Oil sands update - SU, CNQ, and ECA still preferred following Canada trip - Goldman Sachs - May 29, 2006
Following our recent trip to Calgary and Ft. McMurray, we continue to recommend Canadian oil sands-exposed companies such as Suncor Energy, Canadian Natural Resources, and EnCana (all OP/A rated). Our bullish view is based on confidence in resource potential and our outlook for strong crude prices. High activity levels appear to be causing historical capital cost differentiation to morph into similarly high costs for all. This is driving a range of more creative downstream initiatives, with EnCana's search for a domestic refining partner a key catalyst for its shares, in our view. We believe in-situ resource potential, in particular at Suncor, EnCana, and Nexen, remains undervalued by the Street. Clarity on EnCana's downstream strategy later this year and the successful start-up of Long Lake by Nexen in 2007 could yield significant share price appreciation for in-situ-exposed companies.
MINING/UPGRADING COSTS NOW C$60,000-C$80,000 PER BPD OF CAPACITY WITH LESS COST DIFFERENTIATION AMONG COMPANIES EXPECTED
We believe the cost of a new mining/upgrading project has risen to C$60,000-C$80,000 per bpd of capacity, up from C$45,000-C$60,000 in recent years. Historically, there have been some companies such as Suncor Energy that have had a cost advantage over peers. In the current environment Suncor management is not building in that expectation as it considers the costs of its Voyageur project, expected in 2011-12.
We continue to believe that cost inflation drivers are highly cyclical and would move down if crude prices fall -- steel cost would likely decline, the Canadian dollar would likely weaken relative to the US dollar, natural gas input costs would fall (though perhaps less so from current levels) and ultimately labor costs we think would fall as well. Increasingly, however, companies that pursue expansions slated for a 2009-12 startup are becoming dependent on crude oil prices remaining above normal for an even greater period of time than even our bullish outlook calls for in order for the higher costs to not be dilutive to long-term returns. This could place a rising importance for these companies to protect cash flows via hedging strategies and take advantage of attractive long-dated forward curve pricing over the next five years.
COMPANIES WITH TRACK RECORD, GLOBAL REACH REMAIN BETTER POSITIONED TO WEATHER HIGH MINING/UPGRADING COSTS
We continue to believe that companies that have greater flexibility in moving labor globally and those with a track record of successful expansions and operational excellence are better positioned for the next five years versus peers. We believe this favors majors such as Exxon Mobil (OP/A), which, following our meeting with its approximately 70%-owned Canadian subsidiary Imperial Oil, we continue to believe shows a superior combination of creativity and capital discipline. Exxon's existing complex refining capacity has allowed it for now to keep the upstream startup of its Kearl Lake oil sands mining project on time while delaying a decision on upgrading capacity until the project's second phase. Of the Canadian-based companies not affiliated with a super major, we believe Suncor and Canadian Natural remain the best positioned. Suncor's history of both operations and investments combined with an array of future projects should continue to be advantageous even if the company pays a market capital cost rate for its 2010-12 Voyageur expansion. We believe Petro-Canada (U/A) is positioned less well than peers because it has less global reach and lacks a large oil sands project track record. Canadian Natural, like Petro-Canada, lacks the mining/upgrading operating track record, though because CNQ's Horizon project is expected to startup in 2008, the company was able to better manage Phase 1 costs. We are not expecting dramatic Horizon cost overruns at this time.
IN-SITU RESOURCE REMAINS UNDERVALUED DESPITE IMPROVEMENTS IN RELIABILITY
We believe the Street continues to heavily discount deeper in-situ resource relative to shallower, mineable resource. We believe any event that enhances confidence in steam-assisted gravity drainage (or SAGD, the main in-situ technology expected to be used for expansion projects) potential could be a catalyst for shares of Suncor, EnCana, and Nexen. We believe the announcement of a material downstream partner to develop EnCana's oil sands assets, expected during 3Q 2006, could be a near-term catalyst.
While there are reasonable reasons for why the Street has less confidence in in-situ resource -- in-situ is a less commercially proven technology, more energy intensive and project sizes are smaller, while mining is literally more visible -- we believe that recent in-situ performance reflects greater reliability and lower energy intensity than the Street may be expecting. Key SAGD projects like EnCana's Foster Creek, Suncor's Firebag and Petro-Canada's Mackay River have shown improvements in recent quarters. However, uncertainty remains with Nexen/OPTI Canada's Long Lake project, expected to start-up in late 2006/early 2007, owing to a higher-than-expected steam-oil ratio (SOR) at its pilot project. While Nexen and OPTI management remain confident that Long Lake will deliver returns consistent with other leading projects, we think the Street is likely to remain skeptical until the project ramps-up in 2007 and actual results confirm management commentary.
