Back in 1967 the company now known as Suncor Energy (NYSE: SU) opened its Great Canadian Oil Sands mine. Today the company produces some 247,000 barrels of oil equivalent per day (boe/d) from the sands, a tally it will ramp up to 280,000 boe/d by the end of 2010.

Suncor is just one of many companies vying for growth in the region now hosting Canada’s latest oil rush. Later this summer, privately held MEG Energy Corp expects to raise CAD1 billion though an initial public offering (IPO) of 12 percent of its shares. The company, which is 15.8 percent owned by giant Chinese energy concern CNOOC (NYSE: CEO), will use the funds to expand its Christina Lake project. Covering 800 square miles plus of oil sands leases, the company’s properties are projected to be capable of producing over 250,000 boe/d for over 30 years.

MEG’s move is the second major IPO of oil sands properties this year. In late March Athabasca Oil Sands Corp (TSX: ATH, OTC: ATHOF) raised CAD1.35 billion by selling 19 percent of its shares. That was the biggest IPO in Canada since a CAD2.48 billion offering of Manulife Financial Corp (TSX: MFC, NYSE: MFC), the country’s largest insurer, more than a decade ago.

Meanwhile, existing oil sands properties are an increasingly hot commodity. This week, Super Oil Total (NYSE: TOT) announced the takeover of its minority partner in the currently dormant Fort Hills project, UTS Energy Corp (TSX: UTS, OTC: UEYCF). UTS shareholders will receive a 46 percent premium over the pre-deal price of the company. The deal is the fourth largest transaction in Canada’s oil patch this year and almost surely won’t be the last, adding to already surging deal volume of CAD17.4 billion.

The two biggest players in Canada’s oil sands are Suncor and Syncrude, a partnership of major oil companies operated by the Canadian unit of ExxonMobil (NYSE: XOM). And both have very big plans.

Suncor, which merged last year with the former PetroCanada to become Canada’s largest energy player, continues to sell the vast majority of its holdings outside the oil sands. In contrast, it continues to ramp up its oil sands projects. In March the company won approval from Alberta regulators for a three-part expansion of its Firebag project, which will triple current production of 60,000 boe/d by early next year. The company plans a further expansion to a total of more than 240,000 boe/d by 2012.

Syncrude’s key players include ExxonMobil (25 percent), Suncor (12 percent) Chinese giant Sinopec (NYSE: SNP, 9 percent) and Canadian Oil Sands Trust (TSX: COS-U, OTC: COSWF).

The venture produced slightly over 300,000 boe/d in June, a tally it expects to more than double over the next ten years as it completes a series of projects slated for 2014, 2016 and 2020. The venture’s lands have a projected 100-year life of proven plus probable reserves based on current production rates and an estimated resource of 6.8 billion barrels.

Saudi-Sized Opportunity

This isn’t the first rush to oil sands development in Canada’s history. Surging oil prices and the desire to find alternatives to politically challenged imports from the Middle East fueled a drilling boom and exploration boom in the late 1970s early 80s as “Tar to Oil” shows.

This one, however, figures to have considerably longer legs, in large part due to a dearth of alternatives to feed the world’s ever-increasing appetite for oil. Alberta owns 85 percent of the world’s reserves of bitumen–which is refined into useable petroleum products in three major areas (see map below; Source: Wikipedia).

Provincial authorities put total economic reserves–reserves that can be produced profitably at current energy prices–at some 170.4 billion barrels, with a potential total of 1.75 trillion barrels. And those figures continue to ratchet up as more major companies get in on the action.

Altogether, Canada’s tar sands are in fact the largest proven oil reserves outside of Saudi Arabia. Tar sands are already 65 percent of overall Alberta oil output and are expected to hit 88 percent by the end of the decade.

BP (NYSE: BP) now expects to cap its still-gushing Macondo well in the Gulf of Mexico by the end of this month, as a relief well moves into place. That should keep the blown deepwater well’s overall spill from setting a new world record for gallons spewed. In fact, the company’s response and cleanup are likely to be far better than Pemex’ following its Ixtoc shallow water well blowout in 1979, which took 10 months to cap and pumped out some 140 million gallons into the Gulf.

The Macondo spill, however, will be by far the most disastrous in US waters. And the damage is only starting to be felt on the US Gulf Coast, where the seafood and tourism industries are already taking major hits and fears of much greater and more permanent environmental damage are growing.

A New Orleans judge has overturned for now a moratorium on deepwater drilling in the US waters off the Gulf. And this week, his ruling was at least temporarily upheld by a federal appeals court panel.

