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Caught in numbers crunch Playing in the oil sands is a ‘big boy’s game’ as production costs exceed the oil price for smaller companies at US$40 per barrel Gary Park For Petroleum News Shifting sands
The oil sands of Alberta are living proof of the old adage: The bigger they are the harder they fall. Even faster than they grew from a marginal resource to a key element in North America’s energy future, attracting capital spending estimates of C$317 billion over the next 22 years, the oil sands have gone into a tailspin, induced by the collapse of oil prices that did more damage in a few months than years of cost overruns, shortages of construction labor and materials and the threat of harsh climate-change measures. Petroleum News’ Canadian correspondent Gary Park examines the fallout from a drastically revised oil sands agenda and the chances of a recovery in a two-part series. The economics of operating in the oil sands these days can be described in one word: They stink.
Producers of heavy oil, which accounts for 38 percent or 1.05 million barrels per day of Canada’s total oil output (nearly 570,000 bpd from the oil sands and the rest conventionally produced) and all of which trades at a discount to light crudes, have watched their returns nosedive as benchmark crude has declined by more than US$100 per barrel since the summer peak.
Menno Hulshof, an analyst at Dundee Securities, said a prolonged period when the differentials between light and heavy oil remain wide will force companies to make tough decisions.
Oil sands startup Connacher Oil and Gas has already moved in that direction, cutting back production at its Great Divided project to 5,000 bpd from an anticipated 10,000 bpd entering 2009.
For Connacher, the total cost of production, including royalties, is estimated at north of US$50 per barrel.
The message is clear. The cost of staying in business is exceeding the price of oil for smaller operators.
Martin Molyneaux, an analyst at FirstEnergy Capital, said that although the industry is on a knife edge, when oil hits US$40 per barrel and bitumen prices are struggling to hold their own at US$20 “heavy oil becomes a big boy’s game.”
Merrill Lynch analysts have already warned that oil prices below US$38 per barrel could force the shut-in of 800,000 bpd of Canadian production, followed by another 800,000 bpd if prices drop below US$30.
What will emerge from rubble? The debate taking place in oil sands circles these days is what will emerge from the rubble once oil prices regain some equilibrium and who will survive and what it will mean for Canada’s energy self-sufficiency.
The answer could be unpleasant for the opposition parties in the Canadian Parliament — notably the leftist New Democratic Party, whose leader Jack Layton once called for a moratorium on new oil sands development.
A study by the Canadian Energy Research Institute on the economics of oil sands development was released in early November, before the major wave of corporate pullbacks.
It suggested that several years of rising costs coupled with the credit crunch would result in a more gradual and phased approach to oil sands development once costs stabilize.
The study projected investment of C$317 billion over the next 22 years, boosting gross crude bitumen output to 5 million bpd (4.5 million bpd of marketable product), with about 3.6 million bpd of marketable bitumen upgraded to synthetic crude, which can then be refined into gasoline and jet fuel.
C$101 sustained WTI needed CERI said a sustained West Texas Intermediate price of C$101 per barrel over the next 30 years would be needed to maintain a 10 percent return for a new integrated (mining, extraction and upgrading) project with a 2011 startup.
A new in-situ project, using either steam-assisted gravity drainage or cyclic steam stimulation, would need a sustained price of C$80 per barrel.
Based on an average of announced projects, the report pegged the initial capital outlay for a 100,000 bpd integrated project at more than C$140,000 per barrel of synthetic crude (some estimates put Petro-Canada’s stalled Fort Hills project above C$170,000). That assumes an initial startup cost of C$90,000 per barrel for a stand-alone mine producing 100,000 bpd and a price tag of C$58,000 per barrel of synthetic crude for a standalone upgrader.
A 30,000 bpd in-situ steam-assisted gravity drainage project comes in at the bottom end of the price scale at just over C$28,000 per barrel, while the same-sized cyclic steam stimulation project was estimated by the CERI study to cost C$35,000 per barrel.
CERI said that while the current economic slowdown and commodity price slump might help some projects in the early stages of sourcing their construction materials, it believes its cost estimates represent a “reasonable average” of higher and lower cost projects.
Operating costs could drop Those looking for other more positive signs might draw some hope from CERI’s observation that a “continued global economic downturn could help push operating costs lower than they are today.”
Otherwise, labor costs are not likely to experience an early fall, but equipment costs could ease as work opportunities fade for engineering, procurement and construction firms.
The CERI estimates factor in Alberta’s new royalty rates, which are calculated at 6.6 percent before capital costs are paid off — a phase that CERI estimates takes about eight years — and 35.62 percent post-payout.
The model also includes greenhouse gas emissions costs of C$15 per metric ton for projects producing more than 100,000 metric tons per year of carbon dioxide.
Analysts believe the credit crisis will pose a severe challenge for companies trying to raise investment capital to keep announced oil sands projects on track over the next decade, even if capital costs for mining projects in production and for proposed mining projects and upgraders are slashed.
What would restore cuts? The central question is what would bring about the restoration of cuts already made.
Wilf Gobert, a highly respected independent analyst, wrote in the Calgary Herald that the answer varies widely across the spectrum.
“Existing mining projects have lower invested capital and efficiency gains from incremental expansion,” he said.
“While breakeven cash costs may be US$40 per barrel, required rate of return for expansions may be US$75 per barrel and a grassroots mining project may require up to US$100 per barrel.
“On the other hand, in-situ production, which uses wells to pump bitumen to the surface, has much lower capital costs than mining projects, so many projects might proceed with less than US$50 prices.
“The major problem for the future of all new oil sands projects is bitumen upgrading to light quality crude oil,” with the cost of upgraders in Alberta having exploded over the years to a factor of two-to-four times the cost five years ago, while the cost of construction in the U.S. Gulf Coast region is about half the cost in Alberta, Gobert said.
To those who welcome the cooling off of oil sands expansion, he warned the recovery could also be slow, needing a sustained recovery of crude prices and a significant deflation in the cost of facilities and labor.
Advocate of early rebound The chances of an early rebound in crude prices have at least one major advocate.
Fatih Birol, chief economist at the International Energy Agency, said Dec. 29 that a return to US$100 is possible between 2010 and 2015 if the world economy gets back on track.
He bases that forecast on a “serious supply-demand problem” emerging in 2010 and the shift from an energy market dominated by multinational companies to a market ruled by state-owned companies, predicting that national companies could control 80 percent of the increase in oil and gas production by 2030.
Jim Carter, president of Syncrude Canada until he retired in mid-2007, sees two possible developments for the oil sands: A break from a frenetic rate of growth could be an opportunity to bring inflation under control, reduce overheated expectations and integrate technologies to improve environmental performance, and stalled development.
He said a National Oil Sands task Force in the mid-1990s resulted in improved fiscal terms and “set the table for success.”
“We began to see the investment happening,” Carter said. “It made believers even out of those who might not have been.”
But “sometimes things are taken for granted after they have been so strong for so long,” he told the Financial Post. “We need to remember that (oil sands production) is expensive oil.”
How resilient the sector is will become apparent as it grapples with its sternest test yet.
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