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Canadian Natural Resources Ltd. (NYSE:CNQ)

Q2 FY08 Earnings Call

August 7, 2008, 09:00 AM ET

Executives

John G. Langille - Vice-Chairman

Allan P. Markin - Chairman

Steve W. Laut - President and COO

Réal M. Cusson - Senior Vice-President, Marketing

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

Analysts

Brian Singer - Goldman Sachs

Andrew Fairbanks - Merrill Lynch

Robert Plexman - CIBC World Markets

Operator

Good morning, ladies and gentlemen. Welcome to the Canadian Natural Resources' Second 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, giving us the opportunity again to review our second quarter results for 2008 and a review of the development of our ongoing projects. Participating with me today are Allan Markin, our Chairman; Steve Laut, our President and Chief Operating Officer; Doug Proll, our Senior Vice-President of Finance; and Réal Doucet, our Senior Vice-President of Oil Sands.

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

Before I turn the call over to Allan, Steve, Réal, and Doug, I would like to make a couple of initial comments. Our operating results, as you can see in the press release in the second quarter surpassed our budgeted expectations as we saw. Firstly, our Canadian production volumes for both natural gas and crude oil exceeding the top-end of our guidance range, while our international volumes were well within our guidance ranges. And secondly, strong realized prices for our commodities, especially in heavy oil, where the strong demands for diesel products has continued to lower the discount from the benchmark WTI price for our heavy oil.

These two factors contributed to Canadian Natural achieving very strong record quarter cash flow of over $1.8 billion, a 23% increase from the comparable quarter in 2007. On a barrel of oil equivalent basis, this cash flow amounted to $35.86 per boe, which is a 31% increase over the comparable 2007 number. This shows we are also well in control of our cash costs.

Our adjusted net earnings from operations increased to $960 million in the second quarter, a 61% increase over the second quarter of 2007. And of course, this cash flow and earnings from our conventional operations will soon be augmented with results from our oil mining assets. The extreme volatility and the benchmark pricing for both natural gas and crude oil is being experienced in the past month and we will, as always, continue to pursue focused capital discipline to ensure maximum returns are being realized from the development of our very expensive and strong asset base.

With that Al, would you like to make a few comments before you turn it over to Steve?

Allan P. Markin - Chairman

You bet John, thank you. Good morning everyone and thank you for joining us for this early conference call. And thank you especially, all the hardworking craft and staff of the Horizon.

These are exciting times for Canadian Natural. 2008 certainly has been the year of execution as all of our major projects proceed a near completion. Phase 1 of the Horizon project has entered final construction, commissioning and start up and we will soon begin to realize the benefit of the largest single capital project in Canadian Natural's history.

The Primrose East expansion, which is targeted to add 40,000 barrels a day of capacity, is coming in ahead of schedule. First steam is targeted for this September versus the previous target of Q4 '08 and first production is targeted for Q4 of this year versus the previous target of next year in the first quarter.

The other major project located in off shore West Africa proceed has a restoration of shut in production at Baobab in offshore Côte d'Ivoire continues along with the Olowi Project in Offshore Gabon, with first crude oil production there targeted for late 2008 to early 2009. As part of our refined marketing strategy for our heavy crude oil, Canadian Natural has committed to ship fixed volumes on the proposed Keystone Pipeline, U.S. Gulf Coast expansion, running from Hardisty, Alberta to Port Arthur, Texas.

We have simultaneously entered into a supply agreement with a major U.S. Gulf Coast refiner. These agreements represent a significant step in unlocking the value of Canadian Natural's vast heavy crude oil reserves. It is a simple and cost-effective strategy to unlock the value of a barrel of heavy crude oil and reduce the volatility historically experienced in the heavy crude oil market.

With the Keystone Excel agreement; Canadian Natural will retain full ownership of the resource, while gaining access to a very key market for Canadian heavy crude oil. We are at the threshold of the next step in our evolution as we await the production volumes of synthetic crude oil from Horizon. The volumes of heavy crude oil from Primrose East and the light crude oil from offshore West Africa combined with the rest of our conventional assets; both crude oil and natural gas. We are on track and confident in our ability to deliver the future of the company to our shareholders.

Thank you. Steve?

Steve W. Laut - President and Chief Operating Officer

Thanks Al, and good morning everyone. As both Al and John have pointed out, the second quarter was a strong quarter. With oil and gas production exceeded the top end of our production guidance in Canada, and at Horizon we are very near the end of construction and well into our phase start up of Horizon.

Both Réal and I will give you a more detailed descriptionary activities of Horizon in a few minutes. Our cash flow for the year looks to be up significantly in a $7 billion to $7.5 billion range due to higher commodity prices than expected, particularly oil and heavy oil pricing.

Costs in our conventional business are on track, but we do see cost pressures coming this quarter and the fourth quarter. However, the recent softening in gas prices may temper this somewhat. Additional cash flow we'll use to pay down debt, cover the additional costs we are projecting for Horizon construction and commissioning as well as additional capital costs in offshore West Africa.

Now turning to each product and I'll start with oil in Canada and particularly heavy oil and thermal oil. As we believe our heavy oil assets are the most undervalued and under-appreciated assets in our portfolio, and are really the hidden gem in our portfolio. The preliminary of these developments, which has been scheduled to inject first steam late 2008 and bidding on 40,000 barrels a day of heavy oil in early 2009 is on cost and ahead of schedule. We now expect first steaming this September and potentially we'll see oil coming back in November and likely December and our latest projections see an additional 15,000 barrels a day in December.

At this point, from a cost, schedule, and reservoir point of view, Primrose East has been a top docile project execution. And from what we can tell, we expect production volumes to comfortably meet our expectations. Our ability to successfully execute Primrose East, the second phase of our decline plan to bring on stream 325,000 barrels a day of incremental oil from our vast heavy oil assets enhances our confidence and bodes well for our future phases. At Kirby, our 45,000 barrel a day third base, we're in a regulatory process with approval expected in 2009.

