Is it time to panic in the oil sands?

If the current pricing trends continue, at least one of the proposed oil sands pipeline projects would no longer be needed


Oil Sands 20120710Since early June, the price of Western Canadian Select, the benchmark price for heavy crude in western Canada, has dropped from $94 per barrel to barely over $55 per barrel on Friday. The decline in Canadian heavy crude prices has largely mirrored the decline in U.S. benchmark West Texas Intermediate, which has dropped from US$107 in mid-June to just over US$66 Friday, and global benchmark Brent crude, which has declined from $115 per barrel to barely over $70 per barrel Friday. I wrote in early November that the effects of the global slide in crude prices had been partially mitigated for oil sands producers by three factors: decreasing condensate prices, a sliding Canadian dollar, and narrowing differentials between heavy and light crude oil. For the most part, these factors have not done much to buffer the losses for oil sands producers over the last month—the differential between WTI and WCS has come back to $20 per barrel, having been much lower through October, the Canadian dollar lost ground this week, but is only today back to the lows seen in early November when crude was worth significantly more than it is today, and while heavy crude is down 25 per cent since Halloween, the value of condensates used to dilute bitumen for transport have lost much less value. Put all these factors together, and a barrel of bitumen was worth almost 40 per cent less on Friday than it would have been worth on Halloween and almost 50 per cent less than it would have been worth in mid-June.  This is not good news if you’re producing bitumen in the oil sands, but just how bad is it?

Alberta Reference Oil Prices. Source: Bloomberg.

Alberta Reference Oil Prices. Source: Bloomberg.

When oil prices drop as they have, there are three immediate impacts: oil sands revenues drop, which implies lower royalties and lower taxes. The longer-term impacts, largely yet to be felt, will occur if projects start to be delayed or cancelled as a result of the drop in prices. It’s unlikely that projects currently under construction will be cancelled, especially if they have already seen significant capital investment, because the return on investing the remainder required is still likely to be sufficient to keep the project on track. However, as you’ll see below, if these trends continue, there’s reason to expect that new investment decisions on the projects that were expected to lead to further production growth later this decade may be delayed, and that could have a significant impact on pipeline discussions as well as on activity in support industries for oil sands.

To give you a sense of how much the financial outlook for oil sands projects has changed, let’s consider two projects—a new mine similar to Suncor’s Fort Hills project, and a new in situ development similar to the Cenovus Narrows Lake project—and see how the changes in prices have altered potential returns, royalties and taxes. For the comparison, I’ll use prices from today compared to assumptions used last Oct. 31 when Suncor announced the decision to proceed with the Fort Hills project. Those assumptions were as follows:

-Oil prices of $100/bbl (Brent) and $95/bbl (WTI)
-Bitumen prices at 60 per cent of WTI (implemented via a $25.50 WTI-WCS differential in $CAD, and a $7 premium for condensate over WTI in $CAD)
-Canadian dollar at 96 cents US

Suncor also assumed operating expenditures of $20-24/bbl, in today’s dollars, for which I’ve used $22, and I’ve followed their assumptions of sustaining capital expenditures of $15.1 billion, and production capacity of 180,000 barrels per day of bitumen. For the in situ project, I’ve used the same pricing assumptions, operating costs of $20.40 per barrel including costs of natural gas, the same $3-per-barrel ongoing capital costs, but smaller upfront capital costs of $2.2 billion and smaller production capacity of 50,000 barrels per day of bitumen.

For today’s prices, I’ve used the following:

-Oil prices of $70/bbl (Brent) and $65/bbl (WTI)
-Bitumen prices at 60 per cent of WTI (implemented via a $20 WTI-WCS differential in $CAD, and a $3.25 premium for condensate over WTI in $CAD)
-Canadian dollar at 87.5 cents US

If you compare the two project types under each of these two sets of assumptions, shown in the table below, you can see how much the changes in prices observed over the past couple of months could impact new (and existing) oil sands projects.


