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Canadian Natural Resources Limited. (NYSE:CNQ)

Q3 FY08 Earnings Call

November 6, 2008, 9:00 AM ET

Executives

John G. Langille - Vice-Chairman

Allan P. Markin - Chairman

Steve W. Laut - President and COO

Réal J.H. Doucet - Senior Vice-President, Oil Sands

Douglas A. Proll - CFO and Senior Vice-President, Finance

Analysts

Ryan Todd - Deutsche Bank

Andrew Fairbanks - Merrill Lynch

Brian Dutton - Credit Suisse

Amir Arif - FBR Capital Markets

Martin Molyneaux - FirstEnergy Capital

Gordon Gee - RBC Capital Markets

Operator

Good morning, ladies and gentlemen. Welcome to the Canadian Natural Resources' Third Quarter 2008 Conference Call.

I would now like to turn the meeting over to Mr. John Langille, Vice Chairman of Canadian Natural Resources. Please go ahead, Mr. Langille.

John G. Langille - Vice-Chairman

Thank you, operator and good morning, everyone. Thank you for attending this conference call. We will discuss our third quarter results. The progress on completion of our Horizon Project and our budget for the year 2009. This topics will covered in three separate press releases issued today. I'd also refer you to slides posted on our website, which we will be referring to in this call.

Participating with me today are; Allan Markin, our Chairman; Steve Laut, our President and Chief Operating Officer; Réal Doucet, our Senior Vice-President of Oil Sand; Doug Proll, our Senior Vice-President of Finance.

Before we start, I would like to refer you to the comments regarding forward-looking information contained in our press releases and also note that all dollar amounts are in Canadian dollars and production and reserves are both expressed as before royalties unless otherwise stated.

I would like to make a couple of initial comments, before I turn the call over to other participants. Firstly, our third quarter operating results were excellent with production volumes meeting or exceeding our targeted guidance levels. This contributed to us achieving a very strong cash flow from operations of $1.8 billion, which was well in excess of our CapEx requirements. The company's ongoing growth in earnings has further resulted in a much stronger balance sheet.

However, the business world is going through some unprecedented times and events with all of those events as a backdrop, we have adopted a budget for 2009 that will service very well. You will see this morning the flexibility we have to ensure matching of cash flows with necessary CapEx requirements and our ability to remain nimble and changing times.

As importantly, we know how to be a low cost producer. This has been a major prank in our strategy for many, many years. This means been low costs in all aspects from finding costs to operating cost to administrative costs and finally to financing costs. This measure will service very, very well over the next year.

With that Allen, would you like to make a couple of comments?

Allan P. Markin - Chairman

Yes, thank you. Good morning everyone. Canadian Natural's third quarter results and our 2009 budget reflect our continued drive towards developing our low risk, exploitation and exploration based assets, while creating value for our shareholders. They also are an example of how our fundamental approach to business through this well in both good times and bad.

One of our greatest strengths is the company is our flexibility, and in light a recent times flexibility has become even more important. The key focus has always is to create value and again our project portfolio for this flexibility to allocate our capital towards those areas where we will get the best returns.

Spending where we need to, maintaining balance in our portfolio and low cost has led us to strong quarterly production numbers, and as John mentioned, the strong balance sheet. This base is further build upon in a realistic and very fluid budget and flexible budget for 2009.

Our conventional operations have positioned us well, as we work towards completing our major projects. The Primrose East expansion already onstream in October, Phase I of the Horizon project and our two projects in offshore West Africa, Baobab and Olowi. We look forward to the volumes and the cash flow these projects will provide. Steve will provide further details on this projects along with an outline of the 2009 budget.

Canadian Natural is committed to doing it right together for all stakeholders. We remain active participants in the communities in which we operate to ensure that the way we conduct our business not only maximizes economic returns, but also encourages participation within communities well minimizing the impact on the environment.

We have the land, the people and the balance sheet to excel and take advantage of the current market volatility. We believe that a hearing to our core principals thus results in creating value for our shareholders, with some fun and integrity in these difficult times. Thanks.

Steve W. Laut - President and Chief Operating Officer

Al, thank you, for those comments, and good morning, everyone. Steve Laut here, I will be speaking two slide this morning are available on our website as John mentioned at cnrl.com.

I'll make a few comments on Q3, but spend most of my time on our strategy and the 2009 budget. John and Allan stated our Q3 was a strong quarter, Primrose East came onstream early on budget and now following back 1,100 barrels a day roughly per well right on target.

Our primary heavy oil program continues to deliver creating significant value in this oil price environment. We are also making good progress at Olowi. The CSP deck is just installed and jackup is schedule to complete the tieback of the deck and then start drilling towards the end of November.

At Baobab two wells are completed, the first is going at 2,800 barrels a day, less than expected as the horizontal section is about half the length planned and we are choking the well back as we're being cautious in the early stages of the wells life.

At Horizon, we're making steady progress and we have encountered as you read the press release many challenges associated with commissioning and start up of the more complex components of the plant. With that being said, we expect start up in Q4 '09, but to achieve this we cannot experience any further issues that will cause delay to our schedule, and we'll talk in more detail Réal Doucet will, where we are today at Horizon.

