How to invest in Canada's black gold mine

Alberta, Canada, is sitting on a black gold mine in the form of its oil sands and by 2030 it could be pumping out more oil than currently flows out of Iran. Investors should keep a close eye on this story

"It's raining money in Alberta," says the Canadian Globe and Mail. So much so that the Conservative premier, Ralph Klein (see below) is handing out cheques worth C$400 (£198) to every single one of the Canadian province's 2.3 million residents.

So where's the money coming from? The same place most big money comes from these days: the oil market. Alberta, once thought of as just an attractive area of deep forest, turns out to be rather more than this: it is sitting on oil reserves equivalent to an estimated 1.7 trillion barrels of oil in the form of tar sands that cover an area larger than England.

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Before the oil price started rising a few years ago, no one cared very much about Canada's oil sands. Getting oil out of them is not particularly easy: the sands are accessed from open-pit mines and hot water is then added to them. The resulting slurry is piped to an extraction plant, where it is agitated and the oil, in the form of bitumen, is finally skimmed off the top.

And it isn't cheap either. Getting a barrel of oil out of the ground in Mexico or the Middle East can cost as little as $2. However, extracting oil from tar sands runs to more like $12-$18, something that means it really isn't worth doing unless the price of oil is over $30 per barrel, and expected to stay there. And even at $30 or $40 a barrel, much of this oil is not economically viable as it is simply too deep to get out, even at a cost of $18 a barrel.

Still, given the recent rise in oil prices, around 10% of the sands are considered to be worth bothering with and that 10% is not to be sniffed at: it comes to 174 billion barrels worth of useable oil reserves.

To put that in perspective, compare it to the largest oil field ever found in the Middle East Ghawar in Saudia Arabia. This held a total of 75-83 billion barrels worth of oil. Or look at it next to the largest oil cache ever uncovered in North America, Prudhoe Bay in Alaska. That added up to a mere 13 billion barrels.

Right now, Canada is pumping out only one million barrels of oil a day over three-quarters of which is from the tar sands. But if oil prices stay high (as we think they will) and production companies keep developing the oil sands, says the Canadian Association of Petroleum Producers, there is no reason why Canada shouldn't be pumping out three million barrels of oil a day in ten years' time and six million barrels a day by 2030 which is more than Iran currently produces and not far off double the amount that flowed out of pre-war Iraq.

Right now, world demand for oil runs at about 85 million barrels (according to the International Energy Authority) and only 1.2% of it comes from Canada. However, by 2030 we will be using 115 billion barrels of oil per day and and 5.2% of it (assuming six million barrels) will be coming from Canada.

And that is a number that is likely to keep on rising. Regular MoneyWeek readers will be familiar with the peak oil theory also called "Hubbert's Peak", and which is named after the Shell geologist Dr. King Hubbert. In 1956, Hubbert predicted that American domestic oil production would peak in 1970 (and he predicted this correctly it has been falling ever since). Using his methods to look at global oil supplies, analysts have estimated that around the world, production is now at, or near, its peak too.

In 2005, the UK became a net importer of oil for the first time since 1979, as recoverable supplies in the North Sea dwindled and Saudi Arabia, the world's biggest supplier of oil, is thought to be pumping at full capacity (despite its many protestations to the contrary). The fact is that in almost every oil-producing country, oil production is likely to be static, or falling, from now on. But there's one noticeable exception here, and that's Canada.

Another reason for investors to be keeping a very close eye on Canada is the fact that political tensions are making governments around the world nervous about their abilities to get their hands on stable supplies of oil. Who wants to have to rely on Russia or Iran for electricity? Not America, it seems.

George Bush is clearly concerned (as he should be) about America's dependence on the Middle East. His announcement in his State of the Union Address a few weeks ago that he wanted to increase spending on alternative energies was surely less to do with the sudden discovery of an environmental conscience than motivated by his concerns over America's relationship with the likes of Iran and Iraq. Biofuels and wind power may well take off in the US, but in the meantime America's need for politically friendly oil is good news for Canada. The US already imports 80% of the oil Canada produces and is likely to keep wanting to do so.

