Oil Sands Economics Not Always So Compelling
By Stephen Clayson
23 Aug 2005 at 11:00 AM EDT
LONDON (ResourceInvestor.com) -- With the soaring prices of light and medium weight oils such as the Brent Crude and Western Texas Intermediate benchmarks, many investors are looking to cash in by investing in heavy oil production from Canadian oil sands and the like. But do they have all the facts?
There seems to be a pervasive public misconception that crude oil is crude oil, and that light, heavy and intermediate grades are more or less interchangeable. Unfortunately for consumers and industries groaning at the thought of $70 per barrel light and intermediate crude, this is not the case.
Heavy oil is not a perfect substitute for the light, sweet crude that the world has become accustomed to, which is particularly irksome as heavy crude constitutes most known oil reserves. The main problem with this is that heavy grades of oil are currently considered fundamentally inferior to the lighter oils preferred, and purchased at a substantial premium, by refiners.
The output of Canadian oil sands and similar projects elsewhere is of heavy grade crude, which is technically defined as oil with an API gravity of less than 22.3 degrees, but which often scores as low as 8 or 10 degrees. This is true whether the mode of production is from oil sands material in situ or via the physical extraction of solid oil sands through strip mining and processing on the surface.
The actual selling price of heavy oil is generally assigned in relation to one or more benchmarks, such as the Bow River or Lloyd heavy blends. As with most oil contracts, an upward or downward adjustment is then made according to the particular oil’s exact weight and impurity content.
Heavy oil is of course far from useless, but a number of factors currently ensure that it is worth less than lighter oils. Foremost is the fact that when heavy oil is cracked, it yields a greater proportion of less valuable products than would lighter oils. Refiners naturally want to maximise their yield of the most valuable refined products like gasoline and kerosene, rather than the industrial fuel oil and other heavier fractions primarily produced by the cracking of heavy oils.
Furthermore, there is a shortage of refineries worldwide that are set up to deal with heavy oil, and those that tend to be more costly to run than those refining lighter oils due to the greater technical challenges involved in processing heavy grades.
The upshot of all this is that there is a marked divergence in price between light and heavy oils, which has actually widened of late as increases in the price of lighter oils have outpaced those of heavy grades.
Many oil sands ventures are therefore not receiving the headline oil price, which refers to lighter crude oils such as Brent and West Texas Intermediate, but a much lesser figure for their output. This does not appear to be common knowledge, and investors may hence be overestimating the values of some oil sands projects.
The story is different for the largest oil sands players like Shell or Syncrude. These companies crucially own the expensive plants that allow value to be added internally to the heavy oils produced from oil sands by upgrading them to premium priced light synthetic crude oils. The majority of oil sands ventures though are not in this position and thus are receiving significantly lower values for their sales of heavy crude.
Of concern now is that a price bubble has developed in a few oil sands stocks, based upon irrational expectations of returns created by misconceptions about relative oil prices. It is unclear how well known the actual economics of oil sands exploitation is, or what investors’ true impressions of future returns are. If those who are presently misinformed become disillusioned, then a downward correction could befall some share prices in the sector.
The situation might change for the better though. More refineries may be established or converted to cope with heavy oils that have not been upgraded, improving demand for them and hence their price. Or, the prices of light oils may rise significantly further, likely causing those of heavy oils to follow to some extent. Both could deliver a boost to the economics of oil sands projects without upgraders of their own.
This piece is not to undersell the value of heavy oil projects such as those that are now proliferating in Canada, but merely aims to aid the market’s understanding of such ventures, something that may be lacking in some quarters. As ever, investors should exercise caution when choosing their plays and watch out for overhyped propositions. |
