Sources of Hidden Value in Canadian Oil Sands Equities

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Includes: COSWF, IMO, SU, WTOIF
by: Randy Kirk, CFA

At first glance, the idea of mining a type of oily mush – oil sands -- by gigantic shovels in the far north does not sound like a profitable or even a particularly appealing idea. However, contrary to this impression, oil sands mining is very profitable at current oil prices, rivaling conventional oil production in terms of profitability per barrel of oil. The profit potential of oil sands has led to an explosion of activity in the Albertan oil sands regions, indicated by the fact that the total area of Canadian oil sands (over 30,000 square miles) is majority -- over 61% -- leased by oil firms currently, up from only 31% leased in late 2006, according Alberta Energy. The rush to lease land in Northern Alberta is driven by significant advantage for the firms holding the long term leases in all areas of the oil sands territory. Further, at a premium in terms of profitability are those areas in which oil sands can be mined verses “in-situ” methods, as mining oil sands – digging the oil sands from the surface and moving them to extraction facilities -- is a more reliable extraction method at the current date of this writing (10/07) and slightly more profitable than the alternative method of oil sands extraction, “in-situ” production – the heating of oil sands below the surface and then collecting the melted bitumen.

All in all, an analysis of the Canadian oil sands industry indicates that the more established firms with significant lease holdings of land in the mineable regions of the Canadian oil sands regions – namely, Syncrude, Suncor, Imperial Oil and the Athabasca Oil Sands Project – should sell at premiums compared to less established oil sands firms.

This article will discuss the profitability, leasing issues and extraction methods of the Canadian oil sands industry, which have, to date, (to the author’s knowledge) received less attention than they should from investors into oil sands equities. Note that this article does not address environmental issues and taxation issues with regards to oil sands development, so the reader is encouraged to do their own due diligence with regards to these issues.

Introduction to Canadian Oil Sands

Canadian oil sands are a type of heavy oil resource, mixed with sand and water which forms a substance which resembles an "oily mush." The bitumen from the oil sands -- chemically long hydrocarbon chains that are close in structure to those of asphalt -- can be upgraded, after separation from the sand and water, to syncrude (a type of heavy oil), which then can be further refined to gasoline, jet oil, and other premium petroleum products. The majority of Canadian oil sands are located in the Athabasca region of Alberta, an area covering approximately 30,000 square miles, but significant oil sands deposits are also found in the "Peace River" and "Cold Lake" deposits, which are are also located in Northern Alberta but in distinct regions from Athabasca.

Profitability of Oil Sands Firms

Oil sands production is very profitable currently, due to the current, relatively high price of oil. Further, oil sands profitability rivals conventional North American oil production, in terms of profit per barrel of oil extracted. According to Morgan Stanley (source: see the Lloyd Byrne Morgan Stanley presentation on the bottom right hand concern at the Canada Institute here.) oil sands as of 2004 returned an average of 18.0% on capital employed (ROCE of 18%) verses 15.0% for conventional North American oil production. Further, the cost per barrel of oil -- cost defined as cash costs for operation, SG&A, accretion expense, taxes other than income taxes, and DD&A) were $14 per barrel for Suncor's Millennium project verses $16 per barrel for conventional North American oil and gas production. That is to say, at 2004, according to Morgan Stanley, oil sands were actually more profitable per barrel than conventional oil production -- clearly Wall Street and most investors do not appreciate this view, given the relatively low p/e's of the oil sands majors compared to the planned growth rates.

The reasons Morgan Stanley gives for the very competitive costs of oil sands production are: a high degree of "repeatability" -- meaning steady future production and predictable inputs to achieve future production -- due to very large and relatively homogeneous reservoirs, and very low exploration costs, verses conventional oil and gas.

The results of the two, pure play major oil sand producers (Suncor (NYSE:SU) and Syncrude) underscore the profitability of oil sands production demonstrated by the following (source: company financial press releases):

As shown above, both Suncor and Syncrude are currently very profitable based on reported results for the latest six months. However, note that comprehensive analysis of future costs is not presented here, although there has been significant press coverage of rising oil sands labor and equipment costs. However, as shown above, the Oil Sand Majors are still very profitable as the rising price of oil more than offsets the rising operational costs. But in the future, if operational costs go up without a corresponding rise in the price of oil, then this will certainly hurt oil sands firms' profitability.

