One of the casualties of the dramatic fall in oil prices has been the slowdown in the exploitation of Canada's tar sands, the biggest and dirtiest energy project on the planet. No corner of the global oil industry, Forbes reports, has been hurt as badly:
Most producers are struggling just to cover operating costs – forget about paying off billions of dollars invested in strip mines and bitumen refineries.
That's the short-term news. Long-term, the story is the same, if not worse, for investors. A new report released by Innovest Strategic Value Advisors says that even with a recovery in oil prices, tar sands projects will not be economically viable. It's an analysis that has left investors surprised and perplexed, according to Yulia Reuter, author of the report, who presented it last week at the annual Riskmetrics Canadian Proxy Season Briefing in Toronto.
The report, called The Viability of Non-Conventional Oil Development (see pdf attached below), warns that the Alberta tar sands projects "place significant value at risk for investors."
Current levels of financial and environmental, social and governance (ESG) disclosure do not fully reveal the extent of these risks. In addition, the business plans issued by the companies to justify these projects do not take into consideration the most overarching risk to their success: the macroeconomic limits of the price of oil and the opportunity costs of natural gas.
Reuter, in the report, takes these factors and others into account, and as a result has added another dimension to the debate over tar sands development: Not only environmentally, but even financially now, the projects are looking like a bad idea, a lose-lose proposition.
Reuter walked us through the report which highlights four areas of major risk typically ignored by conventional financial analysis:
A ceiling on oil prices. There is an observed historical price ceiling of approximately $100/bbl, beyond which prices rarely remain because demand collapses.
A failure to expect carbon pricing. Oil sands extraction is very carbon intensive, yet most oil sands projects do not anticipate regulatory constraints on CO2 emissions.
A rising price of a key input: natural gas. Natural gas is a key input for transforming oil sands into oil. Yet the price of this input will rise dramatically under the same high oil prices required for the projects to be profitable.
Additional business risks. Oil sands projects face substantial yet undefined costs relating to remediation and infrastructure development in sensitive areas.
The Effect of an Oil Price Ceiling
The first insight that the report provides is that tar sands projects will succeed only within a slender band of oil prices. If oil prices are too low, as they are now, projects stall; if they are too high – above the break point of $100 a barrel – GDP growth slows, stops and reverses, decreasing oil demand and causing prices to drop. It is therefore only in a slender band between operational costs of $65 to $90/bbl and the tolerable oil price high point of $100 a barrel that these projects would be both economically efficient and supported by the economy as a whole. It is a startling insight, since until now, the conventional wisdom was that soaring oil prices could only be good for tar sands development, the higher the better. Not so:
The inability of the global economy to support prices above $100/bbl for any lengthy period will be the limiting factor which prevents oil prices from being high enough over any period of time to support oil sands development.
Reuter uses the figure of $65-$90/bbl as the range for operational costs based on estimates from the oil giant Total. Industry representatives are currently touting profitability at $35-50/bbl, but Reuter's analysis takes into account that most tar sands reserves will have to be mined using the costlier in situ process, since surface deposits will soon be depleted.
The Effect of Carbon Pricing
Reuter also analyzed the effect of carbon pricing on present value and future profitability of tar sands operations. Again, she found that industry analysis fails to account for a carbon price. The Turning Point Regulation adopted by the Canadian government in March 2008 stipulates that any coal or tar sands projects initiated after 2012 must sequester or offset its emissions starting in 2018. Without even considering even tighter regulations as a result of pressure from Canada's biggest oil customer – the United States – Reuter provides some eye-opening calculations.
For example, Suncor and Imperial, two of the biggest tar sands players, will each be facing close to $1.5 billion in carbon costs starting in 2018. That translates into an additional cost of between $6 and $8 per barrel, which discounted into 2007 earnings shaves 12-13% from present day profitability. Other tar sands players face smaller exposure, but the risk is nonetheless a serious factor that investors have to account for.
The Effect of Rising Natural Gas Prices
Tar sands processing requires vast amounts of energy to separate the tar from the sand in which it is trapped, and then to refine it into oil. Projects rely on natural gas to supply this source of energy, and the Canadian government is hoping to attract a gas pipeline from Alaska to provide continued supply. Environmentalists have criticized the plan for wanting to use a clean-burning fossil fuel to manufacture a filthy one – essentially turning gold into lead.
Reuter provides a similar critique from a financial perspective. A price on carbon would make natural gas more valuable as it emits on average 30% less carbon dioxide than oil. One result would be more gas-fired generation of electricty, which would reduce supply; yet at the same time, projected expansion of tar sands would triple the demand for natural gas by 2015 and create "a spiralling inflation effect on the costs of production."
The value of this gas is a significant opportunity cost if utilized in oil sands operations as opposed to being delivered directly to market.
In other words, using natural gas to power tar sands development will not make economic sense, and operations in Alberta will be facing extremely high energy costs that could shut down projects.
Additional Business Risks
In the final section of analysis, Reuter comes to the risks associated with tar sands which are quite familiar: the environmental impacts. Reuter warns investors that from "a climate perspective, these projects face very significant regulatory risks." Her analysis here is understated and sober, serving mostly as a reminder of what others have documented in detail.
The report also points out, unexpectedly, that profits have not yet been made on tar sands as they are still in the capital investment stage.
This creates a risky dynamic for both the company and investors as more capital poured into these projects will create even greater pressure to realize a return on investment on fixed assets for oil sands. This will lead to the expenditure of good money after bad spent on oil sands operations in a vain attempt to get the pay off.
This risky investment picture is hidden in part behind archaic accounting rules. Oil companies are required by regulations to provide a Net Present Value (NPV) estimate of its exploitable oil reserves, giving investors a key metric for analyzing a company's financial prospects. SEC regulations, however, treat tar sands not as oil reserves but as mining reserves, and so companies are not required to disclose NPV estimates. Reuter warns investors to critically review company disclosures and not lump conventional and unconventional reserves into the same category.
Reuter admitted that some of the long running extraction operations in Alberta have generated positive cash flows, but moving forward she told us quite flatly:
Projects in the pipeline will never recoup their investment.
That's fair financial warning to stand up alongside the environmental calamity of tar sands development.