Probably the most important event in Q3 as we all know the world has changed. It has had a broad impact on global economies and creating tremendous volatility. A dramatic drop in oil and gas prices will make a significant impact in the oil and gas industry and a credit crunch will bring its own challenges.

With that in mind, I'm going to turn to our strategy and 2009 budget. As you can see from this slide Canadian Natural's purpose as it should be for every oil and gas company. It creates value for our shareholders on a per share basis through all phases of commodity price cycle.

It's easy to say, but not every company has the ability to deliver. And as this price shows Canadian National has succeeded and will continue to succeed, because we have an effective proven strategy about and strong asset base. Our expertise is broad and deep technically, operationally, and financially. And importantly we deliver disciplined execution.

We are a low cost producer and with high levels of management ownership, we have significant wells at stake and are more clearly aligned with shareholders than any of our peers.

Canadian National has many advantages some of which are the same as why we succeed. Our management business velocity and practice is focused on putting the right people in the right place, and ensures high levels of accountability and is focused on delivery of results. Our assets are strong with vast development, opportunities and upside.

Our strategy as I've said earlier is proven and effective. Importantly, we have control over capital allocation. We are nimble, so we can capture opportunities and we make the hard decisions from which you will see in the 2009 budget.

We have significant free cash flow from our assets, which speaks to the strength of our assets. The Canadian culture although its tough to define is critical to our success as we are a low cost and focus on execution.

Our strategy is shown on the next slide as many of you know its to optimize capital allocation to maximize value. We do this with a defined plan and large inventories of locations and projects in every basin and product we're in.

We are balanced between gas and oil, light, heavy and SCO, near, mid, and long with regards to our methodology to do the drill a bit and acquisitions. And we have a strong balance sheet which has balanced our debt in terms of time and sources of debt.

Opportunistic acquisitions has always been a key part of our strategy and as you'll see and seen many times before that has taken the company to a stronger and higher level.

Controlling cost is the critical plank in our platform. We do that by dominating the area knowledge, infrastructure, and land base in which we operate in core areas. Our strategy reflects Canadian National's belief that ultimately all the assets end up in the hands of the low cost producer and in tough times the low cost producer has the advantage.

Canadian Natural is a low cost producer in terms of F&D costs, operating, G&A, acquisitions, and interest costs. Balance and choice are important part to be successful in a successful execution of our strategy, and it's a key to allocation of capital. We have balanced assets, time lines, and methodology that is soundly back by strong and deep expertise in every area.

We have had great success as you can see in the slide in mature basin game not only in Canada, commercial gas, light and primary heavy oil, but also in the North Sea.

The non-conventional business have created tremendous value for shareholders as we have the expertise to deliver in all these areas including Horizon, our world-class Oil Sands project, our vast thermal heavy oil assets, the hidden gem in our portfolio, offshore West Africa, unconventional gas and deep Foothills gas. All these areas are important points of our growth in value platform.

And to a lesser degree, we are exploration component or exploration driven in a business in offshore West Africa, South Africa and in unconventional gas. Of course, acquisitions have always been an important part of our platform, and we believe that the best exploiters are the best acquirers. Canadian natural utilizes are strong expertise to recognize and capture opportunities. A good example of this would be the 2006 acquisition of Anadarko Canadian core properties. Because we recognize the value in the Deep Basin and out the emerging shale gas price we are able to successfully acquire Anadarko Canada at attractive pricing. Today this acquisition looks very good even in the phase of low gas prices.

In all these components of our platform execution is critical in all areas. With our continued low F&D, operating, and G&A costs it is obvious we execute our base businesses well.

Our major project is shown in the next slide, shows our track record is also good at Espoir, Primose North, Baobab and Primose East. We have been on time and on budget. At Horizon it's been a different story and we are not on time and we are not budget.

Now we have heard from many of you, and I've heard directly from the many of you probably, that are on the phone, that this is understandable considering the highly inflationary environment, the demands for labor, work exceeding construction contractor's capability, etcetera, etcetera, and we have done a good job or better than others.

However, Canadian Natural, Horizon does not meet our criteria for success. We continue to set the bar higher. That being said Horizon was still create tremendous value for all stakeholders and it's a world-class asset.

Our ability to execute and execute to the cycle is shown on slide 15, which shows our quarterly production growth since 1989. The message in the slide is Canadian Natural's ability to add value through each low price cycle.

In 1994, when gas prices dropped 29%, in '98 when oil prices dropped 48%, and 2001 when oil prices dropped 35%. In each and every case Canadian Natural added value and in most cases significant value that the industry has come out of the quarter [ph] by capturing significant value adding opportunities.

We've now experienced a 48% drop in oil price, so far. And Canadian Natural is prepared for this cycle. Although this environment feels scary Canadian Natural is well-positioned and prepared as we have in the past and probably better than we've ever had in the past should be weather this cycle and capture those opportunities that will exist.

So what does that mean for 2009 budget. On the next slide our overall plan is to execute the capital budget in a low price tight and costly credit environment.