We're currently out to bid in our final phase of engineering for the Kirby facilities. At Pelican Lake, our world-class pool with 2.8 billion barrels of oil in plays is a significant resource as we all know. With Polymer flooding we can take recoveries from 5% up to 25% or an incremental 550 million barrels of low cost incremental oil. Our Polymer flood expansion continues on track and is delivering as expected, adding significant value for Canadian Natural shareholders.

Primrose oil [ph] drilling is on track and meeting our expectations, as we continue to high-grade our inventory to capture the high oil prices we're experiencing today. And heavy oil pricing levels are extraordinary. In July, the heavy oil differential was 14% of WTI and August looks like 13% of WTI. The dip now stands about 13% and is less that half the 32% differential it averaged for 2007 with a $120 to $130 oil price a day, versus $70 in 2007; truly extraordinary pricing levels for heavy oil.

Now if you have read in our press release Canadian Natural has committed a 120,000 barrels a day of pipeline capacity on the Keystone Excel Project, which will transport Canadian heavy oil to the Gulf Coast. In addition we have entered into a supply arrangement at Gulf Coast prices with a major Gulf Coast refiner for a 100,000 barrels a day of Canadian heavy oil. This arrangement also allows Canadian Natural the option to acquire pipeline capacity or 10% equity. This pipeline is expected to be complete by Q4, 2011 with initial capacity of over 400,000 barrels a day.

Gaining access to new heavy oil markets and in particular the Gulf Coast markets, the largest refinery market in the world is a significant step in Canadian Natural's achieving our second phase of our three-phase marketing plan. The pipeline arrangement of Canadian Natural and in fact the entire Canadian heavy oil industry to increase heavy oil productions without oversupplying the Midwest market and severely widening heavy oil differentials.

In effect this pipeline agreement and our supply arrangements allowed Canadian Natural to proceed ahead with increased confidence on our thermal heavy oil refining plant to add at 325000 barrels a day of incremental oil, unlock that vast potential of our heavy oil resources and create tremendous value for our share holders.

Turning to gas in Canada. Our gas assets are very strong and our production exceeded the top end of guidance. Our gas volumes have held up remarkably well, considering we build only 175 gas wells in the first half of 2008. Our gas inventory is deep and with our dominating infrastructure and very strong technical and operational teams, we can add significant value from our gas assets in a relatively quick and effective manner. However the relative economics of gas will allow me move to more normal levels, before we'll chose to do so.

Just commenting a little bit on gas. As one of the largest landholders in BC, we are well positioned to capture the significant value on the emergent shale gas plays in the Monterey, Muskwa and EB Shale. In the Monterey in particular, we have over 70,000 acres of prime shale gas land. That being said, we have virtually no exposure to the Horn River Basin which has generated of the recent excitement.

Turning to our international operations which provide lateral [ph] balance and some of the highest return on capital projects in our portfolio. North Sea productions was down in Q2 as we stated in our Q1 call, as we successfully completed a major turnaround, 23 days at Ninian sold. In Q3 and Q4 turnarounds will happen at many at Ninian Central, Ninian North and Murchison which will keep volumes flat in Q3 and Q4. Overall we continue to implement our major basin strategy, mature basin strategy by optimizing waterfronts workovers and recompletions to maintain production capacity adding reserves and extending pure life.

In Guatemala [ph], our deepwater rigs experienced some drilling issues and have added 15 days to our schedule. The first 12 is now complete, however of shorter length and the rig will now move to the second well. We have a one-year contract, as you know for this rig and depending on our effectiveness, we anticipate bringing on at least three as of the pipe well shut in due to sanding. Obviously, we have got some of our floating schedule with the first well and currently we have about 8,000 to 10,000 barrels a day of oil shut in.

At Italy, our development coupon is still on track, our jackup rig has completed the first of too delineation wells, both of which came in through our base plan as expected. We set the template for the first platform and our driving pile to secure. The connective supported platform being built in Sardinia is near completion. However we are scheduled to be completed before August to avoid the holiday season in Italy.

The CSP deck is now scheduled to sail after September 20th, soon we have to meet our schedule, our account exists in meeting that schedule as you can imagine in the holiday season in Italy. The FPSO wasn't dried up in Dubai and is scheduled to sail in the end of October. Everything is on track there; a lot of schedule again is pushed and we will expect sail there in 1st September but now we are pushed again. We are on track to deliver first oil in late 2008 early 2009 ramping up to 20,000 barrels a day. We had plan for some float in the schedule and this allows us to meet the schedule, even though we have some delays in the tower and the FPSO. Really you can see worldwide that construction activities are meeting with severe delays and we have done well on managing delays for oil.

Now Horizon and before I give you an update on Horizon our world-class oil sands project, I will make a few comments. At Horizon, Canadian Natural has achieved a significant milestone as we have finalized construction and being on the state start up of operations. We are now beginning to see the fruition of the largest capital project in Canadian Natural's history. This is a major step in our evolution from a very strong company to an even stronger more sustainable company. As you know Horizon phase I will deliver a 110,000 barrels a day of light suite API crude with no decline for 40 years with virtually no reserve replacement costs going forward.

And as we begin a stage startup of phase I, it is important to point out that we have future phases plan to develop the 6 billion barrels to 8 billion barrels of oil that we have on our list and that we'll alternately bring production levels to just under 500,000 barrels a day or half a million barrels a day, clearly a world-class project that will create huge value for Canadian Natural's shareholders.

Our stage startup consists of seven stages. The first stage mining, we're ready to go. We've been in operations since May and continue to move over burden; we're just waiting that first call from the extraction team for oil sands delivery. On a steam supply, utility plants are all up and operational. And the last high pressure steam was delivered in the third week of July. On our bitumen production side, we're ready to go with first bitumen production targeted for early September. We're in the final stages commissioning now and expect early September for first crude oil production.