The court refused to reinstate the Obama administration’s ban while the government appeals the ruling.

Even if the ruling is ultimately upheld, however, it won’t prevent what are certain to be an unprecedented new wave of regulations on deep water drilling in US waters.

That, in turn, is nearly certain to dramatically increase what’s already a very expensive business.

In fact, a number of companies are already pulling back efforts in the Gulf in favor of developing resources elsewhere. And one of those regions is Canada’s oil sands.

Developing in Canada has one other key advantage: the most favorable regulation in the world, both environmental and regarding foreign investment in projects.

At a time when countries like Nigeria, Venezuela and the Congo are shaking down resource developers for a greater share of profits, Canada is making things easy for foreign capital to get a piece of its action.

Major US companies have long been major investors and are likely to remain the biggest players for the foreseeable future.

ExxonMobil, for example, has reached an arrangement with Canadian Oil Sands to develop the company’s considerable prospects outside Syncrude.

But Canada has also opened up its door to other nations, particularly China, which is a player in other resources such as metallurgical coal and uranium as well.

Chinese money to date has generally been in the form of minority investment in projects. But that country’s escalating demand for natural resources means it’ll continue putting in the money to speed development.

It’s easy to see the motivation of the Ottawa and Alberta governments for encouraging oil sands production. At a time when many federal and local government entities around the world are nearly bust, the province continues to slash its already light debt load. The national government, meanwhile, expects to be running a budget surplus within the next two to three years.

The key is the steady stream of oil royalty revenue that’s made possible by rising oil sands production, even as Canada’s conventional oil output continues to decline. That’s allowed governments to enact policies that encourage growth in other sectors as well, such as cutting corporate tax rates to the lowest levels of any industrialized nation. And the result is a major spur to the Canadian economy, particularly in energy-rich Alberta.

Projects are routinely approved in a timely fashion and companies enjoy numerous tax incentives. In fact, oil and gas companies operating in Alberta now enjoy even more favorable incentives and regulations than they did prior to the 2007 enactment of the “Our Fair Share” proposals, temporary boosts in royalty rates to capture more revenue for government that have now been completely rolled back and then some.

That government support is critical for two reasons. First, as “Hard to Get” demonstrates, producing from oil sands is expensive. Part of the reason is geography. The three main producing regions of Alberta are extremely remote areas and therefore require major investment in transportation and other infrastructure to get the energy to market. Workers must be trained, paid and housed in places that didn’t exist in their current form a decade ago.

Second, no matter what process is used, getting useable oil from tar sands is basically a mining and chemical refining operation. The bitumen must be separated from other elements and then processed intensively even before it can be shipped to refineries as a variant of heavy oil. The result is a process that requires intensive amounts of energy, particularly natural gas. In fact, energy typically accounts for 30 percent-plus of overall production costs in the tar sands.

Finally, there are environmental costs. In the early years of the boom, producers took their liberties with the environment, particularly when it came to disposing of “tailings” or waste. The consequences have now come home to roost in the courts.

In late June a provincial court in Alberta ruled in favor of the government and against Syncrude in a case involving so-called settling basins, where water used in oil sands processing is stored and recycled. The judge ruled owners of settling basins must take into account their impact on migrating birds.

The case dates back to 2008, and the company has made changes to its practices since. As a result, the ruling isn’t expected to have a major financial impact on Syncrude. But it does illustrate the environmental concerns that continue to drive opposition to further oil sands development, including in the US which remains their biggest consumer.

This week US Rep. Harry Waxman (D-CA) registered strong opposition to a planned USD12 billion pipeline that would bring oil from tar sands to US refineries. The Keystone XL pipeline would be a major boon to the economy of several states, particularly Montana. It’s projected to double US ability to consume oil from Canada’s tar sands. Coupled with two other already approved projects, it could take tar sands to 15 percent of US fuel supply, up from just 4 percent now.

The Chairman of the House Committee on Energy and Commerce, however, asserts the pipeline would be “a step in the wrong direction” by continuing dependence on fossil fuels. Much of that opposition is due to allegations that oil sands production creates elevated levels of carbon dioxide blamed for global warming, an argument that also resonates heavily in Europe. The Waxman letter, for example, assets tar sands mining “emits three times more greenhouse gas pollution than traditional oil.” And some have gone so far as to propose that the US government–particularly the US Dept of Defense–no longer use petroleum products that are refined from tar sands.

