The next big play: Canada's oil sands

By Bernard Simon
Financial Times

Over the next few weeks, oil companies from North America and Asia will take decisions that will help determine whether the Canadian province of Alberta joins the ranks of the world's great oil-producing regions.

At stake is a chance for the US to bolster its energy self-sufficiency, for China and Japan to increase their access to much-needed crude supplies and for Canada to gain a long-term economic boost.

Enbridge of Calgary, which operates oil pipelines, late last month began what oilmen call the "open season" for its proposed Gateway project, a 1,160 km pipeline from the provincial capital Edmonton to Canada's Pacific coast.

Terasen, a Vancouver-based pipeline operator that has just been acquired by Kinder Morgan of the US, plans a competing project, also across the Rocky Mountains. They are seeking commitments from refineries along the US west coast and across the Pacific to buy oil produced from Alberta's massive deposits of bitumen-like oilsands.

The refiners' decisions and the building of one or more westward pipelines could determine the success of as much as C$100 billion (Dh308.64 billion) of oilsands projects already announced by producers in Alberta, though it is unlikely that all will come to fruition.

The oilsands, a source of crude for almost four decades, have overtaken Alberta's conventional oil output in the past few years.

But the jump in the oil price and a renewed drive in Washington on energy security have turned a little-noticed curiosity of the global oil industry into one of its hottest prospects.

"It's like a big party right now: everybody wants to come," says Chris Fong, managing director for corporate banking at RBC Capital Markets in Calgary, part of Royal Bank of Canada.

The party is certainly in full swing in Fort McMurray, a former trading post of the pioneering Hudson's Bay Company.

The town, four hours' drive north of Edmonton, has become the commercial centre for the oilsands, its population doubling in 10 years to 61,000.

Melissa Blake, mayor of the Wood-Buffalo regional municipality that includes Fort McMurray, estimates that another 9,000 workers are living in camps and 2,000 in hotels.

Local amenities such as the Boomtown Casino are also doing a roaring trade in the remote location where winter temperatures get as low as minus 40C.

The average price of a house in Fort McMurray topped is now well above levels in Toronto and Vancouver.

Blake says the city is planning for a population of 100,000 by 2010. Her projections reflect a widely shared belief that the oilsands activity is more than a brief wonder.

Describing Fort McMurray as a short-term boom town "is quite wrong", says Stephen Williams, who oversees oilsands operations at Calgary-based Suncor. He predicts that the oilsands "are going to have a big impact on Canada's GDP [gross domestic product] and balance of payments for the next 50 or 100 years".

The oilsands are undoubtedly a vast resource. Located in three main deposits across an area the size of Florida, they are estimated by the US Department of Energy to contain 175 billion barrels of oil. Those reserves are exceeded only by Saudi Arabia and, potentially, Venezuela.

First Energy Capital, a Calgary stockbroker, observed in a recent report that "while oil analysts can only speculate about the state of Saudi Arabian oil, Alberta's oilsands reserves can be easily evaluated by any individual or organisation".

The oilsands, which look and feel like molasses, are found in bands that are 6-10 metres thick. Shallow deposits are extracted by open-pit mining. Two tonnes of oilsands yield about 1.25 barrels of bitumen and a barrel of crude.

At greater depths, the oil is recovered by injecting steam into wells, which melts the bitumen, allowing it to be brought to the surface.

The bitumen is then "upgraded" into heavy crude oil and sent by pipeline to a refinery. "The difference between the conventional world and here," says Williams, who spent much of his earlier career with ExxonMobil in the UK, "is that you can put a spade in the ground and you've got it. You know what it is and where it is".

Four existing projects produce about 1 million bpd of oil. Suncor's site, which started production in 1967, moves close to 1 million tonnes of rock a day, making it by that measure the biggest mining operation in the world. Canadian Natural Resources recently announced a vast expansion of its Horizon project. If all the planned developments come into existence, output from oilsands in the area will rise to about 3 million barrels per day by 2015.

This expansion would more than compensate for dwindling conventional oil production in other parts of western Canada, lifting total Canadian output from 2.5 million bpd to 4 million bpd over the next 10 years.

Some Canadian oilmen are talking of further expansions to boost the total to 5 million bpd or more. "This is no longer an experiment in northern Alberta," says Greg Stringham, vice-president at the Canadian Association of Petroleum Producers. "This is real oil on a world scale that is economic as new supply."

Canada already provides 10 per cent of US oil needs. The oilsands could help the US lower its dependence on supplies from such politically risky areas as the Middle East, Venezuela and west Africa.

As Williams at Suncor puts it: "You've got one of the biggest oil reserves in the world adjacent to the biggest market in the world and the political climate is stable."

US companies have taken a growing interest in the oilsands. ExxonMobil, Chevron and ConocoPhillips are among those with stakes in either existing or proposed projects.

Kinder Morgan in August paid C$6.9 billion for Terasen because, according to Rich Kinder, chief executive, the oilsands were "expected to become an increasingly important supply source to North America and Asia".

France's Total paid C$1.4 billion this year for Deer Creek Energy, which expects to start construction of an oilsands project in 2006.