The co-gen will deliver full electricity load in the second half of September. The sulfur plant is ready to go mid-August and will circulate aiming waiting the first delivery of sour gas. The delayed coker and daily recovery unions which will provide partially upgraded oil production will be ready to go at the end of September and deliver our first partially upgraded oil to tanks at the end of September.

As far as light suite synthetic oil goes, our naphta hydro treating plants is completing loop checks and installation with commissioning and is targeted for the end of October. Gas oil, high steam plant is just finishing the punch lifts, loop checks and heat tracing and we are commissioning as well. We expect the first oil from us two upgraders to come in just outside the fourth quarter and give us the estimated capacity of 70000 barrels a day and this allow us to meet our schedule product ramp up or that we are little late on that startup.

Just with hydro-treating plant, plant 42 was purposely previously pushed back of the schedule. So you could concentrate on 41 and 43, the naphthalene gas oil. It is in final completion in the mechanical stage right now. We are doing heat tracing and insulation on loop checks an it will be ready to go later in the fourth quarter and bring our capacity to 11000 barrels a day of light suite crude oil, maintaining our previous product ramp schedule.

As you can see, we have started up Horizon and we've done a successfully; we are pushed out because of the hydrotreater which is on the critical path. It's just outside of Q3, the plant 41 and plant 43 considering our target start-up date of Q3, we're set back at 2004 in a rapidly-changing environment and particularly the very challenging environment we've seen over the last two years. It is a very solid achievement for our teams at Horizon to be starting up in Q3.

As you will read in the press release, we have completed a thorough review in the last two weeks of July of our schedule and our cost forecasts. We've seen at the level mechanical completion as construction completes stage has not been as high as we expected. This is delayed and longer than expected punch list or a deficiency list and as you knowledge the productivity increase in this punch list is low and has had a knock on effect with instrument loop checks and insulation. The bottom line is push the start up of the Hydrotreaters outside our Q3 start up target and result it in an 8% cost increase from our last estimate of $8.7 billion to $9.27 billion.

And lastly, before I turn it over to Réal, I would like to thank all our teams working on Horizon for their dedication, innovation, perseverance, and hard work. And without these tremendous efforts, we would not be starting the stage startup today.

Réal, can you give us --

Réal M. Cusson - Senior Vice-President, Marketing

Thank you, Steve. First of all before I start to go into the detail of each of these plants I would like also to tell you people that we have achieved a significant milestone in the oil sands here by getting very close to 25 million man hours without a lost time of accidents. Which means for our plant here, even though we have at one time peak here close to 10,000 people on site, we worked for over a year, in fact we work over 15 months without losing a one day of lost time. This is quite an outstanding record in the oil sand, actually when you compare to standard achievement here and we are pretty proud of this.

In doing so, we have accomplished what we were set out to do. And I will start buy brining through the process of this entire plan, how we have commissioned these plants. So starting with the mining, we have commissioned also in the second quarter two more shovels, electric shovels so we now we have four shovels total running out of five. The last one is coming up here within the next two weeks.

We have also 16 trucks already in operation out of 23. And the other 7 are on site already here and they are ready to go in case we don't need them at this time. So the mine also in terms of manpower and equipment and so on is... has been running now for a few months. We have been moving overburden, opening up the phase for oil sand and in fact we are ready to go, we have them in power and we have the equipment in the mining.

Going to the next step now is into the oil preparation plant. So the oil preparation plant has been commissioned already, everything has been turned up and so on and as a matter of fact here, we were a down the first truck of person here coming up this Saturday. We'll have a small ceremony about this. So this is going quite well. The working [ph] of the oil preparation plan has been run on water and also is ready to roll.

When we move on the pipeline has been also commissioned on the water. The extraction plan also has been circulating water and is a pretty well ready right now. We are still finalizing few of the control mechanism and so on. And very shortly we'll be also in a position to get the person through the extraction plan.

We are finalizing now the frac treatment plant. So in the frac treatment plant we have the cyclone and we have the inclined plate settlers. We are starting in fact this weekend to run some water through, finalizing the punch list, and so on. And this plant also will be ready here probably within a couple of weeks.

So by the end of the August, beginning of September, here it looks like we are going to be in a good position to produce diluted glycerin and to do with us of course we need to a diluents, the diluents has been brought in, has been put into through the intermittent tankage. The tankages were ready. If you remember last time we had a bit of a critical pattern of tankage while we've done some strategic moves there. And the tankage are all ready to receive the diluted glycerin, the diluent is there. The diesel also to start the upgrader is on board here now and we have all the packages we need for intermediate and also for filed products.

So continuing along with this, going into the primary upgrader. So the primary upgrader is mechanically completed, electrically completed, instruments completed. We have done the hydro test, we have done the wall down. We are completing right fuel-loop test and by the way all this done also out of our main control room. So we are in September here pretty well ready for all the functions and all the operability of that that plant.

Going in to the frac business, going into the sulfur plant and the hydrogen plant, those two plants also are ready. They have been commissioned. As a matter of fact, we have the flair going right now. So we do have a bit of plan up there and the hydrogen plant also has been commissioned. So it's within operation now. So hydrogen is ready to supply hydrogen and the sulfur plant is ready also. We have a sulfur pad that we're finalizing. The pipeline has been completed. The pad itself is being completed. Now, the spreading tower that goes on these pads are coming up. One is built and the other one is going to be built here within the next 2-3 weeks.

