Upgraders pay off for oil sands companies

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As Canada's oil sands companies report earnings from a quarter marked by roaring crude prices, they reveal the startling financial consequences of the different production strategies used to exploit Alberta's massive resources.

Results vary according to the type of crude the companies produce, and the difference is substantial. For instance, Suncor Energy Inc. , which reported Tuesday, pulled in $90.47 per barrel for the vast majority of its oil sands output. Cenovus Energy Inc. , on the other hand, sold its oil sands crude for just $62.63.

Why such a large spread?

The reason lies in the way in which companies produce the thick oily bitumen found in the Fort McMurray area. Some, such as Suncor and its competitor Syncrude Canada Ltd., run much of that bitumen through "upgraders," huge plants that apply intense heat to transform the oil into a lighter crude. They then sell that lighter product, which is known in the industry as synthetic oil.

Others, such as Cenovus, ConocoPhillips and Athabasca Oil Sands Corp., sell the heavy bitumen without processing it. And while that unprocessed bitumen is almost always worth less than synthetic oil, the spreads in the first quarter were unusually large. That constitutes a major reversal of previous pricing that favoured unrefined crude and which had led the industry to largely abandon plans to build new multibillion-dollar upgraders, which can cost billions of dollars.

While analysts warn that shift may be short-lived, some observers believe it may signal a new reality that could undermine industry's shift to exporting raw oil product.

Upgraders were among the primary victims of the 2008 boom and crash. Construction costs skyrocketed while, at the same time, dwindling supplies of heavy crude from Venezuela and Mexico left U.S. refiners hungry for other sources. That created a bidding war for Canada's heavy bitumen that boosted prices. Suddenly it seemed more lucrative to export unrefined oil, and plans for new upgraders were shelved, including those proposed by companies such as Imperial Oil Ltd., which is building its $8-billion Kearl mine without an upgrader.

The beginning of 2011 brought a sudden change, with corporate earnings showing far greater profits for companies that were shipping upgraded crude - such as Suncor, which saw year-over-year cash flow more than double to $2.4-billion. At Cenovus, cash flow fell 4 per cent to $693-million, despite a 14-per-cent increase in output.

"The first quarter certainly was a quarter for those with upgraders," said Randy Ollenberger, an analyst with BMO Nesbitt Burns.

It's not just upgraders: Companies with refineries, which includes both Suncor and Cenovus, have accrued major refining profits, too, although some of those gains were tempered by oil prices for Cenovus.

But, Mr. Ollenberger cautioned, "I wouldn't necessarily say you should expect that to continue."

That's largely because the first-quarter shift was the product of two major, short-term events. A supply glut reduced the price for heavy crude, as crude backed up in Canada after outages due to repair work on pipelines owned by Enbridge Inc. after a major Michigan spill last year. At the same time, light crude prices soared after a fire knocked out production at the Canadian Natural Resources Ltd. Horizon mine, which produced more than 6 per cent of the country's total oil sands output. Horizon produces synthetic crude, and the fire created a shortage.

But some observers believe the first quarter is a hint of things to come. While heavy oil imports from Mexico and Venezuela may have dipped, they have been partially replaced by a surge in U.S. domestic oil output from prolific new plays such as Bakken in the western U.S. It produced 390,000 barrels per day in 2010, but that is expected to increase 75 per cent by 2017, according to the North Dakota Pipeline Authority.

And like other onshore areas that are also showing explosive growth, Bakken is filled with the light oil preferred by refineries because it produces more valuable products. As refiners buy lighter product, their appetite for Canadian heavy oil diminishes, which is likely to suppress future prices for bitumen, said Ralph Glass, an energy economist with AJM Petroleum Consultant.

That means oil sands producers like Suncor and Syncrude may benefit beyond this quarter.

"The more you can upgrade the bitumen to make it like a synthetic quality, the more you're going to get the higher price for it," Mr. Glass said.

That shift, if it happens, poses important strategic questions for Suncor, which is moving away from synthetic crude. By 2020, it expects its upgrading capacity to cover just over 70 per cent of its oil sands output, a significant drop from today.

Suncor, however, believes it is better to sell a variety of crude types, for a diversified product mix that allows it to weather bumps in both light and heavy prices.

"Long-term we will be a fairly balanced company with lots of flexibility to go either way," chief executive officer Rick George said Tuesday. "That's the beauty of our strategy, compared to a pure bitumen producer."