Source of Value for Oil Sands Firms: Size and Quality of Leased Land

According to Alberta Energy, the majority of the total geographic area of the Athabasca oil sands has been leased by firms. Specifically, the area of the oil sands that has been leased for purposes of oil sands extraction has increased dramatically from 31% of the total area at 6/06 to 61% at 4/07 (and is likely to have increased further as of the time of this writing at 10/07), according to documents here. In addition, the area of the Athabasca oil sands that can be profitably mined by surface mining – note that only approximately 20% of the total Canadian oil sands area can be mined by surface mining methods -- has been nearly 100% leased by major oil sands firms.

Oil sands leases present significant value to the firms processing them. According to Alberta Energy, the leases range in tenure from 15 to 21 years, and can be renewed 1 year before the expiry date -- the legal language gives priority to the existing leaseholders: specifically "Leases are continued if the required minimum level of evaluation has been attained." Evaluation is mainly seismic and other geological evaluation which would normally be done by producing firms (see section 3-7 of Alberta Energy's Alberta Oil Sands Tenure Guidelines) (.pdf). It can be inferred that most of the leases will be renewed and therefore represent something more akin to a “long term” holding of land.

The result of the current Alberta Energy legal language is that the leases have a "first come, first serve" quality -- they go to the highest bidder at auction, then are able to be withheld (in effect) over the long term by the winning bidder. As such, firms with the most leases and the most geologically valuable leases have a significant advantage over firms that are late to the game and/or do not have significant land holdings -- that is, the largest firms, Suncor, Syncrude, Imperial Oil (NYSEMKT:IMO) and the Athabasca Oil Sands Project process significant value due to their large lease holdings.

Note, however, the legal documents do not contain language that prevents the extension clauses from being changed in future years, so it is possible that extensions may be more difficult to renew going forward. This is a factor that investors should watch in future years.

Differences Between Oil Sands Mining and Oil Sands "In Situ" Production

The majority of oil sands production currently (at mid to late 2007) comes from mining methods, which essentially can be described as follows: huge digging machines, which dig surface oil sand, load this oil sand into huge trucks, and move the oil sand to processing facilities. It is emphasized that these trucks and digging machines and shovels are huge, as the Caterpillar 797 truck used for hauling oil sands has been compared by its manufacturer in size to an entire Wal-Mart store and can crush an SUV underneath and the driver of the 797 will not feel a bump. Mining projects account for over 60% of total oil production and a higher majority of production for Syncrude and Suncor's current oil sand production.

In Situ production is described as the melting of underground oil sands and collection of the resultant melted bitumen by vents. In situ production is utilized when the oil sand resource is located far underground, so that surface mining is not possible -- note, that by area, over 75% of Alberta's oil sands are deep underground and appropriate only for in situ production. According to Imperial Oil, which claims to be the most experienced in-situ producer currently at in situ production of 170,000 barrels per day, there are certain geological requirements for in situ production with current technologies: that is, 1. the reservoir should be "clean" with a high bitumen saturation, and/or 2. the reservoir should have a capping shale cover (to keep the heat contained). It is not known what percentage of underground oil sands in Alberta possess these requirements. There is some uncertainty going forward in the predictability of future volumes from in situ production. Bitumen produced by in situ production from a single location has not resulted (as of late 2007) in more than 170,000 barrels per day -- as is the current production level at Imperial Oil's current Cold Lake operations (although note that Imperial Oil is confident that they can continue to increase the production from this property by 4% per annum going forward). Further, conceptually, it is more straightforward to increase production to increase by mining methods -- that is, it is simple under mining methods to increase the number of shovels and trucks, and upgrading and refining capacity. In contrast, with in situ production, it is unclear (in the author's opinion only) whether heating the underground reservoir at a higher temperature to increase bitumen flow and/or more vents constructed to collect melted bitumen would increase production at a steady rate.

Note also that only a relatively small area of the total Canadian oil sands area -- less than 25% of the geographic area -- can be produced with surface mining methods, as surface mining only is applicable when the oil sands are located near the surface, defined as under less than 75 meters of overburden. The mineable area of the oil sands is already nearly 100% leased according to maps from Alberta Energy (large pdf warning).

Therefore, in the author's view, the companies with large lease areas and operations in the mineable areas of the Athabasca oil sands territory (Suncor, Syncrude and Athabasca Oil Sands Project) have increased predictability of future resource development, and therefore should (all other factors equal) be valued at premiums to reserves verses in situ-heavy producers.

Differences in Terms of Profitability between Mining and In Situ Production Methods of Oil Sands

According to Nexen Inc. (NXY), the overall economics are similar between in situ and mining methods -- with a slight edge to the mining process, estimating an operating margin of 56% for mining methods vs 50% for in situ processes per barrel of oil based on $50 oil. However, costs in individual processes can range widely, from $18 to $30 (at late 07) per barrel of heavy oil, depending on the location and geology of the resource.

