Buying Into Canada’s Oil Bonanza

The Katrina hurricane, which knocked out a significant portion of US oil and gas production, is likely to shock Americans (at last) into giving serious attention to their long-term energy supply problems. The impact Katrina has made on global oil markets is also likely to intensify efforts by countries and by the big oil companies to gain access to secure supplies.

This is further confirmation that, as I have been arguing for some time, energy and in particular oil is a sector that should be a major part of your portfolio.

There are plenty of ways to invest in it, but most of them aren't particularly attractive for individual investors. The big oil multinationals are too diversified to capture all the upside potential of higher crude prices. The junior stocks are too exposed to exploration and political risks. Any company that depends on Middle Eastern supplies has become a gamble.

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But there is a particular opportunity for investors in the oil sands of Canada.

It's an enormous resource that has become attractive as higher oil prices have made it profitable to exploit them, despite relatively high costs of production (currently ranging from $11 to $19 a barrel, according to published figures).

The consequence is a scramble by the world's oil giants to acquire a stake in the Canadian resources or to develop those already owned.

Total, the world's third largest oil group, is paying $1.4bn to buy Deer Creek Energy, which owns most of the promising Joslyn oil sands deposit. The Chinese giant Sinopec has bought a 40% stake in a similar venture, Northern Lights. Shell Canada is investing $6bn to double output at its Athabasca project, which already produces 155,000 barrels a day.

The oil sands of Alberta consist of bitumen a heavy, viscous form of crude oil, which at room temperature is like cold molasses mixed in with sand, clay and water. Petro-Canada says "a typical sample of oil sand might contain about 12% bitumen by weight."

The oil is recovered in two ways:

Surface deposits are mined like open-cast coal, with huge diggers scooping up 100 tons at a time. Hot water is used to wash out the oil.

With deeper deposits, steam is driven underground to dilute the bitumen the resulting oil-rich liquid is pumped to the surface.

The oil sands already yield about a third of Canada's total oil production. And that's just a taste of things to come, as the scale of the Alberta deposits is scarcely credible. They're estimated to contain 2.6 trillion barrels of oil. That's more than the conventional oil resources of the whole of the rest of the world, and equivalent to 84 years of current world demand for oil. Proved, recoverable reserves are 315bn barrels, and exceed those of Saudi Arabia. That's at crude prices of $30 or better half current levels.

Oil companies plan to invest more than $100bn between now and the year 2020 to tap this enormous resource.

Several factors make oil sands particularly attractive to them:

Exploration risks and costs are negligible, as the bitumen deposits are on the surface or at shallow depths. That's a situation quite unlike the conventional oil business, where you have to invest large amounts to find substantial new reserves under increasingly difficult conditions deep offshore, for example. Dud wells can put smaller companies out of business.

Once in production, there is no decline as there is with aging conventional fields, nor any need to adopt increasingly costly measures to maintain output.

Technological advances and increasing scale of operations are bringing down costs. Alberta's government envisages operational costs falling to about $7 a barrel within five years.

There are no political risks. Canada is a democracy with a stable legal framework. It welcomes foreign investment and doesn't have major hang-ups about foreigners acquiring ownership of its natural resources to ship home, as most of those resources are far greater than it could ever need for its own use. This could make it a prime target for the giant Chinese energy groups.

Canada is ideally located as a supplier. It lies next to the United States, the world's biggest oil importer, and one anxious to reduce dependence on Middel Eastern supplies. Oil can also be pipelined from Alberta to the Pacific coast for easy shipment to China or Japan, the second and third largest importers.

Alberta offers the security of a fair tax regime, with a royalty on oil sands production at a 25% rate. Developers can plan for long production periods typically 35 years without fear of penal taxes or expropriation.

However, some disadvantages face producers of this unconventional oil:

Because it's very cold, Northern Alberta is a place where it's very difficult to operate in winter minimum temperatures average from 18 to 28 degrees centigrade below freezing from December through March. That also makes it difficult and expensive to get the many craftsmen and engineers needed to build new facilities to extract, process and transport the oil.

You need lots of energy usually natural gas to make the hot water or steam needed to exploit oil sands, and in doing so you generate a lot of greenhouse gases. This strengthens opposition from environmentalists to plans to expand production.

You also need to invest lots of capital several billions of dollars for a single project producing, say, 100,000 barrels a day. Shell Canada expects its current oil sands expansion to cost up to $200 per barrel of daily production capacity.

Yet, obviously the positives far outweigh the negatives. There are expansions planned for at least 12 existing oil sands mining projects, with total daily output set to increase to more than 3m barrels by 2020, from current levels of 680,000 barrels a day.