China National Offshore Oil Company and Sinopec, two of China's biggest energy groups, have invested in small Calgary-based companies with oilsands ambitions. Husky Energy, controlled by Li Ka-shing, the Hong Kong tycoon, is developing one project, planning another and is also considering expanding a bitumen upgrader that it owns on the Alberta-Saskatchewan border. Fong at RBC Capital estimates that more than C$6 billion in debt and equity has been raised for oilsands projects over the past six years. He expects a fresh wave of financing in 2006 as construction starts on the latest round.

There is little concern whether the oil price will stay high. "We can make a living at $20" as a selling price per barrel, says Williams, noting that Suncor went ahead with its Millennium project in the 1980s when oil was at $11.80.

(A bigger worry for now is the strong Canadian dollar, recently at a 12-year high against its US counterpart.)

Dominion Bond Rating Service of Toronto estimates that new oilsands projects are likely to be healthily profitable at world crude prices above $30 a barrel, around half the current level.

Lloyd Byrne, an analyst at Morgan Stanley in New York, says that "costs at Suncor's Millennium are now not only competitive but advantaged".

The oilsands have several advantages over conventional oil deposits, he says, including a lower exploration risk and a longer production life.

Furthermore, the cost of operating conventional oilfields has risen markedly in recent years.

Yet some big questions hang over the future of the oilsands. Dominion titled a lengthy report on the sector, published last month, "One of the world's greatest sources of oil? But not without risk". Williams says that oilsands operations are more akin to manufacturing businesses than to oil wells, requiring tight control over a variety of processes. Recent projects have been dogged by delays and cost overruns. The bill for Shell's Athabasca project, commissioned in April 2003, climbed from C$3.9 billion to C$5.6 billion. An expansion of the Syncrude mine and upgrader, currently under construction, will cost more than C$8 billion, close to double the initial estimate. Soaring prices of natural gas are a concern for oilsands operations, which use huge quantities of gas to produce steam for the extraction process and to upgrade bitumen to crude oil. Producers and developers are scrambling to find less costly alternatives. Among the most closely watched is a refining technology developed by Nexen and Opti Canada, both of Calgary, for their Long Lake project, which is under construction.

The refining process would itself produce the gas needed for steam injection. Long Lake expects to bring operating costs down to $5-$9 a barrel, though some outsiders say the technology has yet to be proved.

Another problem is labour, which is in short supply in northern Alberta, putting upward pressure on wages. Import Connection, a store on Fort McMurray's main street that specialises in foreign foods, sells corn flour to Venezuelan petroleum engineers and biltong (dried meat) to South African mining specialists, showing how wide oilsands producers are casting the net for skilled staff.

The dearth of affordable housing has exacerbated the labour shortage.

Government websites urge anyone thinking of looking for work in the oilsands to ensure they have somewhere to live before making the move.

Housing, labour and infrastructure bottlenecks will probably ease with time. But the companies now weighing big investments in the oilsands also face a more fundamental and long-term issue.

The four existing projects ship virtually their entire output to refineries in the US Midwest, near cities such as Chicago and Minneapolis. But these refineries are already running at capacity in producing heavy crude.

That has deepened the discount on Alberta heavy oil to about $20 a barrel below the light crude price.

"We need markets for the oil," says Stringham of the oil producers' association. "There is no sense in going from 1 million to 3 million barrels a day if we don't have a market for it and the pipelines to carry it." The oilsands producers are keen to create a more competitive market by finding customers in California, the US Gulf coast and east Asia.

They make the argument that most Chinese refineries are closer to the west coast of Canada than to the Middle East.

But a chicken-and-egg situation has developed, with producers reluctant to invest in projects until pipelines are built, and pipeline operators hesitant to commit to adding capacity until markets are found. "Trying to get things synchronised is really key here," says Pat Daniel, Enbridge's chief executive. "In our business, you can't spend $2.5 billion on spec" the amount its pipeline would cost if the company received commitments by the US west coast and Asian refiners to lift the 400,000 bpd it needed to make the project viable.

Some progress has been made in gaining new markets.

Enbridge has approval to send 100,000 bpd as far south as Oklahoma, along a pipeline that previously flowed northward.

Similarly, ExxonMobil plans to reverse a pipeline linking Illinois and Texas. These projects will enable heavy oil from Alberta to compete for the first time in the southern US with similar supplies from Mexico and Venezuela.

Terasen formed a partnership late last month to build a C$1 billion pipeline from the Pacific coast to Edmonton to carry up to 100,000 bpd of condensate. The condensate, recovered as a liquid from natural gas, is used to dilute heavy oil so that it can flow smoothly through pipelines. Enbridge, also planning a condensate pipeline, is widening its diameter because of strong interest among potential users.

Refineries in the Midwest may also step up their capacity to process heavy oil. Enbridge is set to expand its pipeline to Chicago by 2009 at a cost of $1 billion. A $300 million branch line would carry oil to a refining centre near St Louis.

But most crucial in putting the oilsands on the global energy map are the proposed pipelines across the Rockies to the Pacific coast. "If we can't hit this one out of the ballpark as Canadians, I don't know what we can hit," Daniel says. He and the rest of the industry will know the result by early next year.