Don't Build Your Portfolio on Oil Sands

by Tony Daltorio, Investment U Research

The first barrel of oil processed from the heavy, tar-like sands of northern Alberta, Canada, shipped in 1967.

Since then, exploration projects have identified enough of the stuff – also known as bitumen – that only Saudi Arabia is able to top Canada’s 178 billion barrels of proven oil reserves. Among the companies to profit from the discoveries so far…

Exxon Mobil (NYSE: XOM), through its Canadian subsidiary, Imperial Oil (NYSE: IMO). The division has published its plans to begin phase 1 of its C$8 billion Kearl mine project in 2012, which should start bringing in 110,000 barrels a day.
PetroChina (NYSE: PTR): It agreed to pay C$1.9 billion ($1.76 billion) for a majority of the stake in both the Mackay River and Dover projects, run by Athabasca Oil Sands.

No wonder, when the first phase of the Mackay River project comes online in 2014, there will be a daily output of 35,000 barrels. Production could eventually reach 300,000 to 500,000 barrels a day at a total capital cost of as much as C$20 billion ($18.5 billion).

Even the Obama administration approved a C$3.7 billion ($3.4 billion) pipeline – the Alberta Clipper – that aims to carry 800,000 barrels of oil per day from Alberta’s oil sands to a refinery in northern Wisconsin.

So why the renewed interest in oil sands?

The Oil Sand Irony: How an Energy Price Drop Has Boosted This Resource

Part of it comes down to lowered production costs, resulting from a drop in energy prices, of all things.

You see, in order to melt and extract deep deposits of bitumen, work crews have to utilize vast quantities of natural gas. And since the price of that commodity has plummeted, so have business expenses… giving companies such as Canadian Natural Resources (NYSE: CNQ) and Nexen (NYSE: NXY) a little more room to breathe.

In fact, Suncor Energy (NYSE: SU) – the biggest player in the oil sands industry – has seen cash operating costs fall from C$50.85 ($47.10) during the second quarter of 2008, to C$31.30 ($29) per barrel in the same quarter of 2009.

But unfortunately, the story doesn’t end with profits and potential…

Oil Sands Struggling as Demand Dwindles

All isn’t well with the Canadian oil industry. Not at all.

In 2008, when Americans actually had jobs, places to go and products to buy, companies had plans and projections for what they expected to sell.

Today, though, America is shedding hundreds of thousands of jobs a month and the unemployment rate stands at 9.8%. As David Fessler reported here recently, people are saving money and consumers have replaced the mantra of “shop ’til you drop” with “a penny saved is a penny earned.”

This has impacted the Canadian oil industry…

Companies have had to postpone over two-thirds of the projects they planned last year.
The Canadian Association of Petroleum Producers (CAPP) has already lowered its 2020 production projection from 3.8 million barrels of oil a day to no more than 2.9 million. And that’s even if the investment climate improves. In fact, most think that tally will fall much closer to 2 million barrels – a little more than half the 2007 projection.
The CAPP also estimates output from both projects under construction and those already in operation, will only grow from 1.2 million barrels of oil per day, as recorded last year, to 1.9 million barrels a day in 2015.

And despite recent falls in the cost of production, the Cambridge Energy Research Association recently found that, “Unless major technological breakthroughs result in lower costs, the oil sands will remain among the high-cost oil supply options.”

If it were just high costs the industry faced, it could probably muddle through. But that just isn’t the case.

Amid a PR Minefield, Go for These Investments Instead

As the green movement continues its progress in the energy sector, the oil sands business will suffer amid mounting scrutiny on the impact that its activities have on the environment, especially to local water supplies and greenhouse gas emissions.

For example, Syncrude, found itself embroiled in a public relations nightmare earlier this year when 1,600 ducks died after landing in one of its tailings ponds, becoming coated with bitumen residue.

And the industry received an equally harsh blow from National Geographic in March 2009. The publication ran a story with photos of toxic tailings ponds and bleak moonscapes of huge open pit mines – hardly the best public image for an already struggling group.

The industry did its best to defend itself, but could only mount a weak rebuttal by pointing to its efforts to overhaul the practice of open pit mining, which still makes up some half of production.

With that kind of reputation, it’s no wonder Cambridge concluded that, “Sustainability is likely to remain a key theme of future oil sands regulation,” and that, “Pressure to introduce more regulation is not likely to fade, even with the decline in oil prices.”

I can’t help but agree with them, especially with the likelihood of further heavy environmental regulations in the years to come. Unless new technology emerges that can extract oil in a more cost-effective and environmentally friendly manner, the industry just has too many negatives for my taste.

Instead, try investing in companies that find oil in deep waters around the world, or invest in alternative energy companies. You can get broad exposure by taking a look at the PowerShares WilderHill Clean Energy Fund (NYSE: PBW), which invests in alternative energy firms in the WilderHill Clean Energy index and aims to track their piece and yield performance.

Good investing,

Tony Daltorio

P.S. For more on energy sector and infrastructure investments, take a look at David Fessler’s “Hot Stacked” column in The Oxford Club’s newsletter. In it, David profiles the latest trends within the sectors and points investors towards the best stocks. Go here for more details.