There are three things you should notice from this table. First, the rates of return should jump out at you. The mine, which I’d always calculated below Suncor’s published figures of 13 per cent, drops significantly to less than six per cent based on my calculations—a rate at which no oil company would consider building a new mine. Even the in situ project, which would have been projected to earn a robust 18 per cent return on invested capital after taxes using Suncor’s pricing assumptions from last year would only expect 10.5 per cent using today’s prices—a rate of return that would be marginal at best. The second thing you should remark upon is what happens to the government shares of revenues from these projects—while per-barrel revenues drop by 27 per cent, expected royalty and tax revenues would drop by over 50 per cent and profits drop by almost 60 per cent.  Finally, though, notice that these projects remain profitable, both in operating terms and when including the fixed costs of building capital. This last point is why you’re unlikely to see existing facilities, or even facilities for which a substantial amount of construction has been completed, being shut down—it’s likely to be better to earn six per cent on $15 billion than to lose $5 billion, for example.

So, how will these changes in price affect oil sands production, and should they change the discussion around pipelines in Canada? I think it’s too soon to tell. I’ve been bearish on production forecasts for a long time, arguing that cost inflation in the oil sands meant that it was unlikely even before the price drop that near- or long-term production forecasts published by CAPP and others would be met. Simply put, over the last decade, we’ve seen a perfect storm for oil sands development, with oil prices well above forecast levels and natural gas prices at or below expected costs, and forecast production hasn’t materialized—in 2006, CAPP forecast oil sands production to reach four million barrels per day by 2020, while their most recent forecast calls for just over three million. With the recent price drop, combined with the fact that projects in construction and currently operating are likely to continue, and you’ve got ongoing concerns with regard to cost escalation combined with much lower expected revenues. As such, it seems unlikely to me that even the lower levels forecast by CAPP this year for 2020 are likely to be met. Any decisions today are not likely to affect production forecasts in the near term, but in the timeframe relevant to pipeline projects currently before the National Energy Board, the potential is certainly there. As I’ve said above, to date we’ve seen no sign of significant pull-back in capital expenditures, but if the current pricing trends continue, and appear to be longer-lived, expect to see a much lower long-term forecast for oil sands, not to mention light oil from the U.S. Bakken, the next time around. Such a change, as you can see in the figure below, could mean that at least one of the proposed pipeline projects would no longer be needed within the forecast horizon.

Canadian Association of Petroleum Producers representation of available crude for export and existing and proposed pipeline capacity. Source: CAPP 2014.

Canadian Association of Petroleum Producers representation of available crude for export and existing and proposed pipeline capacity. Source: CAPP 2014.

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Is it time to panic in the oil sands?

  1. Oh I certainly hope so.

    Maybe then, they’ll mind their own affairs and stop telling everyone else how to manage.

  2. Thou dost worry too much.

    The cure for high oil prices is high oil prices. The cure for low oil prices is low oil prices. Alberta can catch up with infrastructure if new oil sands projects are deferred into the future.

    The oil price collapse means Venezuela is going to go bust soon. And the high yield debt market in the US is going to go bust, because 20-25% is debt from US shale oil producers. And the US shale oil boom is going to go bust.

    Canadian oil sands producers are big diversified companies with reasonable debt levels (CNQ has natural gas. Suncor has refineries). The small Canadian upstream tight oil producers are much less indebted than their US counterparts.

    The US recession caused by the US shale oil bust will have everyone begging for pipelines to be built, since they will be near shovel ready projects. The end of Venezuela as a functional country will have the United States rushing to build Keystone XL, for oil sands oil to replace Venezuelan oil that they will no longer be able to get. So much of the US recovery (centred on Texas and Louisiana) is based on those refineries and petrochemical plants operating.

    The oil crash is extremely painful for Alberta, and Russia, and Kuwait, and Saudi Arabia in the short term. Long term, it is actually a benefit. People have forgotten the world runs on oil and that global prosperity depends on oil, and will for another century (because the battery/energy storage problem and scalability of energy storage is still a mostly unsolved problem, and require stuff out of the ground, and getting stuff out of the ground requires oil).