In this emotionally and politically charged atmosphere, Alberta and the Canadian national government in Ottawa have had to walk a fine line. As the big investments being made by China show, there’s no shortage of markets for the output of the oil sands globally, no matter what the US government does. But being seen as overly permissive in environmental regulation could invite actions that make sales much more expensive and therefore less profitable. Conversely, clamping down hard on what have to date been acceptable industry practices could destroy the economics of oil sands and therefore the boom.

The good news is both entities are showing themselves increasingly adept on this score, even as technology advances that promises to eventually make today’s concerns moot. Alberta regulators, for example, last month approved plans by Suncor to clean up its tailings ponds over the next several years. The company will spend some CAD1 billion to develop new technology to do the job. Regulators estimate tailings ponds now contain some 840 million cubic meters of fluid and cover a bit over 100 square miles of northern Alberta.

That follows approval in April of a plan by Syncrude to clean up its tailings and another at Fort Hills, the project Total is building its stake in by acquiring UTS. Regulators are reviewing similar plans at the Albian Sands mine operated by Royal Dutch Shell (NYSE: RDS/A) and the Horizon project run by Canadian Natural Resources (TSX: CNQ, NYSE: CNQ).

As for global warming concerns, governments are subsidizing development of new technologies to reduce emissions, just as electric power producers are. Meanwhile, industry has already cut emissions per barrel of oil equivalent by an estimated 35 percent since 1990.

None of this is satisfying industry critics, many of whom remain adamant that the mining process is too destructive and companies are doing too little to fix the problems. 50 members of the US Congress, for example, have joined Waxman’s plea urging the US State Department not to “rubber stamp” the Keystone XL pipeline.

But it’s clear government and industry are on the same page that development can occur and meet environmental safeguards. And even in the European Union, officials have abandoned at least for now plans to bar output of oil sands from the Continent.

The Cost Question

Rising environmental standards, energy costs, geographic isolation and resource needs, however, do add up to one unavoidable fact: Producing from oil sands is far more expensive than producing conventional oil.

As “Hard to Get” shows, the cost of production per barrel of oil equivalent has nearly doubled over the past four years. That’s partly due to surging energy costs. But overall operating expenses have continued to climb even with natural gas prices sinking below USD5 per million British thermal units.

One reason is labor costs, which have surged 50 percent since 2002 according to industry sources and are likely to rise a lot more as production expands and further strains the pool of qualified employees. Companies and provincial authorities are working together to promote industry training. But the impact of those efforts will only be felt slowly and in the meantime wages are going to rise.

The low cost of debt and equity capital has been a major plus for the industry over the past couple years. Capital costs for developing projects, however, have also continued to soar, nearly tripling over the past decade. Statoil (NYSE: STO) estimates break-even oil prices for new oil sands projects using steam assisted gravity drainage technology are now as high as USD65 to USD75 a barrel. And whether bitumen is extracted by drilling or mining, the cost for developing new supply is at least USD60.

That makes oil sands development essentially a bet on oil prices. Were black gold to slip back to where it was a decade ago in the USD20 to USD30 range, the vast majority of existing projects now in operation would be uneconomic. Plunging oil prices did literally shut down the oil sands rush of the 1970s and ’80s. And fear of a reprise was a major reason why oil sands development screeched to a halt during the credit crunch/recession of 2008-09.

On the other hand, higher production costs mean considerably more leveraged profits. And with the pool of available projects for major oil development shrinking dramatically in politically stable lands, companies are willing to pony up the money to put the wheels in motion for much higher output in coming years.

Those kinds of long-term bets are a luxury only exceptionally large companies with huge pools of capital can afford. Even the likes of ExxonMobil, for example, only entered the oil sands development through a consortium that included other giants, so it could minimize the risk of losses from rising costs and/or falling oil prices.

Small players in contrast are constantly at risk to ruin should oil prices fall off a cliff. That’s even in the unlikely event they’re able to scrape up the capital to build the kind of mining and chemical operation needed.

This is the hard lesson learned by investors who fell for pitches from small companies that claimed to be sitting on vast oil sands reserves during the 2008 oil price spike. The plain fact is without a whole lot of capital, even the most promising tar sands deposits are going to stay right where they are. Reserves are important. But the real value is in the facilities needed to get them to market in usable form.

That leaves just a handful of oil sands producers that are truly worth investing in. Starting with the most conservative, Penn West Energy Trust (TSX: PWT-U, NYSE: PWE) as reported here has inked a joint venture with giant sovereign wealth fund China Investment Corp (CIC) to deploy the latter’s capital to develop its oil sands properties. These are assets in the Peace River area where Penn West is currently producing at the low rate of about 2,700 boe/d but which include 237,000 net acres of leases with potential for dramatic expansion.

