End of the oil sands' building frenzy?

Claudia Cattaneo
Financial Post
Friday, December 12, 2008

Oil sand is a mixture of bitumen (a thick, sticky form of crude oil), sand, water and clay.Courtesy of Suncor EnergyOil sand is a mixture of bitumen (a thick, sticky form of crude oil), sand, water and clay.

CALGARY, Alberta -- Canadians have grown accustomed to the flow of multi-billion oil sands investments from all corners of the Earth, turning Canada's currency into a petro-dollar and pumping economic prosperity.

But as the sector struggles with its first downturn since the rush started 11 years ago, there's increasing discussion this is not a short-term pullback, but the end of the oil sands' building frenzy.

The economic crisis and collapse in oil prices have pushed the sector to the brink, resulting in the delay of some $40-billion in new projects, taking 800,000 barrels a day of expected production growth -- about half of what had been expected -- off the table, according to CIBC World Markets.

Meanwhile, existing projects are close to losing money at today's oil prices. According to a recent Merrill Lynch report, many oil sands projects need US$38 a barrel oil to break even. Oil prices settled at US$46.28 a barrel on Friday, keeping projects in the black for now, but curtailing developers' ability to fund expansion.

Industry watchers say companies that scaled back won't be rushing to jump back in, even if oil prices recover above US$90, the level many say is required to build new projects.

Other problems would have to be resolved: mounting costs, tight financing and, of course, environmental challenges. The oil sands' poor image could lead to even tougher environmental legislation.

The implications of a no-growth period for the oil sands are grim, not just for Alberta, but the entire country. The oil sands boom has been Canada's economic engine over the past decade. The country's rise as a major global oil producer would stall and the United States would see its energy security options reduced.

The effects of those cancellations are already being felt. Contracts are being cancelled. Construction jobs in Fort McMurray are drying up. The construction industry slashed its workforce requirements estimate by half for 2010 -- to 22,000 from 44,000 jobs -- in what was to be a peak building year. Workers in Calgary are being sent home.

Oil sands pioneer Jim Carter is clearly concerned for the sector's future. The mining engineer and former president and chief operating officer of Syncrude Canada Ltd., who retired in May, 2007, after nearly three decades in the business, sees two possible scenarios unfolding.

With a much-needed break from years of explosive growth, he says the oil sands would have the opportunity to "recalibrate" -- get inflation under control, lower everyone's expectations and integrate technologies to improve environmental performance.

The other is that development of the oil sands stalls.

Bob Dunbar, president of Strategy West, a Calgary oil sands consulting firm, says the risk of a no-growth period in the oil sands is high.

"If we have a prolonged financial economic crisis, then I think this industry is coming to a halt, other than startup and completion of projects that are already underway," says Mr. Dunbar, who was one of the oil sands' first regulators three decades ago with the Alberta government.

He sees oil sands production growing to 2-million barrels a day, from the current 1.3-million barrels a day, as projects under construction are completed by 2010-2011.

Then, the pipeline dries up. The industry's goal was to produce about 3.5-million barrels a day by 2015.

Not even a short-lived financial crisis greatly improves the picture, he adds. Growth may resume, but at a more moderate pace. "A lot of people in the industry will have received pretty serious body blows, and a lot of people are really going to lose the capability to turn around quickly."

It's not easy to restart projects that take years to plan and build, including obtaining regulatory approvals, assembling huge work forces and manufacturing complex pieces. Those best positioned, he says, would be the developers that have well-established operations. Those at earlier stages would be looking at a long road back.

He also points to U.S. president-elect Barack Obama as another possible impediment to growth. Canada's "dirty oil" could be in for a rougher ride if he takes a harder line on greenhouse gas emissions.

Peter Tertzakian, chief energy economist at ARC Financial Corp. and author of the best-seller A Thousand Barrels a Second says the oil sands frenzy of the last few years is history.

He says growth will moderate significantly from earlier projections. "Companies, when they make their investment decisions going forward, will weigh all the issues, including the cost inflation that arises from aggressive overinvestment in a province that only has three million people, in a remote area that has got a lot of environmental baggage."

Those deciding whether to expand in the business will be more sensitive to the potential for an oil crash, one of the lessons of the financial crisis, Mr. Tertzakian says.

And they will also be thinking harder about whether they want to be in a business with such a poor image.

"The environmental lobby has done a marvelous job of disadvantaging the oil sands from an environmental perspective," Mr. Tertzakian says. "That is the reality. It's damaged goods and it is a high-cost producer."