So, that's not an issue either, so that sulfur pad will be ready. Looking at the utility side, and I'll keep the Hydrotreater for the end to have a bit of detail on that. On the utility side, the water has been circulated everywhere. All pumps, pipes, firewater, processed water, cooling water and also the heat integration to stand which is a whole bunch of exchangers and so all those have been commissioned now and they are also in operation. We had water circulating all the way down to the pump and we had our siphoned system which is the return of the water to have re-circulations and reuse of the water is also fully functional. So all these areas are now in operation.

The steam, same thing. All the boilers are up and we have been producing low steam, low steam, medium steam and high pressure steam for the commissioning the pipe track has been fully commissioned now on air, on water, on gas, nitrogen and the nitrogen plant also that has been commissioned as well.

So we do have blanket area for the tanks and intermittent tankage and the final tankage and so on. So that's also ready for operation. Now, talking about the hydro treating, there are three plants at the hydro treating. So, naphtha hydrotreaters, the diesel hydrotreaters and the gas-oil hydrotreaters. So starting with the naphtha hydro-treater, that plant is mechanically completed, electrically completed and we have loop checked to complete and within two weeks, this plant will be mechanically all done turning into operation. As a matter of fact, operations are already doing the walk down and starting up next week. Half of that plant, which is all the utilities going around and so on will be commissioned. So, this plant is well on its way right now for sometime in September here being ready to accept the oil.

Looking at the gas-oil plant, which is the second one to come on stream. The mechanical completion is done. In other words, all the pipe, piping tools, modules all those kind of things it's all welded in place and so on. We also have run just about every electrical cable too, there's few left, but very few and we're nowwe've done also the hydro-testing. The air blows on there and most of the walk down also with operation has been just about there. So, what's finalizing on that plant is the control loops and we're taking our time to do it very safely.

We want to make sure that the plant whenever starts it's going to run reliably and safely throughout. So, just to note here on this, as a matter of fact, we have taken more time to commission the plant that we were anticipating to start with. So all our procedures are in place. We want to make sure that step by step the plants are commissioned the right way. If there is any deficiencies and it punch list to complete, we will to take our time to do them right and eventually we get the plant running on a very safe matter. We have a accomplished a very high safety record so far. We definitely don't want to loose that had start here for us.

The third plant which is a diesel Hydrotreater is very close to mechanical completion in fact I think there is only a few school left [ph] within a couple of weeks they will be completed. We are also having a major ramp up now into completing the cabling and the termination for it and doing the loop check. This isn't the highest priority right now. Plant 43 and Plant 41s are the priority which is the naphtha and the gas oil.

Now I want to explain something here in terms of our stage startup. We can run this plant with the naphtha and the gas oil plant and produce a 100% pack SCO, which is a 34 EPI, 43 paying SCO. The main reason for this is because the gas oil plant that we have, will run the diesel and the gas oil mix in there. As you know, that the SCO is a mix of gas oil, diesel and naphtha. So naphtha being allied then has to run through its own catalysts and its own reactor. However, the diesel and the gas oil can run quite efficiently and actually through the gas oil plant. And that's what we are going to do.

So what we have in the fact is when you run the gas oil to its capacity, we can produce, combined with the naphtha plant, about 60% to 70% of our total production or 60,000 to 70,000 barrel a day of synthetic crude oil.

So the advantage of this of course for us was to venture this on plant 43 gas oil and the naphtha and get the production going. And then we can take the mobilized resources from these plants then to then plant 42 which is the diesel.

All three plants as a matter of fact our planned to be done here sometime before November. So if we have looked at this in terms of winter's product and we are quite comfortable with this. We do have expensive heat treating in our plant and insulation.

This plant is made to run in the winter, it is made to stop and start also in the winter. And by November we'll have all our heat tracing and insulation completed. We will also have already the naphtha and the gas oil plant running sometimes in September and October.

Each of them and by having those we have heat circulation and you know that this plant is very well heat integrated throughout. So we don't see a major issue for us here starting this plant in the fourth quarter.

The ramp up of the plan was originally set up to have 80% of the production by year end. 100% of the production at the end of the first quarter '09. we will be very, very close to this and our plant will have 60 to 70,000 barrel here in the fourth quarter and there is also a good probability that we will have a 100% of the production here before year end. And we will have just the duty of stabilizing the plant here in the first quarter of '09 to continue our production reliably.

So we are very well positioned right now to get these things rolling. The plant is rumbling right now, the people are very excited about it. We sure want to sometimes moderate the enthusiasm of the operators so that are very enthusiastic about firing the plant early and so on. But we want to do it the right way and we want to make sure that we are safe at the end of the day and once the plant is started, we are reliable. So that's pretty well what the situation is right now in the upgrader. So, for you Steve.

Steve W. Laut - President and Chief Operating Officer

Thanks, Réal. And I guess you can see why we are very confident in our abilities to hit our dates. We had given the ranges here. We expect to start as Réal said. We are also very cognizant of the fact that there are things that could happen that we don't expect you can have mechanical failure in some part of long lead item and then we don't expect could happen, so we have to give ourselves a range on start up. That's why we are conservative at times. As you know the start up of Horizon is a major positive step for us in our ongoing evolution. It will shift and Horizon will shift from a large consumer Canadian Natural's free cash flow to a large and sustainable contributor to Canadian Natural's cash flow.

As a result, our balance sheet will strengthen quickly. Cash flow available to allocate to capital projects will increase dramatically along Canadian Natural modeling term mark the huge value associated with the future expansions at Horizon. But the significant value of our high-quality conventional assets.

Overall, we're in a great shape. Our conventional assets are delivering. We're on the start up stage of Horizon, our balance sheet is strong and with our strong team and dedicated people, we're set to ramp up to the next level much higher level of value creation and delivery proclaiming shareholders.

With that I'll turn it over to Doug, to give you the highlights and our strong financial position.

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

Thank you, Steve. And good morning. In the second quarter of 2008, Canadian Natural generated over $1.85 billion of cash flow from operations or $3.44 a share, reflecting in particular strong commodity prices, narrower than the budgeted heavy oil differentials and our strong production base.

