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Counting up costs and profits in the oil sands

Costs in the oil sands are high, but that fact actually gives investors an advantage, says this analyst, who offers several intriguing picks.

As far back as the eighteenth century, travellers took note of bitumen seeping into the 250-foot high “cutbanks” of the Athabasca River. Of course, since they weren’t travelling in SUVs or even Model-T Fords, the fact that this could be converted into synthetic crude didn’t mean much to them.

Nor would they have worried much about the cost of getting the stuff out. Today everybody worries about the costs.

It’s enormously expensive to extract the bitumen from the tar sands, whether by steam, natural gas, hook or crook. Many people, insiders included, still think it’s too expensive.

“When I tried to test the importance of Canada’s oil sands on a high executive of a leading South American oil company early last year, he giggled dismissively about unreal costs.”

The quote comes from Mr. Michael Smedley, who manages the closed-end Canadian General Investments Fund. Writing in Investor’s Digest of Canada, he doesn’t deny that the costs are high and may get higher.

But he thinks that’s an advantage for investors. You know exactly what you’re getting when you invest in the oil sands. Today’s big players will still be tomorrow’s big players. With this in mind, Mr. Smedley has three big stocks he likes in the oil sands, but he also has a “thriller” pick and one smaller firm that investors might want to consider.

Big today, leaders tomorrow

Whatever the economics of extraction, Mr. Smedley writes, “the oil sands contain most of Canada’s oil and put the country second only to Saudi Arabia in global crude oil reserves. The oil sands of Alberta will be important and globally in the news for years to come.”

In short, whatever the cost, they aren’t going to sit there ignored. Certainly not with oil soaring above $105 a barrel.

“My next thought is that the big names in the oil sands will also be the leaders tomorrow as the industry will remain primarily a capital-intensive investment business, rather than an exploration play.”

Extending that thought back in time, Mr. Smedley explains that in effect it’s yesterday’s players, the ones that got there first, who will thrive (not the eighteenth-century guys, the actual oil companies). “Early arrival got them into the best quality resources close to the banks of the Athabasca River, where the over-burden tends to be at its most shallow and the bitumen at its richest.”

That means that the major blue chip investments in the oil sands will always be the major partners of the big Syncrude project, or their neighbour, Suncor Energy (TSX-SU). Suncor is the only pure oil sands major other than Canadian Oil Sands Trust (TSX-COS.UN), the largest of the Syncrude partners with a 37.6 per cent stake. Next biggest is Imperial Oil Ltd. (TSX-IMO) at 25 per cent.

Mr. Smedley has a few things he particularly likes about each one. Suncor has a high net asset value, $110 a share or higher with about 463 million shares issued, although it has had two two-for-one stock splits. A strong balance sheet allows for acquisition and opens the way to increased production from 2009 and 2011, which will bring Suncor close to its target of 550,000 barrels a day by 2012.

Canadian Oil Sands has more than 479 million units, although it went through a five-for-one split almost two years ago. It also has some 35 years of proven reserves. Mr. Smedley likes the fact that it has branched out from the Athabasca River with its purchase of the “almost forgotten” Canada Southern Petroleum. This junior once made news as a big play on Arctic gas reserves.

Imperial Oil is the biggest producer in western Canada, debt free, but a little stingy with dividends. Rumours continue to surface that U.S. parent Exxon Mobil will take it over in order to get a direct foothold in the oil sands. Mr. Smedley doesn’t think so. “An essential in Exxon’s mantra seems to be return on capital employed and that probably would be soiled on a full takeover of its Canadian subsidiary. In my opinion, IMO is the blue chip leader in our oil and gas industry. Its productive interests outside the Athabasca basin are vast.”

Oil sands thriller

If those are the three big “here today, here tomorrow” companies you can count on in the oil sands, there are also a couple of lesser-known firms that might take you on a thrilling ride. Mr. Smedley’s “best thriller” is Petrobank Energy and Resources Ltd. (TSX-PBG).

In 2005, this company was trading at around $5. The shares opened today at $46.27. The fund manager likes the fact that it avoids steam assisted gravity drainage (SAGD), “the widespread technology which is erratic and performance-ranging in its application — strange how this fact about SAGD is mentioned so little.”

Petrobank uses a cleaner method that keeps its capital per “flowing barrel” closer to $15,000 than the $30,000 or $40,000 for practitioners of the SAGD method. Unlike its competitors, who sink heavy costs into “mucky water pipes,” Petrobank’s Toe-to-Heel Air Injection (THAI) method uses clean water requiring much lower water handling costs. The product recovered is also of higher quality, and needs less upgrading.

So what’s the catch, asks Mr. Smedley? Some observers seem to think Petrobank’s THAI approach is still on trial, or that it can’t really patent the technique. “The high stock price seems to be telling us there is no catch,” he concludes.

Exception to the rule

Finally, the fund manager is willing to make one exception to his rule that the oil sands are for big-capital companies only. He has, he says, “recently somersaulted into a more receptive stance” on Connacher Oil & Gas Ltd. (TSX-CLL).

“Progressing from start-up at admirable speed,” says Mr. Smedley, “Connacher recently broke through 5,000 barrels of daily production at its Pod 1 on the way to 10,000 barrels later this year.” It has more pods to mine and now believes its resource is much bigger than the one to 1.5 million barrels originally estimated.

Connacher also has conventional oil and gas assets. One is a heavy oil refinery in Montana that it acquired in 2006. Another is a Latin American explorer, developer and producer that it founded and still has shares in, Petrolifera Petroleum Ltd. (TSX-PDP).

“I have no idea how the costs overall will pan out for the wide-ranging interests for Connacher,” Mr. Smedley frankly tells his readers in Investor’s Digest of Canada, “but it is planning for a long future and is worthy of more attention.”

The oil sands will keep on getting attention no matter how high the costs go. And for companies and investors alike, it’s a matter of getting what you pay for, according to this fund manager. The deepest pockets are due to yield the tallest profits.