The Oil Sands: Energy Security v. Climate Change

It’ll be all business when President Barack Obama visits Prime Minister Stephen Harper Feb. 19 in Ottawa–no pomp, no ceremony, no parliamentary address.

The broad focus of discussions will be the economy, including where we are now and where we’re going. That means efforts to stabilize the financial system, stimulate the economy and “Buy American” will certainly come up.

The drop-in will include a one-hour meeting between Mr. Obama and Mr. Harper. The new US president will also meet briefly with Liberal Party Leader Michael Ignatieff and host a news conference.

While there will be no public address or state dinner, that Mr. Obama is making his first trip abroad to Ottawa illustrates the importance of the US-Canada relationship. It is, after all, the most significant bilateral trade arrangement in the world; two-way trade in goods and services amounted to more than CAD700 billion in 2006, an average of about CAD1.3 million in trade per minute across the border. The combined Canada-US market represents more than 425 million consumers with a combined GDP of more than USD11.4 trillion.

One particular aspect of the trade relationship that’s also sure to be on the agenda is Alberta’s oil sands. During the 2008 campaign Mr. Obama pledged to wean the US off “dirty, dwindling and dangerously expensive” oil. Many in Canada–focusing on the word “dirty”–interpreted the candidate’s statement as a warning shot across Alberta’s bow, an indication that Obama would oppose US importation of carbon-intensive fuel produced from the oil sands.

But a primary foreign policy objective of the new administration is to reduce US dependence on oil imported from hostile regions; Canada is the US’ No. 1 oil supplier, exporting 1.8 million barrels of oil per day, 20 percent of daily US imports. Canada’s proven reserves rank second in the world to Saudi Arabia’s. When we buy oil from Canada, don’t worry about sponsoring dictatorships or sending money to questionable allies.

At the same time, Mr. Obama has also made addressing climate change a top priority. Canada’s oil sands represent an infinitely safer alternative in national security terms, but critics point to the large amount of natural gas burned to process the sands into synthetic oil, resulting in major greenhouse gas emissions, as well as the production of wastewater and the destruction of boreal forests that are habitats for migrating birds.

Reconciling the apparently conflicting environmental and security objectives will test Mr. Obama, who describes himself–and is widely recognized–as a pragmatist. Mr. Obama position isn’t clear yet, and environmentalists will surely employ his oil sands position as a litmus test for how serious he is about a switch to alternative and renewable energies.

Within the administration you have on one hand the argument that the oil sands comprise the next Saudi Arabia, an abundant source of energy, though in this case free of the geopolitical nightmares attendant to dealing in the Middle East. And then there’s the view that the sands represent a transitional resource to a low-carbon economy; to regard it as anything else is to drain the continent’s financial resources.

Some officials on Mr. Obama’s energy team, such as national security advisor James Jones–picked, in the president’s words because he understands “connection between energy and national security”–will stress the energy-security side.

Last fall, Jones gave a speech in Banff, Alberta, to a group of business leaders and government officials touting the importance of Canada’s oil sands to America’s energy security. At the time, Jones was president of the US Chamber of Commerce’s energy institute, which promotes the development of a long-term energy strategy that “ensures affordable, reliable and diverse energy supplies” including oil shale, oil sands and other unconventional fossil-fuel sources. In Jones’s view, the diversity and security of supply that oil sands provide should trump the environmentally negative consequences of its production.

On the other side of the internal debate is Mr. Obama’s new climate and energy czar, Carol Browner, who initiated efforts at the Environmental Protection Agency during the 1990s to regulate carbon dioxide under the Clean Air Act. And new Council of Environmental Quality chair Nancy Sutley’s strong environmental record suggests trouble for the “dirty” oil industry. These officials will likely argue that the energy-security benefits Canada’s oil might provide are outweighed by its negative environmental impact.

Still others, such as Energy Secretary Steven Chu, will argue that supporting oil sands diverts domestic attention away from renewable energy development, which Mr. Obama recently declared to be the US’s new national mission.

And there’s the matter of Canada protecting its national interests–the US isn’t the only potential consumer of oil sands product. Canadian think tanks are now urging Ottawa to open talks on a North Pacific Energy Security Framework that would include Russia and China.

“Exporters depend on a robust international trading system, and discussions surrounding a North Pacific Energy Security Framework provide Canada with the opportunity to defend a trading system aligned with Canadian interests,” concludes a paper produced by Pierre Alvarez, former president of the Canadian Association of Petroleum Producers and chairman of the Canadian Centre for Energy Information; Michael Cleland, president of the Canadian Gas Association; and Roger Gibbins, president of the Canada West Foundation.