For the first six months of the year, Canadian Natural generated nearly $3.6 billion in cash flow, which closely matched our capital expenditure program for the first half of 2008. The ability to match cash flow with our capital programs reflects our commitment to financial discipline and controlled capital spending.

The second quarter's net loss of $347 million resulted form net unrealized after-tax expenses of $1.3 billion which included the effects of our commodity price risk management program. Excluding these items adjusted net earnings from operations for the second quarter increased to $960 million.

As we have previously discussed, the opportunity cost which has arisen from the commodity price risk management program has been more than offset by the long-term value created in our asset base by allowing the conventional oil and natural gas business to continue to grow, while at the same time allowing for the development of the Horizon project. As cash flow from our conventional operations continues to be strong, we will look forward to the addition of the Horizon projects cash flow which will allow from a managed debt reduction program in 2009 and for the development of our asset base.

As announced and discussed earlier, we are experiencing additional cost pressure at Horizon. Even so, our goal is to manage through and exit the year with the debt-to-EBITDA of less than one and half times and the debt to book capitalization are between 40% and 45%, below or within our targeted ranges of 1.8 to 2.2 times and 35% to 45% respectively.

Our liquid resources remain strong with available unused bank lines of $2.7 billion at the end of the second quarter. This liquidity combined with the plant to balance cash flow with capital expenditures demonstrates our financial discipline in the year which will see us complete four major projects.

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

John G. Langille - Vice-Chairman

Thank you very much, Dan, Steve, Real and Doug. I think you can see that we are well on track to meeting our goals. We are well on track and focused on completing our projects. And we will be continuing to add tremendous sustainable value to Canadian Natural.

With that operator, I will open the call up to any questions that the participants may have.

Question And Answer

Operator

Thank you. [Operator Instructions] The first question is from Brian Singer of Goldman Sachs, please go ahead.

Brian Singer - Goldman Sachs

Thank you and good morning. I joined a little late so I apologize if you discussed this earlier but I was wondering when you think about next year, you think about the winter natural gas drilling program, how fluctuations that we have seen in natural gas prices effect your thoughts and the aggressiveness of drilling and just some thoughts on the interplay between spending for oil and Horizon stage 2 versus spending for natural gas?

Steve W. Laut - President and Chief Operating Officer

Thanks Brian, Steve here. Obviously we are looking at a capital allocation and with the sort of budget here in for 2009 in September but we are to sort of looking at it carefully now. I think it's pretty clear that the returns for oil are significantly better than gas. A year now with the higher gas price and with gas price softening and what we see the gas rates in the U.S. lower 48 increasing. We are concerned that we will see further softening of gas prices. And if they do rebound, I mean not rebound to levels that will be required to compete on the capital allocation basis of oil. Particularly in 2009 in Alberta with the increased royalty regime, Alberta gas projects will have a very, very difficult time and I think you'll see the gas drilling here in Alberta decline markedly in the industry in Canada.

As far as allocating between further projects in Horizon and our oil projects in Canada and in international. I would say, right now Pelican Lake has very much the best drilling. We've got a very disciplined defined program there that we'll continue to execute. We don't see the need to ramp that up or slow that are down. We're trying to keep our cost effectiveness where we are. Primary heavy oil drilling, very much we can dial it up and dial it down with our inventory. And I expect you'll see us more likely dial that up as we go forward. On Horizon, we are very disciplined, and we have Tranche 2 that we are well in our way, we didn't talked much about that at all today in the call. But we are well on our way on Tranche 2 and we look at approving Tranche 3 as we move forward. The one thing that we do see here, in Fort McMurray in particular, area is the cost escalation of the availability of contractors. And as I would say the lack of competition for people that bid on your projects has had a more significant impact on cost increases than even we would have anticipated.

Internationally we see, again few big cost pressures there worldwide with high oil prices there is a big demand for rigs and all associated services. So that most likely areas of CS coal if we are going increase capital going forward increase drilling would be in primarily heavy oil as well as thermal heavy which is more of a disciplined program. So primary heavy oil is where you see the flexibility. A very long answer to a short question.

Brian Singer - Goldman Sachs

Great thanks. I might follow-up with one more short question which is do you see your gas rate counts between, I guess throughout Canada down year-on-year this winter or how do you see that?

Steve W. Laut - President and Chief Operating Officer

I would have said probably a month ago that you'd see that drilling go up, particularly in BC. Now I'm not totally sure we are going to see that happen with a softening in prices. I think BC would still be very strong appears as the Shale gas plays. Alberta I don't believe will be.

Brian Singer - Goldman Sachs

You're speaking for your own rig count or your thoughts on industry.

Steve W. Laut - President and Chief Operating Officer

Industry.

Brian Singer - Goldman Sachs

And what about the shale, what about your rig count?

Steve W. Laut - President and Chief Operating Officer

I think that will reflect the industry.

Brian Singer - Goldman Sachs

Great, thank you.

Operator

Thank you. The next question is from Andrew Fairbanks of Merrill Lynch. Please go ahead.

Andrew Fairbanks - Merrill Lynch

Hi, good morning guys. I just wanted to get your latest thoughts on hedging and whether it be on the more natural gas hedging for next year or will hedging or just like that a tradition you have now, basically run on?

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

Yes, thanks Andrew. With our hedging as you know we won't have the same capital requirements in 2009 as we have had the in the past four years. With it could be coming on stream of cash flow from Horizon and so that will mitigate to a large degree the amount of hedging we will need to do. We will however continue to monitor the markets and look for opportunities to lock in prices. Right now I think the positions you see will continue through, if we get better opportunities particularly like you said on natural gas we will take opportunities in that regard. It looks good hedge gas but it looks a soft market.