There is no question a slowdown in the oil sands would take the edge off Canada's economic growth, Mr. Tertzakian says. "Is that a bad thing? Maybe not, because the country was becoming excessively concentrated on resources."

While the Alberta government would be among the biggest losers if the oil sands stall, that possibility was not discussed in a provincial energy strategy announced Thursday. The strategy assumes growth will continue.

Alberta Energy Minister Mel Knight played up the silver lining of a slowdown in lowering costs and easing labour shortages.

"There are a number of issues, the global economic picture is one of the largest ones," Mr. Knight said. "We are certainly feeling that the price of the commodity is not conducive to any new investment at this point. But one of the major problems now, besides the economic issue, is the situation around regulatory uncertainty. They are looking for some alignment with respect to emissions regulations."

Mr. Knight acknowleges that if Alberta's projected revenue stream from the oil sands deteriorates, the provincial budget would be adjusted.

The attitude adjustment would have to include bringing back some of the conditions that kicked off the oil sands frenzy 11 years ago.

When Suncor announced its $2.2-billion Millennium expansion in 1997, and Syncrude followed with a $6-billion plan, the reaction in the markets and elsewhere was exuberance. At Suncor, executives ran a betting pool over how much the stock would rise. CEO Rick George bet $1. The stock jumped $7.

Canada's oil sands production at the time was about 300,000 b/d. Suncor had started its plant in 1967, Syncrude opened in 1978 and Imperial Oil Ltd.'s thermal operation at Cold Lake started in 1985.

The new investments were made possible by major changes: After years of trying, Suncor and Syncrude improved costs and productivity by adopting new technologies and phasing out bucketwheels and conveyor belts that were prone to breaking down in favour of trucks and shovels, the method that remains in use today.

Operating costs came down from as much as S$40 a barrel to about $11 to $12. Another change was convincing the investment community of the oil sands' potential; so little was known of the deposits that talk about their size was met with disbelief.

The most significant change, however, was an improvement in fiscal terms, the outcome of the 1995 National Oil Sands Task Force.

The initiative pulled together all levels of government, as well as developers, trade unions and suppliers, and got them to buy into the benefits of working together at a time of weak employment and economic growth.

"Because that process engaged so many people, it enabled us to set the table for success," Mr. Carter says. "And we began to see the investment happening. It made believers even out of those who might not have been."

Alberta, under Premier Ralph Klein, agreed to a generic royalty regime that reduced payments substantially, to a minimum 1% before project payout and 25% of net revenue after payout.

The federal government, under Liberal Prime Minister Jean Chretien and Natural Resources Minister Anne McLellan, pitched in with a fast write-off of capital investment through the Accelerated Capital Cost Allowance.

As it turned out, the task force underestimated how much spending would pour into oil sands development -- $21-billion to $25-billion over 25 years. Before oil prices collapsed, the oil sands were on course for $150-billion in spending.

But those diverse interests splintered in the ensuing years as oil prices soared and the oil sands became a target of oil multi-nationals shut out from other basins by governments nationalizing their oil industries.

The federal government, under Tory Prime Minister Stephen Harper, cancelled the Accelerated Capital Cost Allowance in 2007. The Alberta government, under Premier Ed Stelmach, is increasing oil sands royalties next month to a base rate of 1% when the oil price is $55 a barrel and 9% when oil is at $120 a barrel or higher. The post-payout rate starts at 25% when oil is at $55, increasing to 40% when oil is at $120 or higher.

Both levels of government have added further costs to mitigate greenhouse gas emissions. And more environmental costs are coming as the industry installs technology to capture and store carbon and clean up its tailings ponds.

Meanwhile, labour costs have skyrocketed, both as a result of union agreements and competition between developers for scarce staff. Service providers, from engineering firms to labour camp builders, have also increased their prices.

The result is that the cost of adding a barrel of capacity has risen from the $20,000 estimated by Suncor in 1997, to $180,000 this summer for Petro-Canada's Fort Hills project. Petro-Canada has cancelled part of the project and put the rest on hold, while trying to renegotiate contracts.

Mr. Carter is confident the sector is resilient enough that it will find an affordable way to reduce its environmental footprint. As the chairman of the Carbon Capture Council of Alberta, a team from industry and academia assembled by the province to guide carbon capture and storage projects with the help of $2-billion in provincial funding, Mr. Carter is keen to help the oil sands continue.

Still, he sees how fragile it all is. "Sometimes things are taken for granted after they have been so strong for so long," Mr. Carter says.

"We need to remember that this is expensive oil."