Pay down debt, we profiled major capital spending were appropriate. The ramp up of Horizon production and ensure capital flexibility were possibly even tougher time. We conserve our land base from expiries and drainage and will keep our thermal program on track. And prepare for the future with cost reductions and acquisition opportunities. And most importantly focus on value growth and our production growth.

That being said, on the next slide in 2009 our production will grow 10% to 12% year-over-year and 16% to 18% entry to exit, generating significant free cash flow between $2.8 billion and $3.2 billion allowing the equivalent debt repayment.

We have significant liquidity with $2.4 billion of bank lines available and our cash flow was $6.8 billion to $7.2 billion with the capital program of $4 billion. In that capital program we have flexibility to ramp up spending quickly or defer spending if necessary. Our balance sheet is robust and will strengthened through the year.

In 2009, we will reap the rewards of significant pre-2009 capital spending. At the strip, we'll have $2.8 billion to $3.2 billion of free cash flow at $50 and $4 AECO we will have $2.1 billion to $2.5 billion. Even at $40 WTI and $3 AECO gas we have free cash flow of $1.1 to $1.5 billion, which speaks to the strength of our assets and also our ability to hedge, and Doug we will take a little more about 2009 hedge programs, which includes the significant amount of $100 WTI put. Further details of the hedge program are on our website.

As you see Canadian National has significant free cash flow. It is also free cash flowing from each of our businesses in this slide shows from conventional Canada providing largest on the free cash followed by Horizon, the North Sea and offshore West Africa.

As you can see offshore West Africa we have a significant capital spend in 2009, at Olowi are still completing in 2009. Of course this type of free cash flow allows significant debt repayment at a strip and we are below our debt, as shown in this slide even as $50 WTI and $4 AECO and we are comfortably within our debt-to-book range.

Debt repayment is our first priority in the allocation of our free cash flow as shown in this slide. The second priority will be to allocate asset development, acquisitions or share buybacks with the highest return on capital areas being allocated to capital. Our third priority would be dividend in 2009.

On slide 23, we showed 2009 budget as talk before we produce 600 and 651,000 BOEs a day at a mid point, that's 11% increase, and entry to exit 16% to 18% increase.

Our cash flow at the strip as I said before is $6.8 billion to.$7.2 billion. And the capital budget is $4 billion, down 50% in 2008. Horizon, the North Sea and offshore West Africa all see a reduction in capital spending.

Our 2009 capital budget has significant flexibility as shown in the next slide. Our 2009 inventory of projects and locations are shown here, totaled unto $7 billion. We will execute only $4 billion leaving roughly $3 billion of projects and inventory. Of the $4 billion in 2009 capital program, $2 billion is committed capital, and $2 billion roughly is flexible capital, that can be deferred on short notice. We also have ability to bring back roughly 30% of that $3 billion of the inventory projects in three to four months likely after break up and that depends on the market. As you can see, we have tremendous capital flexibility.

The next slide just illustrates how the capital allocation in 2009 is shifted from Horizon as we complete the major construction in 2008.

Now turning briefly to each asset, I'll hit the highlights of each product starting with gas on slide 26. Our gas assets are strong and low cost. We have a deep inventory of 8,000 wells and the second largest land base in Western Canada. And we have meaningful exposure to conventional, unconventional, resource, and exploration play types. In 2009, we'll drill to minimize land expiries and drainage. And we'll also drill our strategic gas plays to have exposure to shale gas, the deep basin and Foothills gas and of course focus on cost reduction.

Alberta natural gas we received the lowest priority due to punitive royalties. And production will decline 12% on gas for the company. As we drilled only 224 net gas wells down from 269, a 25% reduction in 2008.

And point to note here in our 224 gas wells, 65% of those will happen after breakup, and give us additional flexibility to see gas prices soften further. Our thermal assets are very strong and are probably the most under appreciated and least understood assets in our portfolio.

In our defined plan alone we have 33 billion barrels of oil in place with 5.5 billion recoverable. We have and we'll add 3,000 a day of incremental heavy oil production from our defined plan of these assets in a very step wise cost manner as shown on slide 29.

In 2009, we'll enter into the lower part of the base production cycle in thermal, but we'll ramp up Primose East with 40,000 barrels a day. And you will see thermal production up 23% year-over-year. We complete the EDS part of the engineering cycle at Kirby and obtain Kirby regulatory approval and sanction Kirby in 2009. There is significant technology upside in all heavy oil, which has additional value.

If you go through our next slide, it will show our primary heavy oil, program continues to generate robust economics. We have drilled 485 wells in 2009 and Pelican Lake we drill 107 wells and continue to rollout our highly successful polymer flood. As you know, Pelican is a world class pool with 4 billion barrels in place and between 350 million and 475 million barrels recoverable with polymer food, a low cost development.

In the North Sea, significant platform maintenance. We have build drilling inventory and focus on capital cost reduction and operating cost reduction. We expect that the potential acquisition opportunities in this environment in the North Sea.

