Is it priceless oil... or just worthless mud?
For decades, the U.S. Securities and Exchange Commission (SEC) wouldn't allow Canadian oil-sands promoters to call their assets "oil reserves." Instead, the SEC required them to be classified as "mining reserves." It was a distinction that cost them billions of dollars...
The SEC's policy erased the equity on these promoters' balance sheets, taking away most of the value of their resources. This regulatory roadblock made it hard for companies trying to extract petroleum from Canada's oil sands to access capital and secure loans.
The SEC had its reasons, of course. Extracting the extremely heavy oil trapped in the sand of places like Canada's Athabasca region of Alberta is expensive. You have to dig the tarry sand out of the ground and super-heat it to separate the oil. Even then, it's lower-quality than the light, sweet crude that flows from wells in Texas and the Middle East.
Total extraction costs for oil sands can exceed $50 a barrel. Extracting regular oil can cost half that (or less)... So it seemed unlikely that the "oil mud" in Alberta would ever become a profitable source of oil. SEC rules say to count as "reserves," the oil has to be economical to produce. If the promoters of Canadian oil sands couldn't profitably produce the oil, why allow them to count it as a proven oil reserve?
The logic held for a while. But by 2008, with oil trading for much more than $100 a barrel, these assumptions seemed obsolete. The Peak Oil theory had convinced everyone – even the SEC – that even the most marginal source of crude oil was now a crucial resource and could no longer be ignored from a financial and accounting standpoint.
After intense lobbying on behalf of the Canadian oil mud industry, the SEC began to bend. And on June 26, 2008, the promoters got their fondest wish – official recognition from the SEC.
The Securities and Exchange Commission today announced that it has proposed revised oil and gas company reporting requirements to help provide investors with a more accurate and useful picture of the oil and gas reserves that a company holds.
In anticipation of this change, shares of Suncor – the biggest and best-known publicly traded oil-sands company – hit $72 that May. The stock had appreciated 2,900% over the previous 15 years. Its vast reserves of mud... bought for pennies... were now worth billions of dollars... if you believed the SEC.
Not surprisingly... the SEC ruling marked the high water mark in the shares of Suncor.
Within a year... a real oilfield was discovered almost next door. A real oilfield, with real, liquid crude oil that didn't require bulldozers and super-heated steam for production.
They called it the Bakken. And we hope those SEC lawyers have gone out to see it, just so they'll finally learn what a real oilfield looks like.
The Bakken is potentially the largest oilfield in North America. It covers parts of North Dakota, South Dakota, and Montana in the United States. In Canada, it reaches parts of Saskatchewan and Manitoba.
Bloomberg predicts that combined with the nearby Three Forks and Sanish formations, the great Bakken region could be the largest oil producer in North America over the next 30 years.
Production is currently skyrocketing. As of June 30, 4,141 producing oil wells were at work in the Bakken. Production has gone from around 100,000 barrels per day (bpd) in 2009 to 594,000 bpd today. We believe that production will double from here to more than one million bpd in the next 18 months.
This same trend is happening all across the U.S. in the new shale oilfields. For the first time since the 1970s, the amount of oil being produced in America is significantly increasing.
Given the tremendous amount of higher-quality oil now being produced at a lower cost... what do you think the future holds for the oil mud of Canada?
Here's a hint: We believe the SEC will soon change its mind again and rule that Alberta's muddy prairies aren't actually oil at all. You will not want to own those stocks when that happens, as their access to capital and much of the equity on their balance sheets will disappear.
And that's not Canada's only problem...
If you believe the SEC and oil-sands promoters, Alberta's muddy fields hold more than 174 billion barrels of proven crude-oil reserves. That's the world's third-largest reserve total after Saudi Arabia and Venezuela. If it were really oil – the kind of liquid hydrocarbon that flows from traditional oil wells – that would be an incredible asset. But it's not. It's oil mud – known as "bitumen" in the industry – that's difficult and expensive to extract and refine.
Canada produced three million bpd in 2011. Western Canada produced 2.7 million bpd... and 59% of that came from the oil sands. Domestic demand in 2011 for Western Canadian crude oil was 878,000 bpd. Canada exports the rest – approximately two million bpd to the U.S., making it our largest supplier...
The Midwest is the traditional market for Canadian oil-sands producers due to the close proximity and pipeline infrastructure. But the price of oil is collapsing in this market because of the soaring Bakken and Eagle Ford production.
Over the last year, West Texas Intermediate (WTI) crude, the benchmark crude oil in the United States, has sold at a discount of more than $20 compared to the international standard, North Sea Brent crude. Synthetic Crude Oil (SCO), another term for the heavy stuff from the Canadian oil sands, sells at an additional discount. Over the past year, the discount varied between $12 and $15 per barrel to WTI.
In the past six months, those spreads are widening even more. For example, Suncor issued corporate guidance on July 24 that it expects the 2012 spread to be in the $13-$18 range. Historically, the discount between SCO and WTI has peaked at $30.
You must remember... this is the discount to WTI. Think about that for a minute. If WTI oil sells at $100, SCO sells for around $80. WTI oil sells for around $96 today. That puts SCO at around $76. At $76 a barrel, that's only about $10 above the all-in costs for the oil-sands producers. A 20%-30% price drop from here will absolutely kill any profits the Canadian oil-sand producers might make today.
The United States is the world's biggest market for crude oil, with a total refining capacity of almost 18 million barrels per day.
As we mentioned above, the Midwest has been the oil-sands producers' best customer. But domestic producers – like those from the Bakken – are creating competition. The oil-sands producers could ship the stuff to the Gulf Coast refineries. The only problem is... those facilities are more than 2,000 miles away.
The Canadian supply hubs are at Edmonton and Hardisty. Four major pipelines connect these hubs to transport oil out of Canada: the Enbridge Mainline, the Kinder Morgan Trans Mountain Pipeline, the Kinder Morgan Express, and the Keystone Pipeline.
These four pipelines report total capacity of 3.5 million barrels per day. The oil-sands producers' access to that pipeline capacity is limited by demand from downstream locations. In other words... the more transportation capacity Bakken producers require, the less capacity available for the Canadian producers.
As various transport agreements expire and the Bakken continues to increase production, more and more of this capacity will be taken over by those "real" oilfields, whose crude is more valuable and vastly cheaper to produce.
How do we know? Because right now, Bakken producers are using trains to ship oil out of the fields. Rail transportation in the Bakken was used to ship out 8% of production in 2010. So far this year, that's increased to 28% of production.
Obviously, pipelines are far more efficient. As soon as pipeline capacity can be arranged, this new, higher-quality, cheaper-to-produce Bakken crude will squeeze out the SCO oil coming from Canada. So not only is Canadian oil mud likely to be uneconomic to produce... it could also become impossible to transport to refineries because of a lack of pipeline capacity.
With an uneconomic, largely obsolete product... the oil mud industry looks like a prime candidate to sell short.