But, according to Nexen, there are significant differences in components of cost between the two methods: natural gas usage in “in situ” production is generally more than twice the level than in mining production -- because natural gas is used to heat the bitumen underground. But other production costs are more than three times the level in mining methods verses in situ -- because the mining equipment and trucks are expensive to operate, and the sand component of the oil sand from mining methods must be separated out in an extraction process. Upgrading and refining costs are similar between the two methods. See: the Nexen Presentation on this page for details.

The upshot of the above discussion is that both methods in theory can provide a very strong return to shareholders, and therefore the principle difference (in the author's opinion) between the two methods is the attainability of production levels between the two methods -- that is, the mining method is comparatively more reliable and therefore projected increased numbers can be relied upon more securely, as stated in the section above.

Conclusion

The purpose of this analysis was to provide an overview of the producing firms in the Athabasca Oil Sands region, and provide an overview of expected profitability for investors interested in investing in Canadian oil sands. The conclusions of this analysis was that oil sands are currently profitable, and are likely to continue to be profitable -- as long as oil prices continue to stay at elevated levels. Priority was given to the more established firms in the Athabasca region, due to the fact that they have large lease holdings of land, and establish operations -- operations built when prices of equipment were are significantly lower levels than current due to the rise in steel and material costs over the last 3-4 years. Future increases in synthetic oil production is considered likely, although the exact timing of such increases by the firms is difficult to ascertain, but more reliability is given to firms which extract oil sands through mining methods.

Appendix: Brief Overview of the 4 Largest Oil Sands Firms

1. Syncrude Inc. Investors can purchase indirectly through Canadian Oil Sands Trust (OTCQX:COSWF), 37% owner. Syncrude represents a consortium of oil majors and the managing Canadian partner Canadian Oil Sands, Inc, which produced approximately 361,000 barrels of syncrude a day (at 6/07) mainly through mining methods. Syncrude forecasts production of 500,000 bpd by 2015. The market capitalization of Syncrude was approximately $US43Bn at 10/07, representing a price to earnings ratio of 18x on trailing earnings. Syncrude reported lease holdings of oil sands land of 386 square miles at 12/31/06.

2. Suncor (SU). Suncor is the oldest Canadian firm and is 100% publicly held. SU produces approximately 270,000 barrels of syncrude at day at 6/07, produced mainly through mining methods. Suncor forecasts production of 500K to 550K bpd by 2012, the market capitalization was approximately $US45Bn at 10/07. The price to earnings ratio was 19.2x for the last 12 months and is forecasted (by Yahoo finance) at 14.6x for 2008. Suncor reported lease holdings of oil sands land of 772 square miles at 12/31/06.

3. Imperial Oil (IMO). Imperial Oil is approximately 70% owned by ExxonMobile, and produces 140,000 barrels per day in the "Cold Lake" region (not the Athabasca region) through in-situ methods, and, in addition, owns 25% of Syncrude Inc. IMO’s market capitalization was $45Bn at 10/07. IMO’s price to earnings ratio was 14.8x trailing 12 months and 16.0x forecasted for 2008 according to Yahoo finance. Imperial Oil reported lease holdings of oil sands land of 727 square miles at 12/31/06.

4. Athabasca Oil Sands Project [AOSP]. AOSP is 20% owned by the publicly-held Western Oil Sands (OTC:WTOIF), and is also 60% owned by Shell, and 20% owned by Chevron. AOSP produced 180 bpd in mid 2007, produced mainly through mining methods. AOSP forecasts production increases to 500K bpd by 2015. AOSP reported lease holdings of oil sands land of 55 square miles at 12/31/06.

Note that other firms are up and running, including Encana (NYSE:ECA), Nexen and the Consortiums Western Oil Sands Inc, North American Oil Sands Corporation -- producing firms minority and majority owned by partners Chevron (NYSE:CVX), Statoil (STO) and Shell (NYSE:RDS.A) and other oil majors. However, these firms currently (9/07) produce on a significantly lower scale than the four "Oil Sand Majors" listed above, although plan to increase production going forward -- production forecasts are discussed below. Further, note that only three firms, Syncrude, Suncor and the Athabasca Oil Sands Project, are producing oil sands through mining methods (to be described more fully below) on a major scale, while other firms are producing oil sands currently through "in-situ" methods, which involves two methods of pumping hot steam underground and collecting the melted bitumen.

Disclosure: the author holds long positions in both Suncor and Canadian Oil Sands.