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Oil sands buffeted by economic headwinds

Cost inflation and falling North American oil prices are threatening oil-sands developments

The recent drop in North American oil prices has pitched Canada’s high-cost oil-sands sector into turmoil. Hundreds of billions of dollars of new capital expansions are under threat, industry analysts warned this week, although government officials downplayed the risk.

According to Ernst & Young (E&Y), the viability of the oil-sands sector is threatened by a combination of micro- and macroeconomic forces, such as labour shortages and rising costs, as well as lower oil prices.

Canada’s oil sands are already some of the world’s most expensive oil reserves to produce and margins have been squeezed by a strengthening Canadian dollar. Producers have struggled to lower costs, but have usually relied on high oil prices to help them move ahead with ambitious capital expansions.

But with North American oil prices down by about 25% since May and the threat of a double-dip recession in the US, producers could reconsider new projects worth around C$120 billion ($121 billion) – developments that would have helped double oil-sands production by the end of the decade.

“We’re in an interesting spot right now, with prices hovering around $80-85 a barrel,” Lance Mortlock, the head of E&Y’s energy practice told Petroleum Economist. “If it drops any lower, we may see some projects put on hold ... I think we’re still vulnerable”.

Liepert upbeat

His warning contrasted with comments from Alberta’s energy minister, Ron Liepert, who was in New York this week to reassure the financial community that oil sands are a viable proposition even in the uncertain price environment. "I haven't heard of anybody putting their project on hold," he told reporters. "If you want to put $10 billion into a mine, you probably need an $80/b return."

But Liepert has to put on a brave face. Canada’s oil-sands sector has been forced to retrench before, following successive downturns in the 1980s and 1990s. Each time, the government’s public accounts, which rely heavily on oil revenues, were thrown into disarray, threatening funding for public services such as health care and education. Liepert is relying on oil prices of $85/b to help him cut a yawning budget deficit of about C$1.8 billion this fiscal year.

In fact, much of the C$120 billion in new oil-sands investment is comprised of old proposals shelved in the wake of 2008’s global financial crisis and only recently brought back to the table. But now there’s fear they could be delayed once more.

It’s the effect of the nagging boom and bust mentality that the industry has tried to move away from, with mixed results according to Mortlock. Oil-sands producers have considerably more financial and operational flexibility than they had even a decade ago, but have yet to demonstrate that they can weather big downturns without cutting and running.

While the large, expensive mining projects need $80/b oil to breakeven, thermal in situ projects are a viable proposition at $40, or even $50/b. In situ projects are quicker and cheaper to build compared with a mine, but are comparatively more expensive to sustain once up and running. But it gives large integrated producers the flexibility to reallocate spending between the two forms of production as the market dictates. Mortlock said it’s this decoupling of the value chain that has allowed producers to weather volatile market cycles.

Boom-time concerns

Nonetheless, industry has failed to address issues such as looming labour shortages that inevitably arise when the boom times return. Labour is the largest input cost after materials such as steel and the competition for skilled workers in Alberta’s oilfields is growing, said E&Y. A resurgent unconventional-drilling industry is drawing people away from the mines, reducing the talent pool needed to plan the technically challenging oil-sands projects.

On top of this, Alberta is facing shortages of the unskilled support workers needed to keep it all running smoothly – everything from catering personnel to delivery drivers. Oilfield services companies, drilling operators and engineering outfits also feel the pinch. It has a trickle-down effect that washes through the entire economy. In previous boom times, fast-food restaurants such as McDonald’s couldn’t find enough workers to keep up with the demand for their services.

Macroeconomic realities

And those are just the micro-economic factors. The broader macroeconomic realities are clouded by the prospects of recession in the US and the ongoing Eurozone crisis that threatens to destabilise the global economic recovery. Oil-sands operations are extremely capital intensive and the collapse of the US banking system in 2008 had a profound and immediate impact on project financing. In essence, the money flow dried up, prompting Canada’s two largest oil-sands producers, Petro-Canada and Suncor, to consolidate in what became the largest corporate merger in Canadian history.

A second crisis in Europe could reduce direct foreign investment in a sector that is increasingly international in scope – with China, Japan, the US, France, Norway and even Thailand holding positions in Canada.

That degree of global interdependence underscores a pressing need for Canada to develop global markets for its energy. More than 99% of the country’s oil and gas exports flow to the US, which Mortlock notes is undergoing fundamental long-term restructuring in its own consumption and production patterns, which could reduce the need for Canadian oil.

In addition, delays to approving the proposed Keystone XL to the Gulf of Mexico are raising questions about what to do with a growing glut of Canadian crude. A report by Calgary-based FirstEnergy Capital suggested that 42% of Canada’s exports go to just three refineries in the US Midwest – only 5% of exports made it to the lucrative Gulf coast market in 2010.

“Until Keystone XL, or other alternative pipeline projects to deliver crudes from mid-continent to the Gulf are built, the market for Canadian heavy crudes is anything but diversified, and is essentially captive,” said FirstEnergy analyst Michael Dunn. “While the US is the logical destination for Canadian crudes (it is the world’s largest oil consumer and Canada’s neighbour), diversifying one’s customer base is generally a good thing,” he added.

Missed the boat to China

A second pipeline, Northern Gateway, to the British Columbia (BC) coast would help open markets to Asia, but its volume – 550,000 barrels a day (b/d) – amounts to less than one half of 1% of global demand. Likewise, proposals to export liquefied natural gas (LNG) from BC pale in comparison with the plans of countries such as Australia that are fighting for the same LNG Asian buyers.

“There’s a clear need for a broader market, but it’s a risky strategy. It will be interesting to see if we’ve missed the boat,” Mortlock said.

In the short-term, however, oil sands expansion will continue unabated, regardless of the oil price, with more than 750,000 b/d of new output due on stream in the next five years. Starting with Imperial Oil’s C$10 billion Kearl mine in late 2012, the first 110,000 b/d phase will be boosted to 325,000 b/d; followed by 200,000 b/d from Suncor-Total’s Fort Hills and Joslyn mines in 2016-17. Canadian Natural Resources also aims to triple production from its Horizon project to about 300,000 b/d; on the heels of Shell’s 110,000 b/d Athabasca expansion, which started up this spring.

FirstEnergy forecasts total oil-sands production of 2.6 million b/d by 2015, which would represent an 85% increase from 2010 output of 1.4 million b/d.

Whether those growth rates can be sustained in the face of local and broader economic pressures remains to be seen. If history is any guide, those numbers could prove highly optimistic. In Canada’s oil-sands sector, it seems, the more things change the more they stay the same.

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