Andrew Fairbanks - Merrill Lynch

Right. And do you think you'll do any pilot well testing in your Monterey, acreage over the next, a year or so or just basically hold that in inventory until we see some stronger prices?

Steve W. Laut - President and Chief Operating Officer

We got two wells down and that would look good. And we'll probably drill two to three more wells here in the second half of '08 depending on the success there. These are all in BC by the way. We would likely drill more wells in 2009. Of course that all depends on capital allocation and also the economics but we think we have some of the best prime lands for Monterey development in BC. And so we'll slowly and carefully make sure we got it right before we go to a full scale development.

Andrew Fairbanks - Merrill Lynch

Thank you.

Operator

Thank you. The next question is from David Thomas [ph] of Highside Capital Management. Please go ahead.

Unidentified Analyst

Hey Steve, two questions; first on the new pipeline you guys announced, when I look at your schedule for the heavy oil assets ramping up, you've got Kirby coming on in 2011 with 45,000 barrels a day. You are next scheduled for Birch Mountain, 60,000 barrels a day in 2013. Are you guys going to pull any of that forward given that now you've got the capacity?

Steve W. Laut - President and Chief Operating Officer

David, we're, as you know, a very cost focused company. And we believe that the best way to control costs is to be very disciplined in project execution. And we're running all these projects through the gated process. We'll make sure we have our engineering complete and all the regulatory approvals obviously ahead of time so that we can essentially almost become like a cookie cutter operation going from one project to the next.

So for us to accelerate, I think there is a possibility we could do that. But it's something we won't do because that's when you get into cost escalation, when you try to go before... have all your engineering completed. So we won't do that.

Unidentified Analyst

Okay. And then just a follow up on Brian's question. On your conventional asset base, you guys are spending around $2.5 billion. You've got that conventional asset base this year doing $7 billion in cash flow, which makes you quite different than the majority of the E&Ps which are pretty much spending all their cash flow; you are spending a small fraction of it. And that number with Horizon, let's just take consensus estimates, goes up to $10 billion or $11 billion next year at $100 oil. I mean at some point here, I am worrying from a CapEx point of view, you are going to be in a position where you are going to be significantly under spending where you are at an operating cash flow basis. And that's why I asked the question on thermal oil. What are the options for what to do there? How much can you... where can you accelerate and if you can, I guess is the idea just to pay down debt and look for acquisitions?

Steve W. Laut - President and Chief Operating Officer

Well I think David we have a number of opportunities in our portfolio. The first opportunity really is to pay down debt. We are going to get our debt down to very strong levels. We will then look to do more oil drilling on the primary side, we have other projects in offshore West Africa that we will look to go to. We also have a very big exploration project, a big exploration project in South Africa. That's a very expensive shot to take.

The gas program will... obviously we have a bunch that's economics at this point in time because we have dormant infrastructure. We have very a tight land basin, we are low cost. So we have a lot of the inventory on the gas side is,economic but just doesn't be with oil. So we will be able to allocate more to the gas program particularly in BC as we move forward.

We also can look at competing to buy back shares. And as you know, we have always been an inquisitive company. And that's been about half our growth and we have, as know about Anadarko rate during the Horizon construction fees, we are not averse to looking at more acquisitions, particularly if they make sense with our asset base and we can see upside. So you can't propound on those. But we always are looking particularly for asset acquisitions.

Unidentified Analyst

Okay. Great. And then last question, Steve, order of magnitude and looking into 2009. I know you guys haven't done the budget, but kind of what level of '09, 2010 CapEx will Horizon take?

Steve W. Laut - President and Chief Operating Officer

Right now, what we have approved is for Tranche 2, which is about I would say in the $700 million range. There is some sustaining capital and obviously operating cost. But on the capital side, just both 700 million on Tranche 2. We will look as we move into the last half of 2008 or last quarter 2008, I should ay, to approve Tranche 3 which would probably take another $700 to $1 billion depending how quickly we move to allocate to Horizon for Tranche 3.

Unidentified Analyst

Okay. So just so I get the numbers right; you're spending $2.5 billion in your conventional asset base, we add another $750 million or so for Horizon next year to call it $3.3 billion and consensus numbers for cash flow are going to be $10 billion.

Steve W. Laut - President and Chief Operating Officer

You're going to see us probably allocate probably an extra $1 billion to conventional assets.

Unidentified Analyst

Okay.

Steve W. Laut - President and Chief Operating Officer

Now those are all preliminary numbers. We'll shake it all out here in the fall.

Unidentified Analyst

Okay. So then we'll have... so that'll be another $5.5 billion or $6 billion left in operating cash flow or free cash flow?

Steve W. Laut - President and Chief Operating Officer

That's right.

Unidentified Analyst

Okay. Thanks a lot, Steve.

Operator

Thank you. The next question is from Peter Kenner of Tivoli Partners. Please go ahead.

Unidentified Company Representative

Are you there Peter?

Operator

I am sorry, he has hung up. [Operator Instructions]. The next question is from Brian Button [ph] of Credit Suisse. Please go ahead.

Unidentified Analyst

Hi. Steve, I was just wondering on the heavy oil side and this supply agreement that you've negotiated. What's changed here that... I guess you've been in one form or other trying to negotiate this kind of agreement for a number of years. So I was wondering if you could give us an insight as to what's changed, what's brought the refiners to the table and if you could also give us some insight in terms of the pricing mechanism you have received.

Steve W. Laut - President and Chief Operating Officer

I think Brian, what's changed really, and we've seen that over some time here is that there's obviously some concern or anxiety, I would say, in Gulf Coast refiners on the security and supply from Venezuela and the drop in supply from natural declines in Mexico. You can see that there is a large and secure supply in Canada that can be pipeline connected. So I think there is a motivation from them to get supply. And that has allowed us to get together. This is a strictly market deal, so we will get paid essentially a mine differential or whatever the heavy oil prices are in the Gulf Coast. So there is no other mechanism at all. It is strictly market price sale, by and sell.