The North Pacific energy pact contemplated would initially include six countries that share geographic proximity: Canada and Russia, two of the world’s top producers of oil and gas and large net exporters of energy; and the US, China, Japan and South Korea, among the world’s top energy consumers. The six countries account for 54 percent of world energy demand. Among the issues the pact would address are developing Arctic resources; promoting investment in energy and energy trade, and addressing climate change.

Canada’s energy policy has been almost entirely focused on the US. That’s good in the sense that significant dollars have flowed north and the US is a stable market for its products. But Canada–as the current dilemma illustrates–is also subject to policy debates and outcomes that may be harmful to its economic interests.

Focusing exclusively on the oil sands may be a mistake, however. The big picture includes carbon pollution from coal-burning thermal plants, which are actually the biggest single issue in the world and in the US. Canada, already one of the cleanest energy-producing countries in the world, produces 73 percent of its electricity from clean sources such as hydro, while about 75 percent of US electricity comes from carbon-emitting sources.

Regulations to reduce emissions from industry hinge on discussions about a North American a cap-and-trade system, which establish limits on emissions and allow industry to buy and sell credits within established measures. Mr. Harper has said cap-and-trade will be a priority topic for him on Feb. 19.

With his recent rhetoric, Mr. Harper appears to echoing the pro-green language Mr. Obama used on the campaign trail. But like the US president, the prime minister is mindful of North America’s significant economic and security interest in oil sands development.

“We will be making the point,” Mr. Harper said, “of saying we want to work together with the United States on environmental and energy issues.

“To be frank on the oil sands, we’ve got to do a better job environmentally. At the same time, the development of these things is pretty important, in our judgment, to North American energy security.”

Speaking Engagements

There are few better places to combine work and play than Sin City: Join Canadian Edge, Editor Roger Conrad and The Energy Strategist Editor Elliott Gue for The Money Show Las Vegas, May 11-14, 2009, at The Mandalay Bay Resort & Casino.

With Elliott’s and Roger’s sage advice, this is one trip to Vegas that won’t make a wreck out of you.

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And make plans to join Roger, Elliott, Gregg Early and Benjamin Shepherd at the 18th Atlanta Investment Conference. Sponsored by Friends for Autism, the conference is held in a mountain setting north of Atlanta from Thursday, April 23, to Saturday, April 25.

Roger, a steady hand through many market events such as the one we’re dealing with now, will talk about Canadian income and royalty trusts as well as his new service focused on exploiting the greatest spending boom in history, New World 3.0.

Elliott will detail the new direction for Personal Finance and provide insight into his approach to stock selection and portfolio management. What’s required now amid these difficult times are clarity and focus, qualities Elliott has demonstrated in these pages and through The Energy Strategist for years.

Gregg, a constant at PF for nearly two decades, will be there to address recent developments with the publication. He’ll also discuss the Smart Grid, an endeavor he’s exploring as part of his role with New World 3.0.

Ben, editor of Louis Rukeyser’s Mutual Funds and Louis Rukeyser’s Wall Street, the in-house mutual fund expert, will discuss efficient, cost effective ways to simplify the investing process.

Be sure to bring your questions. These guys love to talk markets and everything that impacts them.

Attendance is limited to 175 of the most enlightened, savvy individual investors. Go to http://www.aicatchota.com/ for more information. Meals are included for the Canadian Edge discounted price of $459 for a single and $599 for couples. Call 770-952-7861 or e-mail altinvestconf@mindspring.com to register.

The Roundup

Two more Canadian Edge Conservative Portfolio holdings have now reported earnings, Energy Savings Income Fund (TSX: SIF-U, OTC: ESIUF) and Great Lakes Hydro Income Fund (TSX: GLH-U, OTC: GLHIF) joining Bell Aliant Regional Communications Income Fund (TSX: BA-U, OTC: BLIAF) among the ranks of those companies with solid fourth quarter and full year 2008 numbers.

We’ll continue to provide updates here and in Flash Alerts throughout earnings season, which will extend well into March.

Conservative Portfolio

Energy Savings Income Fund (TSX: SIF-U, OTC: ESIUF) reported a 14.2 percent rise in revenue on a net addition of 23,000 customers during its fiscal third quarter; sales for the three months ended Dec. 31, 2008 rose to USD513.6 million from USD449.7 million.

The company reported a net loss of USD49.1 million (USD0.44 per unit) because of the impact of mark-to-market valuations on commodities futures positions.

Adjusted profit, based on operating results, was USD46.6 million (USD0.42 per unit). A year ago, adjusted net income was USD34.8 million (USD0.32 per unit). Energy Savings said it holds its futures positions to maturity, so quarterly mar-to-market gains and losses don’t impact the long-term financial performance of the fund. Energy Savings Income Fund is a buy up to USD10.