IN-SITU RESERVOIR QUALITY: CAN EVERY COMPANY REALLY HAVE THE HIGHEST QUALITY DIRT?
Following our meetings, the question of which in-situ project has superior reservoir quality remains unclear, as most companies not surprisingly portrayed their specific projects as top-tier relative to peers'. Consensus recovery rates of original oil in place seemed to range between 50%-60%. We believe that greater confidence in recovery rates will come over time, and we do believe many of the major in-situ projects could turn out to be high quality.
LABOR BOOM FORCING MORE CREATIVE DOWNSTREAM OPTIONS
The increasing lack of availability and resulting higher cost of labor has caused companies pursuing oil sands expansions to consider a wider array of strategies for participating in value beyond bitumen. Our discussions with companies and our visit to Fort McMurray indicate that, not unexpectedly, labor markets have become even tighter than a year ago. We believe that this is commensurate with the strong global expansion that has tightened construction labor globally. We continue to expect tight labor costs given our bullish outlook for commodity prices.
In order to reduce the need to add new jobs in Fort McMurray, companies are attempting to shift labor to other locales by either building upgraders in Edmonton or eliminating upgrading altogether and sending bitumen longer distances to complex refineries. We believe that while Edmonton is a more developed, easier-to-access community, any capital cost savings from shifting labor activity there is likely to be short lived in our view. At some point, the operating costs of transporting bitumen longer distances and converting refineries to process heavier crude/bitumen blends could yield higher returns than constructing upgraders in a frothy labor environment. EnCana and Exxon Mobil in particular are focusing on this for now.
RISK OF DECLINING VENEZUELAN AND MEXICAN PRODUCTION A KEY FACTOR DRIVING RISING US GULF COAST DEMAND FOR CANADIAN OIL
We believe that any further evidence of a downturn in heavy crude production from key oil exporters to the United States like Venezuela and Mexico could strengthen the bargaining position of Canadian bitumen producers in negotiations with refiners. We are not expecting a strong rebound in either Mexican or Venezuelan production in the near to medium term, the result of underinvestment in the upstream sector by their respective governments. The result could be greater imports from Saudi Arabia or, more likely, from Canada to the Gulf Coast. The result of ongoing negotiations between EnCana and potential downstream partners should be a key indicator of downstream attitudes and how much of the pie both upstream and downstream players are willing to sacrifice.
TECHNOLOGY: COKE GASIFICATION USE SEEMS FURTHER OFF AS INDUSTRY WATCHES LONG LAKE
Companies seemed less optimistic than in the past regarding the use of coke gasification as an alternative to natural gas consumption. We believe this position, expressed most vocally by Suncor, could be an attempt to secure tax breaks from the Canadian government which may care more deeply about reducing natural gas consumption by oil sands companies. Or it may reflect reduced confidence that the high capital costs of a solids gasification plant could improve returns. Liquids-stream asphaltene gasification remains in a wait-and-see mode with the pending startup of Nexen and OPTI's Long Lake project. We have greater confidence in the technology following meetings with both companies, though there may be somewhat higher operating risk given the continuous nature of the process technology. Nexen (IL/A) in our view remains the highest risk/highest reward of the large oil sands levered companies, because of the importance to its shares for both the Long Lake and Buzzard projects to be successful.
TECHNOLOGY: SUNCOR MOBILE CRUSHING PILOT SHOWING SIGNS OF SUCCESS
We believe the most significant conclusion from our tour of Suncor's oil sands facility is that the company's pilot project to test the use of mobile crushing technology is initially successful, which could lead to the project being expanded in the future. Mobile crushing could improve maintenance costs of mining projects by reducing the need for using trucks to haul oil sand to the extraction facility. It could disproportionately benefit older projects such as Suncor's which are increasingly relying on further trucking distances. We expect the company to have more details on the state of the pilot project in the next six months, though employees at the facility were very optimistic for expansion.
Rating and pricing information Canadian Natural Resources Ltd. (OP/A, $53.59), EnCana Corp. (OP/A, $48.77), Exxon Mobil Corp. (OP/A, $61.58), Nexen Inc. (IL/A, $54.41), Petro-Canada (U/A, $44.71) and Suncor Energy Inc. (OP/A, $80.62)
Each of the analysts named below hereby certifies that, with respect to each subject company and its securities for which the analyst is responsible in this report, (1) all of the views expressed in this report accurately reflect his or her personal views about the subject companies and securities, and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report: Arjun Murti, Brian Singer. |