Unidentified Analyst

And what's your transportation cost?

Steve W. Laut - President and Chief Operating Officer

Our transportation costs are not being disclosed at this point in time. Obviously, that's part of the arrangement we have with TransCanada.

Unidentified Analyst

Okay. And second question and circling back to the gas questions you are receiving, what kind of recycle ratios are you seeing now on natural gas in Western Canada versus primarily heavy oil and thermal heavy oil?

Steve W. Laut - President and Chief Operating Officer

Well the gas recycle ratios are 2, maybe a little bit less. With the softening in prices, if you took the instantaneous, you would be below 2. We see recycle ratios on heavy oil depending where you are on what field and what product, degree of heaviness here the 9 or 14 degree API, anywhere from sort of 5 up in some cases to 10. So you get very, very quick payouts on heavy oil, particularly primary heavy oil in these places. We are making in excess of $90 a barrel for heavy oil, which nobody would ever dreamed of 3 or 4 years ago.

Unidentified Analyst

Thank you very much.

Operator

Thank you. The next question is from Harry Mathier [ph] of Lehman Brothers. Please go ahead.

Unidentified Analyst

Hi guys, thanks. A couple of questions. First, just on the hydrotreaters, is there anything specific about what's left to be done that should cause us some concern as we move closer towards winter? I know everything gets more difficult up there as the temperature drops, but is there anything that is left to be done that is much more difficult in the winter months that could cause, if the schedule slips a little bit more, a more significant delay into 2009?

And then the second question is just on the debt. I know, Doug, you provided some color on your debt targets by the end of the year. Can you give us any sense for next year in terms of what you're looking at for debt reduction? You saw that sizable term loan outstanding. Is the intention as of now to pay that down on the cash flow prior to its maturity in October 2009? And if so, can you give us a sense for initially where you think debt to cap or debt to EBITDA might stand during 2009?

Steve W. Laut - President and Chief Operating Officer

Hey Harry, Réal [ph] asked this question on hydrotreaters, and by the look of it, you guys are trying to get the 2009 budget out of us before we even do it. So I'm not sure how much Doug can give you. But on the hydrotreaters really, it's Plant 42 or the diesel hydrotreater that's at risk for cause of cold weather issues. And as we offset most of the mechanical completion will be done; that's probably going be the most affected by piping and electrical instrumentation. All the outside work will be... that will be the most affected. But I think we will have that mostly done. So it'd really the loop checks and insulation. And if we are running hot and we have got heat tracing, insulation is not the highest priority. So I don't see a big issue there. Réal, you want to give a little bit more color and probably a much more definitive answer?

Réal M. Cusson - Senior Vice-President, Marketing

Yes, okay. First of all, yes, you are right Steve that it is Plant 42 because the other ones are going to be in operation anyway. So in this plan, what could have been a credit for one would have been the hydrotesting for example because we do that with water or glycol. For example, last winter, we did a lot of hydrotesting on some of the plant already that we were starting to commission and then we have done them quite successfully with glycol, so there was no issue. However, in this plant here in Plant 42, all the hydrotesting, the air blows and so on to close up the plant will be all done here well before December anyway. So that should not be an issue. But providing if we have for example an early cold weather in October or November, we would use glycol and that would be an issue.

What would be left at the end is the cooling... the load check and so one which are really electronic kind of thing. They are all done internally; in other words, in the heated environment. And the termination, which is also most of them, the external one like to the instrumentations are done. It's the one going into the control rooms and all those kind of things. So we don't right now foresee any major issue. The plant itself will start first of all on nitrogen and then it will start on hydrocarbon, which is already hot. So we don't foresee a major, really major issue of starting up even if we have few cold days here.

Steve W. Laut - President and Chief Operating Officer

So, Harry, I guess just to add to that, we are... the only issue that could push a cost out for us here, I would say, is an unusual event, which we can't predict. We've run all our pumps and motors in most of the hydrotreaters now, so we don't expect to see issues there. But you never know once you start to run it up that you could see an issue somewhere in the plant with a pump or a motor that may be a long lead item and could cause some delay and extra expense. So with that, I'll expect Doug to give you rest of the 2009 budget that we haven't done.

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

Thanks Steve. So you're absolutely right. We have the $2.3 billion payment that's due in October of 2009 and we're looking at that number. I guess there is two ways I would answer that. Number one is the numbers that was worked out of Steve previously where we will have sufficient cash flow and we will be allocating a good portion of our cash flow for 2009 towards that payment. The other thing that I would mention is I did say that we had $2.7 billion of unused lines. And of course, we could also use our existing lines to retire that debt. But it would be our preference to retire it from cash flow.

Unidentified Analyst

Great, thank you very much.

Operator

Thank you. The next question is from Robert Plexman of CIBC World Markets. Please go ahead

Robert Plexman - CIBC World Markets

Good morning everyone. I have a few questions related to Horizon. I just want to make sure I've got this right because you essentially are saying you are a couple of months behind but hope to get caught up before winter and basis stay on track.

Steve W. Laut - President and Chief Operating Officer

Basically, it's really... as you heard Réal describe it, most of the stuff is going to be done in the first part of the quarter and most of the plant is running and starting up at stage plant before we get close to enter. So, it's just the hydrotreators that we are a bit concerned about. Plant 41 and 43 the gas oil and Naphtha shouldn't be an issue. Plant 42 will be the one at our risk for winter start up and we have a choice there. If we feel it's really too cold to delay it, even longer if you want, because we will be able to run close to 70,000 barrels a day with the hydrotreators that we have in operation.

Robert Plexman - CIBC World Markets

So, one thing would you expect it to clear a commercial operation start counting revenue out of it?