In offshore West Africa, we will complete Espoir FPSO upgrade and get two more wells drilled and completed at Baobab. We will continue with the Olowi development in Gabon with production coming onstream early 2009 in the first quarter and ramp up to 20,000 barrels a day by year-end. We will also progress the exciting exploration prospect in South Africa, and drive on from there.

At Horizon, our world-class Oil Sands project with 6 billion to 8 billion barrels recoverable we are very close to startup in Phase 1 at 110,000 barrels a day. Phases 2 to 5 will take us through 500,000 barrels a day or $0.5 million barrels a day, with a 40 year reserve life and no decline with virtually no reserve replacement cost.

We've added potential the technology upside. There is absolutely no question that Horizon is a world-class project and will add tremendous value Canadian Natural shareholders.

2009 we will ramp up Phase 1 production, focus on reliability, focus on reducing operating costs and reducing capital costs in our future expansion. Our business rational here at Horizon, is we are not going to build in a high cost environment for a moderate price world.

So the budget shown in the next slide for Horizon will include reprofiling, a significant portion of Phase 2 Tranche 2 spending. We reprofile the Tranche 3 spending as well, before we sanction and we only spend $574 million in Horizon in 2009.

Before I continue on with the rest of the talk on the slide. I will turn it over to Réal Doucet, at this time for more detailed update on the current status of Horizon.

Réal J.H. Doucet - Senior Vice-President, Oil Sands

Thank you, Steve. Good morning ladies and gentlemen. And here as like Steve said, we have implemented the strategy here to startup our plan in the very systematic way, and even though it will take us more time, we want to make sure as we are doing it safely and we are doing it also with reliability. So I will go over these plans one-by-one, as already where we are up right now, as we stand here today.

First of all in the mining area, the mining is completed, and equipments are all on side, we have been running now for quite some time in the overburden and we have run also on show about 300,000 bbl/d into the pressure as a test and it's been done quite successfully.

So we are ready for the mining, and we have all the operators as well, all trained. We have five shovels, 23 trucks and all the support equipment to carry us through. On the ore preparation plan, the plan is completed also has been tested and we are ready for operation.

On the Hydrotransport lines that has a completed those also and it's been tested and ready for operation. The piperack, same way too has been completed it is in fact live and operational right now. So the steam, the natural gas, the water, the nitrogen or the commodities needed for the plant as a whole everywhere in each area is accessible and its operational.

On the extraction plan it has been completed also has been tested. We have produce 160,000 barrel of bitumen for testing so for and the plan is ready for operation.

On the froth treatment plant, we have $0.01 back on the plan. It's been fixed now. We have a bit of a design issue and the plan is completed now and we are finalizing the commissioning and as a matter of fact we're going to do the final testing and make it ready for operation here next week.

In the delayed coker and diluent recovery unit the plant has been completed. It's on circulation right now with diesel. All the pumps, pipes and so on has been all tested. The coking mechanism has been tested as well. The furnace has been heated and the refractory has been tested and the plan is ready for operation.

On a cogeneration plant, the same thing has been completed. We are producing steam for all the other commodities plant requirement. We are also producing power. We have tested our turbo generator and we know that its producing 110% now at design capacity so far. So we are ready also on the cogeneration side.

On the sulfur plant, the plant has been completed. It's the internal virtue operation, and we are right now at the final stage of commissioning and testing. On the tankage side, all the tanks are completed. They're all ready for operation, we are finalizing right now the insulation of them, and we have already put the diluted material of or the diluent for the naphtha for the operation is already there. The diesel is there also inventory for the circulations and so on, so the tankages are all ready and include also the final tankages, the blending, area, the truck loading area for the sulfur and also the pipeline to send the material down south.

On the main control room, all the plants right now are run by the control room. It's been fully operational for quite sometime now and it's working remarkably well. On the utilities and services, all the water, all the natural gas, all the commodities required to operate the plants are fully functional for the operational and also the systems instrumentations and so on its all operational as well.

Like I said the SCO pipeline is ready and the hydrogen plant also to supply the hydrogen to the hydrotreater is also completed. It has been turnover to operation and as of yesterday we are producing hydrogen.

On the hydrotreater, which is the critical path right now and the most difficult plant to commission. There is three hydrotreater plant naphtha hydrotreater, which is Plant 41, the gas oil which is Plant 43, and the diesel, which is Plant 42. So the strategy for us right now is to bring Plant 41, which by the way right now is in the hands of operation, so the project has been completed there and operations are doing the commissioning as we speak.

On the gas oil hydrotreater at Plant 43, we still have some electrical heat tracings to complete and we want to make sure that all the electrical heat tracing and insulations are completed before start up so that the winter startup will not influence the integrity of the plant.

This will be completed shortly also and the Plant 43 is expected to be started and produce first part of the year and before at year end. As for the Distillate Hydrotreating Plant right now we have completed the mechanical on it. We have completed all the hydro test and so on. We are also again into heat tracing and insulation making sure that we are completing all these heat tracing and insulation before startups so that winter also has no influence on our startup. This plant should be started in the first quarter of '09, it is not needed for first oil.