Under the terms of the deal Penn West retains 55 percent of the venture and will develop the asset with CAD817 million of CIC’s money. CIC is also acquiring 5 percent of Penn West’s units for an additional CAD435 million in proceeds to be similarly deployed. CIC has also committed to further funding as well as development progresses. The result is a major opportunity for Penn West to boost its production from this valuable resource, something it has not counted on in growth projections, and with limited financial risk.

The biggest question market about Penn West–which also draws about 60 percent of its current output from conventional light oil–is what dividend it will pay when it converts from trust to corporation, probably at the end of 2010. Management has made no bones about the fact that it wants to invest more cash in its portfolio of promising properties, which has implied at least some reduction in the current monthly payout of CAD0.15 per share.

My expectation as an outsider is that Penn West will reduce its payout to some degree. And when it does so, at least some investors are going to sell their shares, pushing down its share price.

Whether that happens or not, however, the fact remains that Penn West currently trades at only about 80 cents per dollar of proven reserves as calculated at the beginning of the year.

In my view, the only possible explanation of that discount is uncertainty about its 2011 plans, which will disappear when management makes a statement one way or the other.

In the meantime, Penn West Energy Trust is a solid value in the energy patch and a buy up to USD22 for those who don’t already own it.

Canadian Oil Sands Trust is also likely to cut its distribution when it converts to a corporation in 2011. In fact, management has already telegraphed this move by lifting the quarterly payout to CAD0.50 per unit in May for the purpose of maximizing tax pools for after the conversion.

That being said, however, this pure play on oil sands–virtually all income is from its royalty on its 37 percent stake in the Syncrude partnership–remains the best leveraged bet on oil sands with aggressive plans for production increases, the best possible operating management and a very strong balance sheet. Cash flow after conversion will rise and fall with oil prices, meaning dividends and the share price will as well. But for those who can weather the ups and downs, Canadian Oil Sands Trust is a solid buy below USD35.

As Canada’s largest home grown energy company, Suncor is also Alberta’s biggest oil sands producer. The company, which merged last August with the former Petro-Canada, produced an average of 563,600 boe/d day in the first quarter of 2010, with 60 percent total production coming from oil sands. That percentage will steadily increase in coming years as the company sheds non-oil sands assets and ramps up output from the sands.

Suncor’s biggest drawback as an investment is its paltry yield of barely 1 percent, as paying dividends is clearly a secondary objective to growth. The stock is trading at less than half its mid-2008 high and at a discount to the value of its reserves; it more than makes up for the modest yield with upside potential. Buy Suncor Energy up to USD30.

EnCana Corp (TSX: ECA, NYSE: ECA) spinoff Cenovus Energy (TSX: CVE, NYSE: CVE) shows every sign of emerging as another Suncor in coming years. The company’s initially in-place bitumen reserves are currently estimated at 137 billion barrels, with great potential for increases.

The company expects to be able to develop that into average production of 300,000 boe/d by 2019, at an average finding and development cost of CAD8 per barrel.

Those are compelling economics for the company, which as part of Encana enjoyed a long reputation for delivering. And it augurs substantial gains for the shares, whether it stays as an independent company or is gobbled up by another player as many anticipate. Here again, the yield of less than 3 percent is nothing to write home about. But for those interested more in growth, Cenovus Energy is a solid buy up to USD25.

Finally, Canadian Edge readers should keep their eye on the MEG Energy IPO, which we’ll be covering here. I’ve generally had a jaundiced eye toward IPOs over the years, mainly because so few actually ever turn out well for investors. That’s in large part because they tend to represent unproven companies as well as attract hype.

The IPO of Athabasca earlier this year certainly fell into the latter category, coming out at CAD18 but then retreating just months later to its current level of around CAD11. The company looks very promising and the capital raised is a big plus for its plans. But it looks like investors are going to have to wait a while for the red ink to turn black.

The MEG deal, however, involves a company that already has oil sands assets in place that produce 25,000 boe/d. It also has a prominent backer in 16.7 percent owner CNOOC and firm plans to boost output to 210,000 boe/d per day in the coming years. As a result, it has greater promise to reward investors sooner. We’ll start tracking the stock in How They Rate once it begins trading. In the meantime, investors should still wait until there’s some trading history before jumping in.

Energy to Market

Oil sands development isn’t just a benefit for producers. In fact, companies from a wide range of industries stand to benefit richly with rising cash flow and distributions.

For some time, my favorite oil sands infrastructure play has been Pembina Pipeline Income Fund (TSX: PIF-U, OTC: PMBIF). That remains the case today, even as the stock has pushed on up close to my buy target of USD18.