That means that within 15 years, even without any projects additional to those already planned, production from Alberta's oil sands will be larger than current output from a major conventional field such as the North Sea. Within a quarter-century, according to one estimate, it could exceed output from Saudi Arabia.

Another useful table, from Canadian analysts McDep Associates, shows total recoverable resources in millions of barrels:

Suncor Energy 12,500

Nexen 2,500

Imperial Oil 10,000

Western Oil Sands 2,200

Can. Natural Resources 9,500

EnCana 2,000

Petro-Canada 3,700

OPTI Canada 1,900

Shell Canada 3,600

Deer Creek (Total) 1,800

Can. Oil Sands Trust 3,200

UTS Energy 1,100

Husky Energy 2,900

BlackRock Ventures 300

However, there are important factors other than reserves to be taken into account should you wish to take a stake in the Canadian oil sands.

For example, you need to know how much of the value of a stock reflects oil sands potential, and how much other assets such as conventional oil, natural gas, or downstream (distribution) businesses.

Tom Ebbern, research director at Tristone Capital in Calgary, warns that most of the oil sands potential lies in deeper deposits that require complex extraction methods. Only a handful of players have the technology to exploit those deposits. (This was why the Chinese oil giant CNOOC recently paid $122 million for one-sixth of oil sands technology experts MEG Energy).

The stocks that I think are particularly interesting (all listed in Toronto) are:

Canadian Oil Sands Trust. This is probably the best "pure play" in oil sands, as its only asset is a 35% holding in Syncrude, the largest of the four mines actually producing oil, and with plans to double output to 500,000 barrels a day.

McDep Associates rates it as one of the most attractive oil and gas companies in the world, as Syncrude is "the largest long-life oil resource in North America." The company claims its proven reserves "represent more than a 35-year lifespan using today's infrastructure, with the potential to extend reserve life beyond the year 2050".

It has already made most of the investment needed to expand production to the 350,000 barrels a day level, and has a low projected price/earnings multiple of 11x. Distributions by this listed trust could reach an annual rate of 13% by the third quarter of next year on the current share price of about $125.

A potential disadvantage is that under Canadian law, non-residents may not hold more than 49% of the units of such a listed trust, so it's unlikely ever to attract a takeover bid from a foreign oil company.

Canadian Natural Resources has the third-largest oil sand reserves and its wholly-owned Horizon project is due to come on stream within five years.

It isn't a pure oil sands play as the company is already a substantial producer of oil and natural gas from conventional sources its current daily output of more than 500,000 barrels of oil equivalent, half in the form of gas, can be compared to planned output from Horizon of 230,000 within a decade.

However, analyst research suggests that those huge oil sands reserves could more than double the value of the shares. Canada's Raymond James Equity Research recently claimed: "The market is giving only about $2 to $3 per share of value for the first phase of the Horizon oil sands project, yet we calculate that phase's value to be $22 per share." (At time of writing, the stock is trading at $58).

This is the kind of company that could be a takeover target for the oil-hungry Chinese giants.

Husky Energy is another one that could attract a bid from China, especially as it already has a Chinese connection spending $40m this year looking for oil off the coasts of China and Indonesia.

In Canada it produces 350,000 barrels of oil equivalent a day from conventional sources. Its oil sand reserves are a massive 3bn barrels, with its Tucker project due to come into production next year with 30,000 barrels, to be followed by its much bigger Sunrise project.

Suncor Energy was the first company to exploit the oil sands, and is almost a pure play, as its chain of filling stations in Canada and the US is a very small part of its value.

Its large market capitalization ($26bn), additional listing in New York, greater liquidity and absence of foreign ownership limit makes it attractive to institutional investors and hedge funds.

However, it's such an obvious target for takeover by a Chinese or other major international player that its shares have been driven to a high valuation of about 22 times forward earnings.

OPTI Canada is an interesting small cap that's a pure play. It has oil sand reserves of 1.9bn barrels. Phase One of its Long Lake project, where its equal partner is Nexen, is due to come on stream next year with a planned annual output of 70,000 barrels a day, with Phase Two doubling production by 2010.

Its expertise in the thermal recovery method (sending down steam to melt the bitumen) could make it a Chinese or Indian target.

Western Oil Sands is another interesting small cap that is a pure play, but it's an unlikely target for the Asians. It has oil sand reserves of 2.2bn barrels and a 20% share in the Athabasca operation controlled by Shell Canada, where it provides operational management, mining and bitumen extraction expertise.

As Athabasca expands, the company owns the rights to maintain its share of future growth.

By now you will have got the message, that I'm really enthusiastic about the investment potential of all that "heavy" oil in Alberta. But don't be in a rush to invest. Wait for world oil prices to come back a bit, into the lower 60s or even the higher 50s, before you think about buying.

By Martin Spring in On Target, a private newsletter on global strategy