So, with Plant 41 the naphtha and Plant 43 the gas oil, we will be able to produce about 50% to 60% of our total capacity going to startup here, and then during the first quarter we will bring the Distillate Hydrotreating Plant into operation also for full capacity here by the end of the first quarter, of course there is a ramp up, and looking at fine tuning treating all these equipment for us that is run in 2009 we will be in full capacity production.

We have accomplished also over 15 million man-hours on site so far in a very safely manner. We have of course substantial reduction in our manpower on-site now, we are down to 2,500 which is essentially more then half of that impart in the hydrotreater right now completing the heat tracing and the installation.

You have our operational, personal all in place. We have supplemented them also with some contractors right now, licenses to help us also tweaking and fine tuning all the equipment as we have to produce the production reliably and concentrate.

So on these Steve get back to you.

Steve W. Laut - President and Chief Operating Officer

Thanks Réal. As you can see we are very close on Horizon, although close is not good enough. In summary, the overall picture, our gas assets are very strong. We have 8,000 wells and inventory. We have a strong exposure to natural and to shale gas and largest plant based in Western Canada.

Our heavy crude program and assets are very, very strong with over 300,000 barrels a day of incremental oil to come onstream over the next 10 to 15 years. Internationally, we continue with the Baobab drilling, Olowi development and in the future exploration potential at South Africa.

As we you've heard Réal talk about horizon, we will be onstream here in Phase 1. We have Phase 2 through 5 to take us just under 500,000 barrel a day. This is significant value for all Canadian Natural shareholders.

Canadian Natural's advantage is clear and I will repeat it again, we had the management business philosophy and practice, our balanced assets, our strong vast opportunities, we have a balanced and proven effective strategy and importantly, control over capital allocation and we are nimble, we'll capture opportunities, we'll make tough decisions, we have significant free cash flow from our assets that sets us apart.

Our culture is important at low cost and execution focused. And as you see in this last slide, I believe we are today better prepared than ever before to survive and thrive in this environment and capitalized on those opportunities that may occur in this environment.

We are in great shape. And with that I'll turn it over to Doug to give you more information on our financials.

Douglas A. Proll - Chief Financial Officer and Senior Vice-President, Finance

Thank you, Steve and good morning. In the third quarter of 2008 and nine months ended September 30th cash flow and cash expenditures were imbalanced and the increase in our long-term debt is mostly attributable to a weakening Canadian dollar over the period.

Cash flow from operations for the nine months ended September 30th was $9.99 per share up for $8.74 in the comparable period in 2007. We have experienced large swings in quarterly net income moving from net earnings to lost to net earnings attributable to mark-to-market accounting of our commodity hedge program and certain other unrealized items.

However, our non-GAAP measure of adjusted net earnings from operations which exclude unrealized gains and losses and was relatively stable through this period. Adjusted net earnings from operations were $2.8 billion or $5.17 per share for the nine months ended September 30th.

Adding to our operational strength is our balance sheet strength. Our debt to book capitalization was 41% at the end of Q3 compared to 45% at the end of 2007 and June 30th. Further our debt to EBITDA ratio was 1.7 times at September 30th, slightly below our targeted range of 1.8 to 2.2 times and we are below our debt agreement financial covenant of 3.5 times.

Resulting from the worldwide credit disruptions and as discussed in our MD&A in the liquidity and capital resource section, the company has undertaken a thorough review with liquidity resources, as well as the exposure to counterparties and has concluded that its capital resources are sufficient to meet ongoing short, medium, and long-term commitments. Further the company believes that this counterparties currently have the financial capacity to settle outstanding obligations in the normal course of business.

I'd also like to touch on our hedge books for a moment. Our hedge policy is undertaking for the purposes of our underpinning commodity prices to support cash flow from operations, so that we can carry out our capital expenditure program.

For 2009, we have roughly 30% of our oil and liquids production with 25,000 barrels in collars with a floor of $70 and ceiling of 111, and we also have 92,000 barrels a day with a floor of $100 a barrel.

In addition, we have 500,000 GJ's of AECO natural gas collars with a floor of $6 and ceiling of $8.60 for the period through the first quarter of 2009. All positions for the remainder of 2008 and 2009 are provided on our website, and we will be watching for opportunities to add more to support our cash flows.

Turning briefly to our 2009 budget our guidance is posted on the website and is detailed in the budget release. We believe this budget and the underlying strategy is right for the time. It is prepared conservatively and with maximum flexibility.

It underpins Canadian Natural's commitment to maintaining a strong financial position. It addresses our intent to retire the Anadarko Canada acquisition financing loan with free cash flow in 2009, and it provides for cash flow from each of our core business segment thereby allowing for a full and complete process of allocation of capital.

Thank you and I will return you to John for some closing comments.

John G. Langille - Vice-Chairman

Thank you very much Steve, Réal, and Doug for the summary of our excellent position as we go through the fourth quarter of 2008, and into 2009 under some very challenging economic conditions.

Canadian Natural remains very well-positioned to meet all of those challenges and continue to create value for its shareholders.

With that operator, I'd like to open up the conference call to any questions that may... people may have.

