2 Major Threats to Canada's Oil Sands Producers

While Alberta's oil sands hold the promise of providing both the U.S. and Canada with greater energy security over the next several years, they also face some grave challenges.

Some of the biggest near-term threats include depressed pricing for oil sands crude and spiraling operating costs. Let's take a closer look.

Soaring operating costs
Oil sands, often referred to as tar sands, are viscous mixtures of sand or clay, water, and a heavy substance known as bitumen. Due to bitumen's physical characteristics, extracting and processing oil sands crude is much more expensive than extracting and processing conventional oil.


There are two main ways of recovering the stuff. The first is by mining it and then transporting it on trucks to plants that separate the bitumen from sand. The second way is extraction via in-situ methods, in which operators use steam to separate bitumen from sand underground, which allows it to then be pumped to the surface.

Since both processes are highly complex, requiring sophisticated equipment and highly skilled workers, break-even costs are often very high. According to energy consultancy Wood Mackenzie, break-even costs for in-situ steam-driven projects range from $65-$70 a barrel, while break-even costs for mining projects can range as high as $90-$100 per barrel.  

For mining operations, one of the most commonly used trucks is Caterpillar's Caterpillar 797, or Cat 797 for short - an enormous dump truck with a 400-ton capacity that's capable of hauling a million pounds of bituminous sand at a single time.

As it turns out, Cat 797 drivers are paid quite well. They can expect to earn $36-$39 an hour, with some drivers able to bring in more than $150,000 a year including overtime, according to an article in The Wall Street Journal last year.

Salaries for engineers and technicians are similarly high. According to the Association of Professional Engineers and Geoscientists of Alberta, the typical senior geoscientist in Alberta's oil sands saw his or her base salary rise to as much as $231,000 last year, representing a 14.5% improvement over the previous year.  

Low prices for Western Canadian crude
The other major challenge facing oil sands producers is extremely depressed prices for their output. Until very recently, oil sands crude traded at a more than $40 discount to the global crude oil benchmark, Brent, which took a major toll on oil sands operators' bottom lines.

Suncor Energy's experience is instructive. The company is the biggest Canadian oil sands producer by output, yet it too hasn't been immune to the severe margin pressures that have eaten into oil sands producers' profits.

For the full-year 2012, it cost Suncor an average of $67.23 to produce a barrel of oil, which it sold for an average of $82.60 per barrel, which comes out to an operating margin of just under 19%. By comparison, Kodiak Oil & Gas , an exploration and production company with operations focused primarily in North Dakota's Bakken Shale, reported a trailing-12-month operating margin of 43.5%- more than twice Suncor's margin.

That doesn't mean Kodiak is twice as efficient as Suncor. Rather, it reflects the weaker economics of Canadian oil sands production, as compared to tight oil production in the Bakken. While labor and other operating costs in Alberta's oil sands have climbed steadily higher, operating costs in the Bakken have actually been declining over the past year and a half.  

For instance, Continental Resources , the largest leasehold owner in the Bakken, said its average well costs last year fell to $8.2 million, a decrease of about $1 million from the previous year. Similarly, Kodiak Oil & Gas reported a 15%-20% decline in average well costs for 2012, which fell to $9.7 million-$10.2 million.

In addition to falling well costs, Kodiak has reported major improvements in lease operating expenses, spud-to-rig release days, and other important measures. The company is no doubt a dynamic growth story - it offers tremendous opportunities, but with those opportunities come great risks. Before you hitch your horse to this carriage, let us help you with your due diligence. To find out whether Kodiak is currently a buy or a sell, you're invited to check out The Motley Fool's premium research report on the company, which comes with a full year of updates and analysis as key news breaks. To get started simply click here now.

The article 2 Major Threats to Canada's Oil Sands Producers originally appeared on Fool.com.

Motley Fool contributor Arjun Sreekumar has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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