Delays Loom in Oil Sands as Small Cos Eye Market Turmoil

CALGARY (Dow Jones Newswires), September 19, 2008

While plummeting oil prices have unnerved Alberta's oil sands industry, it is the fallout from the banking crisis that is keeping company executives awake at night.

Fears of a clampdown on credit availability surged after two of Wall Street's biggest investment names disappeared last weekend, with Lehman Brothers Holdings Inc. (LEH) suddenly filing for bankruptcy and Merrill Lynch & Co. (MER) due to be sold to Bank of America Corp. (BAC). Morgan Stanley (MS) could also be swallowed up by Wachovia Corp. (WB).

Meanwhile, the seemingly unrelenting rise in crude oil futures has skidded to a halt, shedding more than $50 from July's record $145.29 a barrel.

"If the credit markets are a disaster, we're going to have to slow down," said Richard Gusella, president and chief executive of the small oil sands developer Connacher Oil & Gas Ltd. (CLL.T). "When the banks have trouble, we all have trouble."

Until recently, banks and other investors have been eagerly pouring their dollars into Alberta's vast oil sands, the world's second-biggest reserves behind Saudi Arabia's trove. Rocketing crude prices have more than compensated for spiraling cost inflation and a growing regulatory burden, and many analysts reckon only a sustained dip toward $70 a barrel will affect most major projects proposed by major oil companies. The more costly developments, however, may flounder well before then, with implications for production growth forecasts that have already been scaled back this summer.

"There's a whole mix of projects - some of them candidly wouldn't make it even with a very high oil price," said Peter Tertzakian, chief energy economist at ARC Financial, a Calgary-based private-equity firm. "The cost of capital going up combined with the price of oil going down makes it more likely that already weak supply expectations (for non-Organization of Petroleum Exporting Countries) aren't going to be met. Is this going to be a problem? Yes."

But if oil prices do go down and stay down, the full impact likely won't be felt for a while yet.

"It's not like natural gas prices, where we see an immediate reaction in gas drilling rates - for the oil sands there'll be a two- to three-year lag," said Chris Seasons, president of Devon Energy Corp.'s (DVN) Canadian arm. "Developing an oil sands project is quite a long and involved process... and they last for 25 years on average. Once you're into it, it's pretty rare for someone just to stop."

Skinnier Economics

While the oil majors ride out the storm, smaller companies reliant on outside financing and investor confidence could find themselves vulnerable to a takeover.

Would-be oil sands developer UTS Energy Corp. (UTS.T) has had a particularly rough few days. The Calgary-based company owns a 20% stake in the massive Fort Hills oil sands development in northern Alberta with its much-bigger partners Petro-Canada (PCZ) and Teck Cominco Ltd. (TCK).

After the weekend's carnage on Wall Street, investors hammered UTS' stock on the Toronto Stock Exchange on growing doubts the company could raise its share of project costs, previously estimated at around C$1.5 billion. Then on Wednesday, the Fort Hills partners hiked estimated project costs by more than 50% to nearly C$24 billion, more than doubling UTS' funding needs and prompting a flurry of target price and rating downgrades from analysts.

UTS shares closed Thursday at C$1.60, just above half of last Friday's close.

Petro-Canada and Teck Cominco's bulk could still power Fort Hills through to completion, despite market concerns that the increase pinches already skinny economics. Other projects by small developers may struggle to get off the ground entirely.

"Very marginal projects that are being driven by companies that can't get easy access to capital in the current credit environment are either going to be delayed, deferred or canceled," Tertzakian said.

Full Steam Ahead

Not only has easy credit evaporated, inflation has pushed up average break-even costs. Analysts previously pegged crude prices around $70 a barrel to support new oil sands projects, but this could now be in the $90-$95 a barrel range to generate returns of around 10%, reckons Chris Feltin, vice-president and director of institutional research at Tristone Capital Corp. Tertzakian believes some projects may need $100 oil.

Of course, not all oil sands projects are created equal. Digging the sludgy oil sands bitumen out of the ground in vast open pit mines usually costs more than using steam to soften the bitumen and pumping it to the surface. Building an upgrader, which processes the bitumen into refinery-ready crudes of varying quality, is another major expense.

Fort Hills, for example, is an integrated mining project planning an initial development phase of 140,000 barrels a day. Connacher's modular project, which uses the steaming technology, is working in bite-sized chunks of 10,000 barrels a day.

"Oil at $60 a barrel does it for us," Connacher's Gusella said. "That covers all our operating costs, royalties, interest on debt and 15% return on investment."

But current conditions aren't yet enough to prompt another downward revision to oil sands output projections next summer, said Greg Stringham, vice president of markets and fiscal policy at the Canadian Association of Petroleum Producers, which publishes the widely watched annual forecasts.

Even if falling crude prices push some higher-cost projects off the table, the oil sands themselves could prevent a long-term slump to unsustainable levels, Tristone's Feltin said.

As the marginal non-OPEC barrel, break-even costs for the oil sands may form a natural floor to crude prices.

"It's a thesis I'm using to justify long-term oil prices north of $100 a barrel," Feltin said. "Realistically, when international oil companies are looking for easy-to-access oil reserves, the oil sands pop up first."

Others are less convinced of an explicit link. While the oil sands may play a role, some analysts reckon OPEC will start agitating for production cuts if crude slips too far, and the markets could switch their current focus on slumping demand back to tightening supply conditions. Both could kick crude prices back above $100 at some stage.

For the major producers, though, it's largely business as usual.

"Big companies have the staying power to go through the sags in the market," said Bob Skinner, a senior vice president at StatoilHydro ASA's (STO) Canadian unit. "If the industry reacted to every little - well, this is a big one - drop or fluctuation in price there wouldn't be any oil sands projects. As far as we're concerned, we're going full steam ahead."

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