Question And Answer

Operator

Thank you. [Operator Instructions]. The first question will be from Ryan Todd of Deutsche Bank. Please go ahead.

Ryan Todd - Deutsche Bank

Good morning, gentlemen. I appreciate all the details you have given us on cash flows and liquidity, and just had a question. So it is fair to say that you will try to maintain going forward your capital spending within in terms of debt pay down plus CapEx spending within generated cash flow? And how much you're assuming... you have a lot of room on your credit facilities as well. Given opportunities is there any willingness to dip into credit facilities or is it going to be simply focused on maintaining within your cash flow?

Steve W. Laut - President and Chief Operating Officer

I think what we're going to do here is pretty clear as we have a lot of flexibility in our capital budgets, we have no intention at this point in time to dip into the bank line. There will be opportunities, but I don't expect them to be showing up here anytime soon. I think it can take some time for this whole thing to unwind. So we will live within our capital budget.

Ryan Todd - Deutsche Bank

Great, I appreciate it. And you have a quite a bit of flexible capital spending in the budget. It looks like about half of the budget next year is relatively flexible. Where is most of that flexibility and then again if you look at lower oil price environment, if you look at the $60, $50 level, and you've said that your focus is on generating not production growth, but on generating value and how does the capital allocation change within your flexible asset in terms of the $60 the $50 environment. Is more of that money going to heavy oil versus convention gas or vice versa, how would you prioritize your spending on your assets?

Steve W. Laut - President and Chief Operating Officer

Actually to look at that, obviously addressing the flexibility the most flexibility in our capital program is obliviously in Canada, again the conventional asset and we look at what gives us highest return over the long term and also in the short terms to capturing the price spikes when we see, so right now obviously oil is still quite a bit better than gas, and we are always monitoring the relative economics between oil and gas and heavy and light and other projects as well. We obviously have water flood optimization other enhanced recovery projects. We all have to balance near, mid, and long term aspects of all our program. So we do have a conventional flexibility. Depending gas prices aren't that great right now oil is much better. And so as you can see in 2009 most of our capital is directed towards oil and heavy oil.

Ryan Todd - Deutsche Bank

Okay, I appreciate and you often stressed how the market doesn't get very well, the value of the thermal oil properties. Can you just discus what type of cash flow did the thermal oil properties have at $60 or $50 WTI price, so its fairly robust.

Steve W. Laut - President and Chief Operating Officer

It's very robust in our operating costs are probably about $15, its $16 on thermal heavy oil, depending on the gas price. Obviously right now the differentials are narrow, so if you get $60 WTI takeoff, say at the max $20, $30, or $40 WTI convert that to Canadian and so your 50 and your operating costs are 16, so very high margins than you have to take off the F&D costs, which probably are around the now I would say 9 to $10 range.

Ryan Todd - Deutsche Bank

Great, I appreciate that gentlemen. Finally, on you have obviously delayed... you pushback as a lot people have some capital spend there at Horizon. As you look across the states and most of your competitors as well as deferred quite a bit of capital at Horizon... well not Horizon, sorry in the Oil sands. What aspect do you see to having in the next 12 months on costs I know its very difficult to gauge and if everybody pushes back and you have probably more capital flexibility then some of your competitors? Is there any opportunity as cost and now quicken up to reaccelerate some of that or its going to be conservatism for the next 12 to 18 months and we'll just stick with the deferral?

Steve W. Laut - President and Chief Operating Officer

Well it's sound really deferral capital, reprofiling the capital and how we will spend that capital. So the projects are really differed as to how we reprofile the capital. And obviously we think it will take some time, before we see some kind of normalization of costs and quite frankly we've got to see how price as shake out. We don't want to build high cost environment and have a low price environment for a while.

And let me give you an example that really sort of captures what we mean by reprofiling. This year we had to do some several work in our diversion dike around our dam for the Tar River. Our estimate to do that work was $20 million. We went out bid to do that work in May, June time. The range of bids from a number bidders came in at $40 million to $75 million, and again our estimate was $20 million.

So we reprofile that work and what we means is we didn't do it and we try to find different ways to do it. We recently this fall had a contractor who happened to be between jobs. And he had not have work lined up immediately, which unusual. He put a bid into do the work for $14 million. That work is now being completed. The quality work is good, he is on time and he not going over the budget.

So two issues here, one, work that we estimated is $20 million you get bids between $40 and $76 million or $75 million. That tells you the amount of growth in the market. The second thing is we had an estimate of $20 million and we have got it done for $14 million. So in a way, we are actually affected by the markets as well by our estimate higher, then when it can actually get it done in a normal market.

So those are some of the things that we need to capture and get adjusted to hear, not only a Horizon but through out the oil sands business in total rate. Its just reprofiling and differing with other projects we bring back hopefully some normalcy and how long that will take, I am not sure. But, I think it will be more longer than a year.

Ryan Todd - Deutsche Bank

Okay. Thank you. I appreciate all the details.

Operator

Thank you. The next question will be from Andrew Fairbanks from Merrill Lynch. Please go ahead.