Great Lakes Hydro Income Fund (TSX: GLH-U, OTC: GLHIF) generated 22 percent more power in the fourth quarter of 2008 than in the fourth quarter of 2007, and 2008 was a record year in terms of generation.

Fourth quarter revenue totaled CAD39.9 million, up from CAD33.3 million a year ago; income before non-cash items was CAD18.7 million, up from CAD11.3 million. For the year Great Lakes saw revenue of CAD195.7 million and income before non-cash items of CAD100.1 million, up from CAD155.8 million and CAD65.3 million, respectively.

Generation was up for all four segments–Quebec, Ontario, British Columbia and New England–for the full year, although Ontario’s fourth quarter was hampered by poor hydrology conditions. Operating expenses rose in line with increased power generation.

As of Dec. 31, 2008 the fund had CAD46.1 million available though its existing credit and hydrology facilities and a current cash balance of CAD9 million. Great Lakes Hydro Income Fund is a buy up to USD18.

Here’s the roundup of news from the How They Rate universe.

Oil and Gas

Bonterra Oil & Gas (TSX: BNE, OTC: BNEFF) has trimmed its January dividend, payable Feb. 27 to shareholders of record Feb. 18, by 25 percent to CAD0.12 from CAD0.16.

The significant decline in natural gas prices and the expiration of risk management contracts substantially reduced cash flow. This reduction was partially offset by marginal increases in crude oil prices and levels of production. The reduction in dividend is necessary to preserve balance sheet strength. Bonterra Oil & Gas is a buy up to USD20.

Business Trusts

IBI Income Fund (TSX: IBG-U, OTC: IBIBF) has boosted the amount available under its existing lending facility from CAD85 million to CAD100 million and also extended the term of its bridge and operating facilities to Dec. 31, 2009. IBI Income Fund is a buy up to USD15.

Real Estate Trusts

Calloway REIT (TSX: CWT-U, OTC: CWYUF) announced the completion of a CAD105 million syndicated, revolving operating facility, secured against a pool of 10 properties. The floating rate facility has a term of up to 18 months and an interest rate of approximately 3.85 percent. The financing will cover all of Calloway’s 2009 new capital requirements. Calloway REIT is a buy up to USD10.

Energy Services

Precision Drilling Trust (TSX: PD-U, NYSE: PDS) announced that it’s suspending its distribution “for an indefinite period” while it focuses on reducing debt and shoring up its capital base, a step taken in response to early 2009 operating results. The previously announced distribution of CAD0.04 per unit payable on Feb. 17 to unitholders of record on Jan. 30 is unaffected by the suspension.

Precision reported net earnings of CAD92 million (CAD0.71 unit) for the quarter ended Dec. 31, 2008, basically flat compared to CAD89 million (CAD0.71 per unit) in the fourth quarter of 2007. Revenue was CAD335 million, up 35 percent from CAD249 million a year ago.

Revenues for 2008 rose 9 percent from 2007 levels to CAD1.1 billion, driven primarily by the impact of high commodity prices on customer demand in the third quarter and the beginning of the fourth quarter of 2008, which offset the effects of lower activity and customer pricing in Canada in the first half of 2008.

Growth in the US land drilling market also had a positive impact through 2008. But as is well documented, demand of all kinds virtually evaporated during the fourth quarter.

Precision reported net earnings of CAD303 million (CAD2.39 per unit) for 2008, down from CAD346 million (CAD2.75 per unit) in 2007. The net earnings decrease was driven primarily by lower activity and customer pricing in Canada during the first half of 2008 relative to 2007 and higher 2008 income tax expense. Precision Drilling Trust remains a buy up to USD12.

Financial Services

Home Equity Income Trust (TSX: HEQ-U, OTC: HEITF) is taking a somewhat novel approach to the conversion question: The company will apply to the Minister of Finance for its operating subsidiary, Canadian Home Income Plan Corp (CHIP), to become a federally regulated Schedule I bank.

Subject to the review and approval of its application by the Office of the Superintendent of Financial Institutions (OSFI) and the Minister of Finance, the company hopes to be operating HomEquity Bank commencing in the third quarter of 2009.

Obtaining a bank charter would enable HomEquity Bank to access retail deposits sourced through deposit brokers and directly hold reverse mortgages so as to grow Home Equity’s consolidated reverse mortgage portfolio and increase its spread income. Retail deposits represent a stable and cost-effective source of funds that will be used to supplement the wholesale funding strategy the company has followed since its IPO in 2002.

Subject to unitholder approval (a meeting is tentatively scheduled for the last week of April), Home Equity will convert its business structure from an income trust to a taxable corporation prior to approval of its application. Home Equity will continue to pay monthly distributions of CAD0.06 per unit. Hold Home Equity Income Trust.