Our Tar-Sands Outlook, Part 2: Weak Fundamentals



By DEBORAH ROGERS 

The tar-sands industry faces numerous vulnerabilities, none of which appears insurmountable on its own. Taken as a whole, however, these vulnerabilities create a daunting constellation of risks, as we explained last week in a report we published.

That report, which we published with Oil Change International, examined the top 10 large tar-sands producers as well as the top 10 junior tar-sand producers. It noted that although tar-sands assets are considered long-lived and that they therefore have the potential to bring long-term stability to a producer’s financials, the operative word there is potential.

While each tar-sands company we looked at reported growth or stability in production, each also reported shrinking price realizations and growing operating expenditures — a combination that means margins are being squeezed.

Transportation bottlenecks have proved costly with new pipeline construction in limbo, forcing operators to ship crude by rail or barge in a costly option that eats up about 10 percent of sales revenues. That’s three times what it costs to move oil by pipeline, and it suggests that tar-sands producers simply cannot improve their cash flow if they must rely on rail and barge.

Although capital expenditures have exploded over the past three years, they have produced little actual free cash flow, which is important because if operations are not generating enough cash to cover costs, then producers are left essentially two options: borrow more money or issue more equity. These options have their limits, of course, because no company can fall back on them forever.

Seven of the top ten companies we looked at report that their free cash flow is not only negative but that it is demonstrating a long-term pattern of deterioration. This pattern can be seen among junior tar-sands producers as well. Further, capital expenditure is proving exceedingly challenging for the juniors because they’re less able to access the capital markets than larger producers.

That hurdle segues into another one: Foreign investment — or the lack thereof. A Canadian government policy change implemented in 2012 has hampered foreign investment in tar sands and dried up capital for the juniors, which need foreign support because Canada’s capital markets aren’t big enough to support the tar-sands development envisioned by the industry.

Other problems include the global oil market itself, which has not supported tar-sands oil prices. 

There’s also the fact that tar-sands production costs are increasing. The single greatest contributor to this reality is the remote location of most of the production sites. Remote locations place a premium on labor, steel and cement on construction and operations alike. Data from the Canadian Energy Research Institution shows that steam-assisted gravity-drainage operations costs jumped 5.1 precent from 2011 to 2013, mining and extraction costs increased 6.1 percent, and integrated mining and upgrading costs grew 7.9 percent.

Anecdotal production-cost evidence also spells trouble for the industry. This past December, one tar-sands producer, Canadian Natural Resources, revised its cost estimate on a joint project with the Albertan government upwards by 49 percent. 

Cost inflation like that has not encouraged investment, and indeed has called into question the very model for profitable tar-sands extraction. Our research suggests tar-sands companies must fetch $85-125 per barrel to break even, a high bar to profitability in a world that prices crude oil today at $80-$85 per barrel.

Stock prices tell us something as well. While the Dow Jones Industrial Average is up about 57 percent since 2010, the stock price of the top-performing tar-sands company, Imperial, has risen only 26 percent. The next-best performer, Suncor, is up about 2.3 percent, and most tar-sands companies have shown negative stock returns. This trend is especially notable in light of the history of oil and gas stocks, which used to be leaders of indexes rather than laggards.

One more risk to tar-sands development stems from those posed by rising regulatory constraints on carbon, and the potential that trends creates for leaving companies with stranded assets. This risk was noted last year by S&P, which predicted tar-sand producer downgrades as a result through 2017.

Our takeaway — in addition to what my colleague Tom Sanzillo wrote about here yesterday on the huge and growing risks associated with public opposition — is that the tar-sands industry is in no position to sustain the capital expenditures required to support its expansion.

Deborah Rogers is an IEEFA oil-industry financial consultant.