    A Canadian recession will cure Ontario and Quebec of much of their delusional economic and provincial government fantasies.

    Can Nigeria survive as a functional country with the oil price collapse?

    The Black Swan from QE never comes from where you expect it to come from. QE enabled US shale oil producers to overdrill with high yield debt, and investors searching for yield because of financila repression from QE bought this debt, and now it is all going to go bust.

    • I see you’ve gone to Disneyworld.

  3. The future of Black Gold depends on what happens in future months with the reemerging Black Plague.

  4. Is it time to panic in the oil sands?

    Not at all.

    The price of oil is cyclical, demand will again increase.

    Pipeline projects will be built, these capital projects are very long term.

    Good time to pick up more oil patch dividend paying stocks, don’t be short sighted, look at the long game.

  5. LOL…..apparently these CEO’s have NO knowledge of basic economics.
    It’s called the supply/demand function of the ‘free market’.
    6X production coupled with lower demand = declining prices.
    You don’t get to go to your competitors and ask them to lower their production so that YOU can cash in.

    • You obviously don’y realize that other OPEC member countries and Russia were the ones asking Saudi Arabia to curtail production.

      LOL at you once again Dianne.

  6. I believe your assumption that well head / plant gate bitumen is priced at 60% of WTI in the current scenario is overly optimistic. Most of the factors that give rise to this discount are closer to “absolute” dollar contributors than “relative” dollar contributors. Specifically the cost to move bitumen to distant markets and the discount required to encourage adequate investment in coking infrastructure don’t change much in absolute dollar terms at WTI=$100 versus WTI=$65. It is mostly Upgrading yield that imparts some relative aspect to the discount and this is far less significant than the cost of transportation and coking infrastructure.
    I think Suncor used 60% of WTI for Plant Gate for Fort Hills. Your numbers show 60% of WTI might be a good number @ Hardisty in the current environment. With incremental costs involved for moving from Plant gate to Hardisty I am guessing well head values are closer to 50% of WTI currently.
    I agree with your bottom line – current projections for oil sands production are likely far too optimistic. I don’t think the fix comes over night. Many years of concerted effort will be required to address critical infrastructure and social license issues if we want to establish a place for future development of the oil sands in the global energy mix.

    • I agree – I generally use a real-dollar discount rather than a percentage discount, where that real dollar discount reflects transportation and refining cost and yield differences. I used Suncor’s number as the assumption for the approval base case, and then used today’s discounts in real dollar terms the comparable.

  7. The oil sands has a lot more to worry about than low prices….competitive priced decomposing canola based bioplastics are already making inroads in the oil based plastics market, farmers will turn to harvesting wind and solar as governments renege on their promised compensation programs for traditional crops and adverse climate events (ie. droughts, floods), already renewable energy is employing more people than the oil & gas industry and that is without the direct government subsidies enjoyed by O&G.

    • I suppose you saw that on the Teevee. So did I, and it’s utter nonsense.
      1) The propagandists included hydroelectric in their big announcement but in practice they’re only pushing wind, solar and bioenergy.
      2) There are more people employed in the Fort Mac area alone than in the entire renewable industry’ (Google it)
      3) The propagandist’s figure included fabrication but excluded the more than 50,000 workers fabricating pipe, doing downhole surveys, drilling holes, and servicing the oil patch.

      Anyway, even if the press release wasn’t an out and out lie, when did the number of people employed in an industry become the metric for measuring its viability?

  8. I don’t recall them shutting oil sands production down in 1998 when it went to $11/barrel and I wouldn’t expect it now. That’s simply environmental dreaming. The reality is its an opportunity of the bigger producers to squeeze the oil servicing industry til it says uncle. The reality is a lot of the “cost” has driven up due to the servicing industry being a bit on the greedy side. This won’t last too long but the next year will be fun. Enjoy the cheap prices while they last.

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