As reported here, the company’s signature asset is the exclusive pipeline franchise for Syncrude. Cash flows are based on capacity, so they’ll rise as the venture’s needs to get bitumen to market grow. And they’re not affected by swings in energy prices or even when Syncrude output is below capacity. The company has added similar arrangements with Canadian Natural Resources’ Horizon oil sands system and the Mitsue and Nipisi system is on time for a mid-2011 start up.

Pembina also has conventional midstream energy and related marketing assets, much of which are focused on Canada’s fast-growing shale output. The company still plans to convert to a corporation in the second half of 2010 without cutting dividends, another long-term plus.

Expanding oil sands production also means developing the infrastructure in what were previously uninhabited regions, and fast. Here the primary player is Bird Construction Income Fund (TSX: BDT-U, OTC: BIRDF) will also hold its dividend when it converts to a corporation on Jan. 1, 2011.

The company has held its leading position in the infrastructure construction and design business throughout Canada in both good times and bad. Most impressively, it was able to counter the drop off in activity in the Alberta Oil Sands region the past couple years by winning a slew of public sector contracts, including most recently a CAD118 million deal with Defense Construction Canada to build a new facility in St. John’s, Newfoundland.

That’s kept earnings up and order backlog near the record CAD1 billion peak achieved before the 2008 crash. Now with the oil patch reviving, Bird’s in the driver’s seat to snap up another mother lode of valuable contracts for everything from production facility foundations to government buildings and schools. That should keep earnings rising both before and after the corporate conversion, which is expected for Jan. 1, 2011.

Now at its lowest price in several months, Bird Construction Income Fund is a buy up to USD33.

Canadian National Railway (TSX: CNR, NYSE: CNI) is the best way to bet on growing Asian demand for oil sands output. The company currently derives 40 percent plus of its profits from moving goods for export, largely thanks to rising Chinese demand for metallurgical coal used in smelting steel. Now it’s gearing up to facilitate the export of oil sands to the Far East, via a proposed rail network.

The company’s immediate goal is to ship 300,000 to 400,000 barrels a day between Fort McMurray and Edmonton, with an ultimate target of 4 million barrels. That’s a huge potential business in addition to what’s already a steady one and promises to rachet up earnings to the tune of 12 percent plus a year to mid-decade and beyond.

Like all railways, Canadian National’s earnings are heavily influenced by Canadian economic activity. That was a drag in 2008 and 2009 but it’s rapidly becoming a plus for this very secure outfit. The low yield of less than 2 percent will likely deter income investors. But Canadian National Railway is a solid buy up to USD60 for those looking for reliable and robust growth.

Environmental cleanup is only going to become more important in coming years for the oil sands region. And investors in Newalta Corp (TSX: NAL, OTC: NWLTF) are set to grab their share of the spoils.

The company’s earnings in recent years were hit hard by the depression in Canada’s energy patch and later by the country’s overall industrial slowdown. But management has continued to build a leading position in the industrial and natural resource cleanup business throughout Canada, with a growing emphasis in the oil sands.

The company, which makes money off cleanup contracts and by selling recycled materials, plans CAD60 million in growth capital spending for 2010, to be financed by resurgent operating cash flow. The stock has come back a long way from its low in early 2009, but it still trades at barely one-third its highs in the last decade. That implies a lot more upside to come, though the yield is only around 2 percent. Buy Newalta Corp up to USD10 if you haven’t already.

Last but not least, ActivEnergy Income Fund (TSX: AEU-U, OTC: ATVYF) and EnerVest Energy & Oil Sands (TSX: EOS-U, OTC: EOSOF) offer mutual fund investors a targeted way to bet on the oil sands growth. Both hold a mix of oil and gas producers and related stocks, with EnerVest the more weighted toward pure oil sands.

Both are closed-end funds traded on the Toronto Stock Exchange (TSX) and to a lesser extent over the counter (OTC) in the US, and sell at a discount to the value of their underlying assets. Like all funds, yields are generally unpredictable–no one should count on ActivEnergy’s stated yield of 12 percent holding–but are likely to remain generous.

The key drawback of buying a fund versus the best individual companies is you get the bad and ugly as well as the good. And both funds’ fates are going to be determined heavily by what happens to oil and gas prices, so no one should mistake them for CE Conservative Holdings or even our safe Mutual Fund Alternatives in the Portfolio.

But for those who want a fund play on an industry with very bright prospects, ActivEnergy Income Fund is a buy up to USD7, while EnerVest Energy & Oil Sands is a buy to USD8.