However, America is not the only country to have noticed the slippery sand in Canada. China has too. And China provides real competition: its energy usage is rising fast, but it has scant reserves (under 1.5% of world supply), meaning it has to import more than 40% of the oil it uses. The result? China has been buying up all the bits of Canadian oil sand land it can get its hands on, as well as investing in a variety of start-up producers and signing a deal for a £1.95bn mega-pipeline to the Pacific coast to supply oil from Canada to the Asia-Pacific region. The pipeline will cross the Rocky Mountains before tankers ship the oil to China, South Korea, Japan and America.

The world's other oil majors have also been realising that they need to be in on the act. Shell has been operating in Canada for years and ExxonMobil, Chevron Texaco and Total Fina have all spent millions setting up in the area. The black gold rush in Alberta looks set to continue for many, many years to come. In the box on page 22 we look at how you can best invest in it.

Firms to give you a foothold in oil

Royal Dutch Shell (RDSA, 1,870p) has long been a MoneyWeek favourite. And it hasn't disappointed. Earlier this month, it announced the highest corporate profits in the history of the British markets, and its shares are up just over 13% in the last year. But that doesn't mean there isn't more to come. Shell's exposure to the Canadian oil sands is the longest standing of the oil majors and last year it made over C$2bn a year from Alberta slightly above analysts consensus estimates. Other firms with exposure to the region are ExxonMobil (EXX, 3,428p), Chevron Texaco (US:CVX, $55.62) and Total Fina (FP:FPNV, e213).

And there are hordes of smaller players to consider. Canada's stockmarket is one of the most mature, open markets in the world, and thanks to Canada's large supplies of natural resources it is well stocked with mining firms. A Toronto-listed stock well worth considering is Husky Energy Inc (TO:HSE, C$66.60), which cites the oil sands of northern Alberta as one of its "long-term growth areas." The firm is at the forefront of the development of new technology to extract the oil from the sands and it expects its first production to come through in 2007, peaking at 235,000 barrels per day from two projects. Husky, while small, is a "world class" firm, Peter Gibson, senior analyst at Desjardins Securities told Canada's National Post. The shares trade on a p/e of 14 times.

Gibson's other top picks in the Canadian energy sector include Canadian Oil Sands Trust (TO:COS-UN, C$140), an investment trust, which claims to have the purest exposure around. It owns 35.5% of the Syncrude Joint Venture, the largest holder of Alberta's mineable oil sands leases, which produced 103 billion barrels in 2004 from its two main sites. The shares have had a great run up over 70% in the last year but still trade on a p/e of only just over 15 times. Recent results came in "merely in line" with expectations, says David Berman, also in the National Post, but "analysts continue to gush" over the potential of this blue-chip trust.

The man who would be king of the sands

"Welcome to Ralph's world", as Ralph Klein, or King Ralph, as he is known to his constituents, said when he won the last election in Alberta. And what a world it has become. The tar sands have made Klein an important man in Canadian politics. The bonanza provided by the rising oil price has meant that his budget deficit has disappeared: instead, he has a surplus large enough that he can hand out free cash as a windfall to his constituents (C$400 each).

Whether this is a good idea or not is debatable (the Liberals in Alberta think the C$1bn should have been put into the health service instead), but it has certainly made him popular with the average man in the street. Anyway, the handout hardly leaves him short: there is still C$7bn of the budget surplus left.

To crib from Shakespeare's Twelfth Night, says Deborah Yedlin in the Canadian Globe and Mail, "Some are born great, some achieve greatness and others have greatness thrust upon them." It could be argued that Alberta "started out as an understudy but is about to achieve greatness as it's cast in a leading role, thanks to a geological accident called the oil sands".

None of this is to say that Alberta doesn't have its difficulties. Once considered an area of extraordinary beauty, it's now seeing its near-virgin boreal forests sliced down to make way for the biggest Caterpillar trucks in the world (their wheels alone are each bigger than a double-decker bus). Like everything, the oil boom is coming at a price.