Oil Sands Efficiency: Not a MacGuffin

By David Dittman • May 27, 2011 • Canadian Edge Weekly

Canadian oil sands producer MEG Energy Corp (TSX: MEG, OTC: MEGEF) more than doubled output in the first 12 weeks of 2011, and it cut operating costs per unit of production by 60.5 percent, another impressive feat for a company that continues to mark new bounds for efficiency for oil sands production.

“Our objective is really quite simple, and it’s just to define a series of commercial in situ oil sands projects by finding and delineating the quality sands that exist within it and then converting those resources into reserves,” said CEO William J. McCaffrey during the company’s first-quarter conference call. Although this is only the second full reporting quarter following MEG’s July 2010 initial public offering, the company has churned out numbers worthy of the seasoned operating veteran that it actually is. Production averaged 27,653 barrels of bitumen per day during the first quarter, while its Christina Lake plant facility” operated at close to 100 percent reliability, “virtually no downtime.”

MEG’s steam-to-oil ratio–a key measure of efficiency for steam-assisted gravity drainage (SAGD) operations, this is the amount of steam needed to produce every barrel of oil–was 2.46-to-1 in the quarter. Once sufficient heat is retained within the bitumen well the 33 bitumen wells MEG is currently steaming, the plan is to drill infill wells and then introduce non-condensable gas, a process that should reduce the steam-to-gas ratio to the lower 2s. Management forecast a ratio from 2.2-to-1 to 2.6-to-1 over the next 12 months.

MEG drilled 142 cores holes in the quarter to complete its winter drilling program according to plan. The work was concentrated in Phase 2B and Phase 3 at its Christina Lake project in Alberta’s Athabasca region. Phase 1 and Phase 2 began production in 2008 and 2009, respectively, and have a combined design production capacity of 25,000 barrels a day. Phase 2 came on stream late in 2009; by June 2010 the combined average production from these two phases had already exceeded 26,000 barrels a day. Phase 2B is being designed to add 35,000 barrels a day of production capacity, which would bring MEG’s combined production capacity at the Christina Lake Project to 60,000 barrels.

Phase 3, which will add another 150,000 barrels to daily production, is in the regulatory approval stage. MEG is following a detailed development plan that focuses on building smaller components in piece-meal fashion, in a way that allows the company to fund its growth organically on its way to 210,000 barrels per day of production from Christina Lake.

 What got management really excited during its quarterly conference call, however, was the continuing decline of MEG Energy’s per-barrel operating cost. In a business notorious for its high costs, MEG seems to be on a different, more efficient path that could at least salve the hurt environmentalists feel when they consider the (absolutely critical, from an energy security perspective) development of the vast Canadian oil sands.

Of its CAD14 per barrel total, an average of CAD8.68 per barrel was for non-energy costs, a 9 percent reduction from the fourth quarter of 2010. MEG’s net operating cost of CAD8.63 per barrel is among the oil sands industry’s very lowest figures. Full-year guidance for net operating cost is CAD9 to CAD11 per barrel, an estimate that includes a CAD0.50 for a planned September turnaround at its production plant.

The net operating cost figure includes a power credit from MEG’s use of cogeneration, another efficiency step to mitigate concern about environmental impacts of oil sands production. Cogeneration enables the creation of two energy products–bitumen and electricity–from one energy source, natural gas. Clean natural gas is used to produce electricity; excess heat created in this process is used to produce steam. MEG uses the steam and power for its production operations and sells any excess electricity back to the Alberta grid, which results in greener power for the province.

Identifying and converting oil sands resources into reserves is a complex and expensive process, made more economic by the continuing rise in demand for crude from emerging markets such as China. MEG’s production costs are impressive, but only in the context of oil sands production, not in the broader category of oil and gas production. But as is becoming increasingly clear, the world’s supply of cheap oil is waning. There is oil out there, but it’s in hard-to-access places. Because we’re still decades away from achieving carbon independence, we’re going to need relatively accessible resources such as the Canadian oil sands. MEG Energy is demonstrating that the resource can be exploited responsibly using innovation, as language on the company website suggests.

The Canadian oil sands is simply a problem that can and must be solved.

The Canadian Oil Sands and the Federal Budget

One of the first tangible payoffs from the Conservative Party of Canada’s resounding victory in the recent parliamentary elections is about to come down, as Finance Minister Jim Flaherty, now the longest serving among his peers in the Group of Seven, will roll out a budget first introduced in March but never voted on because opposition parties pulled the plug on the Tories’ minority government.

The headline feature, from an American income investor’s perspective, is fulfillment of a long-term plan to take the corporate tax rate to 15 percent from its current level of 16.5 percent. As Roger Conrad notes in the May Canadian Edge Feature Article, taxes aren’t the only factor that determines the level of dividends a company will pay. But with another demand on cash flow set to come down and predictability for the foreseeable future–or at least the next four years–on tax policy corporate investment and, therefore, dividend growth should pick up steam.