Andrew Fairbanks - Merrill Lynch

Good morning, gentlemen. Very pleased to see the $100, that you put in place in the quarter. I was just curious, wanted to gauge your interest in additional hedging as you look at 2009 or potentially every longer and just I guess more broadly, how did you strategically balance upside price potential versus the potential for additional acquisition in the downside price margin. Giving up something on either side of the hedging decision, serious as your thoughts on that, that how you build through that and if you which tends to win out?

Steve W. Laut - President and Chief Operating Officer

You will be looking at that hedging opportunities and the opportunities to place both collars and puts as we move forward into 2009 and beyond. I think that where we are right now or I believe where we are right now is winning this $60 environment having comes from a $147 environment. We are trying to protect it from the downside. But as the economy those take up over the next period time I think the consensus is the prices will go up. Having said that we have work to do in the near-term and the mid-term and we have to make sure that those capital expenditures are undertaking that our balance sheet is protected and so we will cautious, but we will be putting on more hedges as we move forward.

Andrew Fairbanks - Merrill Lynch

And how do you found the liquidity in the market is there still a non-conservative influences in power capacity out there as a year ago or is the composition changing back to the old days of liquidity, that's it?

Steve W. Laut - President and Chief Operating Officer

I think as financial institutions as their balance sheet have tightened and they look at several ways of doing business, the market has got a lot tighter and the spreads between the business is no difference than they have on our bonds have widened and so we have to take that into consideration. Having said that we still have very strong counterparty. All of our counterparties have been affected, but at the same time our strong and we've discussed this with them and at no time do we have any concerns with those counterparties.

Andrew Fairbanks - Merrill Lynch

That's great, thank you.

Operator

Thank you. The next question will be from Brian Dutton from Credit Suisse. Please go ahead.

Brian Dutton - Credit Suisse

Yes good morning, Steve. We're hearing a little bit. There is difficulty hearing on the call, but I think you started getting into the topic here reprofiling. Did you give us what exactly you mean of the reprofiling here Tranches 2 and 3 at Horizon?

Steve W. Laut - President and Chief Operating Officer

We really mean that Brian is that we're going to adjust how we spend the capital overtime and take those opportunities to get cost in line. Obviously, we are not in a mega project mode anymore and we can do this a bit by bit and get better cost and better control on our costs. And we'll take the time and do it right. As you know we are value creators not value destroyers, so we're out there to get the best cost and get our production on at lowest cost. That what we really mean by recouping. It's not that we're deferring project. It's that we're going to take our time and do it right and spend the capital in a more prudent manner.

Brian Dutton - Credit Suisse

So you have no preset time table at this point?

Steve W. Laut - President and Chief Operating Officer

At this point no.

Brian Dutton - Credit Suisse

All right. Second question, I think I have asked this before on previous conference call. And again you were starting to get into in terms of some of the returns you are looking at new businesses. So could you compare today the net backs you're seeing for your conventional heavy oil, your thermal heavy oil versus the opportunities you just see on natural gas?

Steve W. Laut - President and Chief Operating Officer

Probably the best way for me to answer that would be just on a recycle ratios, which is really the net backs divided by the F&D cost. And I'd say that earlier in the year back in May and June the recycle ratios were six to seven on the oil projects and maybe two on gas. Today obviously the recycle ratios have contracted. We see recycle ratios in thermal about 2, 2.2 and some of the primary heavy oil and on gas were about 1.5 or 1.4. So, the relative economics have moved closer but everything has really shifted downwards.

Brian Dutton - Credit Suisse

Great, thank you very much.

Operator

Thank you. The next question will be from Amir Arif from FBR Capital Markets. Please go ahead.

Amir Arif - FBR Capital Markets

Good morning, guys. I had a couple of questions, first of all just on your '09 outlook your capital spending on the conventional side is staying the same, your conventional productions is going to drop about 4%, can you just shed some light on that. If there's anything I thought it would be the other way around with the Primrose East CapEx spend in '08 and production comes in '09?

Steve W. Laut - President and Chief Operating Officer

What you're seeing Amir is what we've done in the Primrose, as you know, it was a cyclic operation, and we have a large base production in that cycle. So it actually masks the effect of bringing Primrose East totally on. It's something we're alluded to you before. So what we see here that the production is up on thermal year-over-year by 23%, so that is not as much as it would be it had we not been in the low part of cycle for the base production throughout the year. As far as gas obviously we're spending very little on gas. We have... we're drilling more well... less wells, but they are deeper and take longer to get on and we are giving ourselves a lot of flexibility of whether we complete that or not. So the North Sea is declining we are not spending not drilling any wells there are really and which is going to take us some time for allow you to get on as we had anticipated, but we will ramp it up 20,000 barrels a day. I hope that answers your question, but really, we are not spending enough capital on the gas side to maintain production. And on the oil side, it's really the cycling in Primrose East that affects it.

Amir Arif - FBR Capital Markets

Okay. If you could take out the impact of the cycling from Primrose what would you say as your maintenance capital or capital you need to keep production flat?

