Petro-Canada Bets Big on Oil Sands

OTTAWA Sep 10, 2007 (Dow Jones Newswires)

Long-suffering Petro-Canada (PCZ) investors may think their luck has turned this past year as the company starts to shake off a reputation for operational unreliability and its share price has risen. But its biggest challenge yet lies ahead: a massive C$26.2 billion oil sands project that has some analysts wondering whether it might halt the stock's upward march.

Canada's fourth-largest oil and gas producer has set itself an aggressive schedule for bringing 280,000 barrels a day of synthetic crude onstream by 2014. Meanwhile, other oil sands projects are struggling increasingly with scarce labor and materials, sending budgets spiraling upward.

So the question is, can Petro-Canada pull it off?

Even a year ago, the overwhelming response probably would have been doubt, but now opinion is mixed. While all acknowledge the massive cost pressures that are straining Alberta's oil sands patch, some believe the company is being unfairly penalized for past mistakes and is currently undervalued by the market.

But Sam La Bell, vice president at Toronto-based Veritas Investment Research Corp., still has doubts about the oil sands project. In an August research note, he calls the recent cost estimates "a careful bit of subterfuge" to disguise borderline economics. The company didn't return calls for comment.

Petro-Canada, together with UTS Energy Corp. (UTS.T) and mining firm Teck Cominco Ltd. (TCK), plans to develop an oil sands mine north of Fort McMurray, Alberta, and build an upgrader to convert the sludgy bitumen into a light, sweet synthetic crude near Edmonton. In late June, the Fort Hills partners announced that the first 140,000-barrel-a-day phase would cost an estimated C$14.1 billion, and the second C$12.1 billion. But these numbers exclude the initial engineering costs needed ahead of project sanction: C$1.9 billion for both phases, or nearly 7% of total costs.

As the majority shareholder with a 55% working interest, Petro-Canada shoulders the bulk of this cost, and more besides, thanks to an agreement when the company bought its stake from UTS two years ago. And with UTS indicating it may sell down its 30% stake further, Petro-Canada could well be tempted to add to its interest.

This is a "bet-the-company type of investment" that only provides decent returns if oil stays above $60 a barrel and the project sticks to its budget, La Bell says. But Petro-Canada's track record with managing big projects leaves much to be desired.

Terra Nova, a 125,000-barrel-a-day oilfield off Canada's east coast, is the egregious example. Petro-Canada is the operator with a 34% majority interest, but the development was beset with problems since it started up five years ago, and only returned to near normal rates at the end of 2006. Most damagingly, the company admitted it had cut corners - or as Chief Executive Ron Brenneman put it, made "operational compromises" - when building the offshore platform, taking a direct hit to its reliability as a result.

The company stresses that it is learning from its past mistakes. In a July conference call, Brenneman said: "We've made execution a priority, both the reliability of our operations and the management of our projects." And Petro-Canada seems to be reaping the rewards, with robust profit in recent quarters.

Martin Molyneaux, managing director of institutional research at Calgary-based First Energy Capital, advises against using Terra Nova as a symbol for the company's management skills.

"You have every right to criticize Terra Nova ... but everyone is struggling offshore right now because it's so busy," Molyneaux said. "And I would caution against equating offshore with oil sands - it's a different kind of project."

Previous oil sands developments have run into difficulties on the mining side. A recent example is the expansion at the mine run by the Syncrude consortium, in which Petro-Canada holds a 12% stake, that was finally completed for nearly twice the initial C$4.1 billion estimate.

But Teck Cominco will be in the driving seat for the Fort Hills mine, which analysts regard with approval.

Teck Cominco has "a lot of experience with large-scale mining projects," La Bell told Dow Jones Newswires. "They're a credible partner to have onside."

Meanwhile, Petro-Canada's main role will likely be on the upgrader, and the company is no slouch when it comes to the downstream.

The refining and marketing operations have frequently shored up Petro-Canada's revenue when problems with the upstream business cramped profits. In the recent second-quarter financial results, record refining margins boosted the division's operating earnings to C$249 million. UBS analyst Andrew Potter said downstream earnings for the first half of 2007 had already exceeded previous annual earnings for the unit, which he expects to continue its strong contributions to overall profits despite weakening margins.

But Petro-Canada's upstream has also started pulling its weight. Output at its offshore East Coast oilfields and its wholly owned MacKay River oil sands project jumped 30% in the second quarter versus last year, while the Buzzard field in the North Sea hit peak 200,000-barrel-a-day production.

So project management is indeed improving, which bodes well for Fort Hills. But one of the biggest cost pressures is labor, an issue that Neil Camarta, Petro-Canada's senior vice president for oil sands, says "keeps me awake at night."

In a recent interview with Dow Jones, Camarta said: "We've spent the last year ... working the cost down, but being smart about it." The key to building on time and on budget is to find enough skilled workers to do it, he added, and Fort Hills plans to stagger the startup of the mine and upgrader so "we're not competing with ourselves" for labor.

But this isn't as controllable as project managers would like, argues La Bell, who notes recent union demands for significant wage increases over the next several years. This would outstrip the contingencies Petro-Canada has set aside for inflation and cost overruns.

And these cost overruns can strike right up to the finish line. Earlier this month, Nexen Inc. (NXY) and OPTI Canada Inc. (OPC.T) delayed startup for their joint Long Lake oil sands project by six months and hiked cost estimates by C$800 million to C$6.1 billion - a project whose construction was judged to be nearly complete in April. The culprit here was also labor, with the project partners citing difficulties in finding enough pipefitters in particular, which hurt productivity.

Justin Bouchard at Raymond James said in a note: "The project management has clearly faltered, and we now wonder if C$6.1 billion is indeed the final revision."

Despite these challenges, many analysts are still positive about Petro-Canada, whose shares have gained about 32% in the past year after trailing its peers in the past, trading recently at around C$55.

Petro-Canada's price-earnings ratio for 2007 earnings is 10.68, a discount compared with other Canadian integrated oil companies such as Imperial Oil Ltd. (IMO), with a 15.41 ratio; Husky Energy Inc. (HSE.T), at 11.85; and Suncor Energy Inc. (SU), at 19.56.

Even La Bell is neutral on the stock, though he thinks the company is fairly valued around current levels.

Others are decidedly more bullish, with Peters & Co. Ltd. and UBS setting 12-month targets of C$65 a share and C$68, respectively.

First Energy's Molyneaux has a top pick recommendation on Petro-Canada and says: "If they execute as well as they have been for the better part of a year, we don't see any reason why they shouldn't be in the mid-C$70 range."

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