The budget will reiterate the now majority government’s plan to return to budget balance by 2014; that’s a year earlier than stated in the March budget, the new target a result of campaign promising.

Another positive consequence of Prime Minister Stephen Harper’s majority is the dramatically reduced risk of new environmental regulation would at least slow oil sands development. During the recent campaign the new official opposition New Democratic Party (NDP) did run on a platform that included curtailing oil sands development as part of a carbon regulation strategy, but the reality of majority control in the House of Commons is that no such radical step will be taken. The Conservative approach to regulating carbon emphasizes investing in low- and zero-emission technologies, which should actually warm the hearts of green technology advocates.

At the end of the day the biggest single factor determining the health of the Canadian economy is the price of oil, and that’s subject to a lot of factors beyond any government’s control. But Mr. Harper, now in charge of a majority, has a free field to balance the budget, reduce taxes and stimulate investment. The Canadian oil sands will be a significant destination for this investment, both domestic and foreign, and the resource will remain a key part of the North American energy solution.

The Roundup

Canada’s Big Six banks began reporting fiscal 2011 second-quarter (ended April 30) on Wednesday, May 25. Almost nobody talked about it ahead of time, but margin pressure is starting impact domestic operations, as revealed in results reported thus far.

TD Bank (TSX: TD, NYSE: TD) reported that net interest margin–the difference between interest rates banks charge and interest on deposits they pay out–fell to 2.38 percent in the second quarter from 2.41 percent in the first and 2.39 percent a year ago. For Canadian Imperial Bank of Commerce (TSX: CM, NYSE: CM) net interest margin was 1.94 percent, down from 2.08 percent in the first quarter and 2.16 in the second quarter of fiscal 2010. Bank of Montreal (TSX: BMO, NYSE: BMO) beat estimates, but its results weren’t enough to sway a negative crowd in the early stages of big bank reporting.

National Bank of Canada (TSX: NA, OTC: NOIGF), the No. 6 bank in Canada, stood out again from its bigger peers by beating analyst estimates on both earnings and revenue for the second quarter and boosting its dividend by CAD0.05 per share. It’s the second time in three quarters National Bank has hiked its payout, and its recently announced acquisition of asset manager/investment boutique Wellington West is a step toward more dividend growth.

Royal Bank of Canada (TSX: RY, NYSE: RY) announces results today, May 27, and Bank of Nova Scotia (TSX: BNS, NYSE: BNS) closes out Big Six reporting next Tuesday, May 31.We’ll have the full scoop on Big Six earnings and what they suggest about the condition of the Canadian economy in Canadian Current in the June Canadian Edge, which will be published next Friday, Jun. 3.

Here’s a summary of the state of first-quarter earnings for Portfolio recommendations, including links to where to find analysis of numbers for those that have reported and announced (or estimated) dates for those that haven’t.

Aggressive Holdings 

Conservative Holdings
  • AltaGas Ltd (TSX: ALA, OTC: ATGFF)–May Portfolio Update
  • Artis REIT (TSX: AX-U, OTC: ARESF)–May 20 Flash Alert
  • Atlantic Power Corp (TSX: ATP, NYSE: AT)–May 13 Flash Alert
  • Bird Construction Inc (TSX: BDT, OTC: BIRDF)–Jun. 8 (estimate)
  • Brookfield Renewable Power Fund (TSX: BRC-U, OTC: BRBMF)–May 20 Flash Alert
  • Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF)–May 13 Flash Alert
  • Capstone Infrastructure Corp (TSX: CSE, OTC: MCQPF)–Jun. 9 (confirmed)
  • Cineplex Inc (TSX: CGX, OTC: CPXGF)–May 13 Flash Alert
  • Colabor Group (TSX: GCL, OTC: COLFF)–May Portfolio Update
  • Davis + Henderson Income Corp (TSX: DH, OTC: DHIFF)–May 13 Flash Alert
  • Extendicare REIT (TSX: EXE-U, OTC: EXETF)–Jun. 7 (confirmed)
  • IBI Group Inc (TSX: IBG, OTC: IBIBF)–Jun. 1 (confirmed)
  • Innergex Renewable Energy (TSX: INE, OTC: INGXF)– Jun. 7 (confirmed)
  • Just Energy Group Inc (TSX: JE, OTC: JSTEF)–May 20 Flash Alert
  • Keyera Corp (TSX: KEY, OTC: KEYUF)–May 13 Flash Alert
  • Northern Property REIT (TSX: NPR-U, OTC: NPRUF)–Jun. 14 (confirmed)
  • Pembina Pipeline Corp (TSX: PPL, OTC: PBNPF)–May 26 Flash Alert
  • RioCan REIT (TSX: REI-U, OTC: RIOCF)–May 20 Flash Alert
  • TransForce Inc (TSX: TFI, OTC: TFIFF)–May 20 Flash Alert

 

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