Steve W. Laut - President and Chief Operating Officer

I think well in today's cost environment we probably need $1.4 billion to $1.6 billion capital just to keep gas flat and taking up the cyclic nature of oil. We probably need... I would say close to $1 billion really to stay flat there. And then that just that would be we would not do any of the longer-term projects to the water floods enhanced recoveries.

Amir Arif - FBR Capital Markets

Okay, that answers that. Second question in terms of the supply agreement with the with U.S refiner for 100,000 barrels a day with plenty of contract on the volume metric side. Can you shed some color in terms of why you elected that market prices as this is just a volatility, as your view on heavy oil differentials?

Steve W. Laut - President and Chief Operating Officer

We've done here is, the contract is at market price and so what we've done is we believe that the mine differential is always a bit lower than the western Canadian select differential in Chicago. So by having that pipeline and the contract we are able to grow our heavy oil production and meet the demand on our sight to have more markets to put that heavy oil for widening the differential.

Amir Arif - FBR Capital Markets

Okay.

Steve W. Laut - President and Chief Operating Officer

We also need to get there for our market productions, to get the market... you can't have the too much oil flooded into Pad 2 or the Midwest. It will just widen the differential, so its critical not only for us to really for the whole Canadian industry.

Going back just to your capital question, Amir one of the things that we do have on the oil side this years, a very large strip well program that is defining our future general program in more detail. So we can execute that as we go forward.

Amir Arif - FBR Capital Markets

Okay, it sounds great. And then just one final question, on your thermal oil sands growth strategy, what point on the volume side is getting concerned about too much of the oil production or then what's your oil sands production going in your take what's directly to the refinery, you are not concerned about needing an additional coker?

Steve W. Laut - President and Chief Operating Officer

At this point in time, we have a fairly well defined program. So we know when our oil is coming. So we don't believe pipeline capacity be an issue. Pipeline to the Gulf Coast will be ready in Q4, 2011. So likely 2012 sometimes for oil and the way our program is set, we don't see any real tough restrictions or market crunch is coming. If we did we would probably slow down the thermal program, but at this point we do not see any reason to do that.

Amir Arif - FBR Capital Markets

Thanks.

Operator

Thank you. [Operator Instructions]. The next question will be from Martin Molyneaux from FirstEnergy Capital. Please go ahead.

Martin Molyneaux - FirstEnergy Capital

Steve, I am really switching gears here, you mentioned the first well at Baobab was drilled and on it something like 2,800 barrels a day. Can you just kind give a bit more definition of what the program that lies ahead is and roughly what we should be expecting in terms of timing and what your thoughts are in terms of productivity?

Steve W. Laut - President and Chief Operating Officer

Martin as you know it was a deepwater development subsea so it take some time. The first well is done and gravel packed in 2,800 barrels a day. It has more capacity. Our expectations were to drill 4,000 barrels a day, but we get the whole rig drilled in the reservoir. The second well is now drilled and completed and it will come on here probably in December. We're going to try and test the well through the rig just to make sure that gravel pack is in good shape, but then the rig will move off onto the next well and at some point in time, in the next month or so we'll definitely interconnect it to the pipeline.

We will then move to our next well, which is what we call C-12 and we will drill that and depending on the time it takes to get that that will be a third well. We will try to get to the fourth well, so the third well will be done in 2009 here, and that will come on probably late 2008 or early 2009. So we're trying to see if we can get another well in and our contract and we do have this improve roughly a year, so it will be due to get back in May.

Martin Molyneaux - FirstEnergy Capital

Great.

Steve W. Laut - President and Chief Operating Officer

That's the program. We'll see what we get the results, so we've been very, very cautious so these are expensive wells and we want to make sure we don't cost of completion [ph] down by opening up too quickly.

Martin Molyneaux - FirstEnergy Capital

Fair enough. Thank you.

Operator

Thank you. Your next will be from Gordon Gee from RBC Capital Markets. Please go ahead.

Gordon Gee - RBC Capital Markets

Good morning. I notice on this same capital for Horizon in your budget that's a bit, is that a long-term run too or is that just a short-term here?

Steve W. Laut - President and Chief Operating Officer

Gordon that's probably a short-term or is a short-term issue. We will have the sustaining capital every year. I would think it will be more in the $80 to $100 range. In sustaining capital, we have given ourselves allowance in the first year of operation you quite often see new pumps or new motors fail on you and we have to give ourselves a capital allowance to replace some of those performance. If we're lucky we won't have to spent all those money.

Gordon Gee - RBC Capital Markets

Okay. Thanks.

Operator

Thank you. There are no further questions registered at this time, Mr. Langille. So I will turn the meeting back to you.

John G. Langille - Vice-Chairman

Thank you very much operator, and thank you ladies and gentlemen for attending our conference all. As usual if you do have any further questions please do not hesitate to contact us. And have a good day, and we look forward to working through a very challenging 2009, but at the other end we will come out much stronger company. Thank you very much.

Operator

Thank you. The conference call has concluded. You may disconnect your telephone line at this time. We thank you very much for your participation. .

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Source: Canadian Natural Resources Ltd. Q3 2008 Earnings Call Transcript
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