up their balance sheets, cut debt, free up cash to invest elsewhere, and to blunt environmental criticism, rather than as a complete shunning of the oil sands. Most of those that have sold assets have retained some material foothold.

The less covered side of the story is the resulting consolidation of production among the acquisitive Canadian mainstay operators who aim to drive down costs through scale and focus. Their bet: this isn't the end of growth for the oil sands and sentiment will swing back into its favour as it has done time and again in the past.

There are sound reasons for this optimism. Some remarkable trends are happening on the ground in Northern Alberta that point to continued, if subdued, growth over the next decade, irrespective of the vicissitudes of crude price.

Technology boost

On the technology front, oil sands innovations have overcome seemingly intractable commercial realities before and could very well again. Remember that steam-assisted gravity drainage (SAGD) technology revolutionised oil sands production, but required persistent development and shepherding from oil sands pioneer Robert Butler at ExxonMobil-owned Imperial Oil. Decades passed from Butler's original technical concept in 1969, to the granting of the first commercial patent in 1982, to government-supported pilot testing throughout the 1980s, to an appropriate fiscal regime and the first (small-scale) commercial operation in 1996, at Cenovus' Foster Creek.

Despite costly barriers, a new wave of breakthrough oil sands technologies are now nearing commercial viability. Direct Contact Steam Generation, like other steam technologies, could eliminate the vast majority of greenhouse gas emissions from the SAGD process by trapping carbon dioxide. At the same time, promising upgrading technologies could alleviate bottlenecked pipelines and lower the stubborn transportation and crude quality discounts that suppress oil sands prices. The addition of solvents to the SAGD process, eventually even obviating the need for steam, has produced enticing economic results in pilots and will soon be commercial.

Operating, sustaining, and new-build capital costs are also falling faster than most analysts foresaw. SAGD projects that in 2014 required a WTI price of $80-90 per barrel to be profitable are being revamped, and now might need only $50-60/b oil and even less as new technologies become commercial.

On the regulatory front, progressive environmental laws are often bemoaned by the industry. But there is a flip side in that tighter carbon regulations could help repair the oil sands' toxic environmental reputation. Alberta's 'Climate Leadership Plan' is one of the most potent climate policies directed at the hydrocarbon sector anywhere in the world. Some feel this shift helped engender the approval of Kinder Morgan's Trans Mountain Expansion project, adding 0.59m b/d of egress capacity to Asia, ostensibly by 2019. The surprise election of Donald Trump has given a hitherto unthinkable optimism to the high-profile 0.83m b/d Keystone XL pipeline to the US. Both pipelines could propel oil sands growth, though still face formidable hurdles to construction, and may succumb to similar dead-ends as the highly-politicised Northern Gateway (Enbridge) and recently shelved Energy East (TransCanada) projects.

Output optimism

The inertia of oil sands development is probably the most salient, underappreciated driver of the growth outlook. Even with the price rout, oil sands production is forecast to grow by 45% between 2014 and 2020, having already increased by 30% through 2017.

Price elasticity is only really relevant over the long-term. Whether mined at the surface or produced from the subsurface (called 'in-situ'), oil sands production is far more like manufacturing than other oil provinces. And because operating a capital-intensive manufacturing plant below full utilisation hampers economics, and production operations are prodigiously costly to shut-down, producers are unlikely to shut-in even at prices below the 2016 nadir. Save for improbable, temporary events like the 2016 Fort McMurray wildfire, overall oil sands production effectively does not declinecapacity tends to accumulate like a snowball rolling down a hill.

Oil sands production responds at a snail's pace compared to its high-declining counterpart south of the border: US light tight oil (LTO). Inexorable ongoing production and long construction lead-times for new production, means the oil sands will neither curtail production to contribute to a global rebalancing (like Opec and LTO), nor rapidly boost it within months to keep an oil price spike in check (like LTO).

One might then be understandably bearish or bullish, depending on perspective. The international energy community, including the major IOCs and foreign national oil companies, exhibits bearish behaviour as they struggle to contain costs with their ventures and crude prices remain around $50. Conversely, Canadian-based oil sands bedrock producers like Suncor, Cenovus, CNRL, and Imperial Oil are, at least to some extent, doubling-down, betting that their cumulative years of experience pioneering and developing oil sands manufacturing, as well as their recently acquired increased scale, will help them compete with other global crude producers.

This latter approach proved successful in the late 1990s and early 2000s, when they developed technologies and expanded production rather impressively amid low oil prices, before the rest of the world rushed in and costs skyrocketed. Such countercyclical investments, though difficult to stomach at the time, have historically proven fruitful, especially since oil sands projects show little to no decline and the reserves are practically inexhaustible, unlike their short-cycle LTO capital competitor and equally capital-intensive, long-cycle deep-water plays.

The more bullish proclaim that the oil sands are primed to deliver the scale of technical improvements seen in the Permian Basin and other US shale plays, citing recent and impressive innovation and cost-cutting efforts among the remaining Canadian producers. However, although oil-sands producers are indeed becoming more efficient, the direct comparison to LTO players is misguided and unnecessary. These two sources of crude are dichotomous, with fundamentally different geology, operations, and lifecycles. They produce grades of crude at opposite ends of the API spectrum and therefore do not compete with each other at the refinery gate. They are also governed by antithetical investor typesa rapid growth, leveraged focus versus a preference for long-term cash flows and dividends.

Falling costs, streamlined designs and operations, labour and supplier availability, technological improvements, environmental impact reduction, low declining assets, and (eventually) new exit pipeline capacity, all point toward some level of continued growth in the oil sands. Research groups are estimating production of roughly 3.1m b/d to 3.3m b/d by 2020, with a projected increment of 1m b/d to 2m b/d from 2020 to 2030. More bullish scenarios forecast as much as 3m b/d of incremental growth.

Prognostications aside, what is most vital for sizeable oil sands growth, is that the cornerstone Canadian-based producers demonstrate success in driving down full-cycle costs through a combination of technology and productivity, even beyond what has been already accomplished; and, of course, that the global oil price remains relatively robust.

Peter Findlay is a Vice President in the PwC Deals Practice in Calgary, and a Research Associate with the Oxford Institute for Energy Studies

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