Steve W. Laut - President and Chief Operating Officer

I think once we start selling HCL [ph], into the pipeline on a sort of a consistent basis and once we get probably a weeks worth of run time.

Robert Plexman - CIBC World Markets

Okay. And can you be more specific in terms of like is that October, November?

Steve W. Laut - President and Chief Operating Officer

Yes.

Robert Plexman - CIBC World Markets

Yes okay. Okay, good. And also, the long lead times that have been ordered related to the second - third phase, just want to check. Is the cost for those that is included in the $9.3 billion?

Steve W. Laut - President and Chief Operating Officer

No, that's spaced on its own.

Robert Plexman - CIBC World Markets

Okay. Okay thanks.

Operator

Thank you. The next question is from Peter Kenner of Tivoli. Please go ahead.

Unidentified Analyst

Hi, good morning. Could you tell me... I know that you might have discussed this before, but in terms of heavy oil and regular oil. At what prices is it profitable for oil... heavy oil and regular oil to be at?

Steve W. Laut - President and Chief Operating Officer

That's a very good question. It's all dependant on the cost. When you see cost escalation out there with rising oil prices.

Unidentified Analyst

At today's prices, let's say.

Steve W. Laut - President and Chief Operating Officer

At today's prices. Cost, you mean?

Unidentified Analyst

Yes.

Steve W. Laut - President and Chief Operating Officer

I would say for heavy oil, I would think we are particularly... low differentials in that $50 to $60 range. For thermal oil, I am going to say $60 to $70. Pelican Lake is probably lower than... probably in the low end of 50s. That's going forward for those types oils. And well our light oil drilling in Canada is not that much. So probably wouldn't give you a number there. I think you'd probably need to be in the $70 range to do North Sea drilling and in that... with our prospects, probably that's $60 to $70 oil range in offshore West Africa.

Unidentified Analyst

$60 to $70. Okay. And do you foresee that oil... the heavy oil and the other oils that we are talking about... they will that the prices that we are seeing now, what price do you have in your model as to where oil is going to be going forward?

Unidentified Company Representative

Well right now, we run our long-term price in the $70 to $80 range WTI.

Unidentified Analyst

Okay.

Unidentified Company Representative

The differentials are a lot higher. Going forward here, I expect differentials will rise from 17% we have seen in the second quarter and 13% we see today probably up closer to that 30% level we have seen historically. So that's what our long-term view is.

Unidentified Analyst

Okay, great. Thank you very much.

Operator

Thank you. The next question is from David Wheeler [ph] of Alliance. Please go ahead.

Unidentified Analyst

Hi, good morning, I had a question for you on the next tranches of expansion at Horizon. Basically tranches 1 through 4, I guess. When we think about Horizon Phase I costs coming in just north of $80,000 per flowing barrel and the industry looking at cost for projects in 2010 to 2012 between $100,000 and $150,000 per barrel. And I recognize some of the next phase your initial stage had some of the costs incorporated in that for the next phases. What might be a reasonable expectation? You mentioned costs are higher than you previously expected. What might be a reasonable expectation for a range per flowing barrel for the next several tranches at Horizon?

Steve W. Laut - President and Chief Operating Officer

Obviously, we're doing this in tranches so we can better cost control. But we are seeing our ability to control costs to have an effect on the market to be lessening. So our range now, I think a reasonable range would be to use between 90,000 and maybe $120,000 or $130,000 per flowing barrel. I think we'd get up to the 120,000 or 130,000 barrels a day, we'd have to think very carefully if we proceed at that point. The only some of these things are going to get more in line is either that capacity in the contracting side of the business or the service side of the business and construction side increases or activity decreases before you get some more rationality in the cost side of the business in Fort McMurray.

Unidentified Analyst

And Steve, if you say 120,000 to 130,000 might give you pause, is there an oil price at which you'd be comfortable going ahead at those price levels? Or is it just the fact that those numbers are too inflated, too big?

Steve W. Laut - President and Chief Operating Officer

The thing we will have to think long and hard about at those cost levels is at what price... and these are 40 year projects... what is the long-term price? I would hate to build $120 or $140 WTI cost world and then produce the product out at a $60 world for the next 40 years. When you can take your time and do it... get a lower cost. So that is the need we'll have to have when we get to Tranche 3 and Tranche 4 to get to the full Phase II, III buildout as well as Phases IV and V for Horizon to get us to just under half a million barrels. I would expect at each decision point, we'll have that debate towards costs and what our future outlook for oil is, and that's a very dynamic discussion.

Unidentified Analyst

Okay. And it sounds like Tranche 1 and 2 because those are lower capital tranches that those are go ahead and the decision point on that might be on Tranche 3 or 4, is that fair?

Steve W. Laut - President and Chief Operating Officer

Tranche 1 is complete, Tranche 2 is under construction right now or is approved, Tranche 3 is coming up here shortly for approval. So it will be for Tranche 3. I would suspect Tranche 3 and 4 actually do have costs manage as we pre built in Phase I. So maybe we'll look at it. We'll obviously look at it, but there is less risk on Tranche 3 and maybe more risk on Tranche 4, but it's going to be definitely there for Phase IV and V, but there is some time period, so we'll have a better feel for further costs and for what we believe the prices will be going forward. It's a very difficult question to answer to try to predict the future.

Unidentified Analyst

Sure. Okay, that's great. Thank you.

Operator

Thank you. There are no further questions registered at this time. I would now like to turn the meeting back over to Mr. Langille.

John G. Langille - Vice-Chairman

Thanks very much operator and thank you everyone for attending our conference call. As usual, if you have any further question, please do not hesitate to contact us and everybody have a good day. Thank you very much.

Operator

Thank you. The conference has now ended. Please disconnect your lines at this time. Thank you for your participation.

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Source: Canadian Natural Resources Ltd. Q2 2008 Earnings Call Transcript
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