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The game has changed for investors in oil sands

Oil Sands mining operation at Albian Sands' Muskeg River Mine

Larry MacDougal/Larry MacDougal

With oil prices back above $100 (U.S.) a barrel and growing instability in the Middle East, the world has its eyes on Canada's oil sands. Again.

Except this time the region is viewed in a different light. When crude last hit $100 in 2008, some of the world's biggest oil companies flooded the region and bought up whatever they could - whether it was assets or whole companies. Today, investors can't count on acquisitions to deliver big premiums.

"That game is over" because many of the players' sizes have changed, says Mason Granger, portfolio manager at Sentry Investments. From 2006 to 2008, the oil behemoths had a wide choice of small and mid-sized acquisition targets. Today, giants would have to buy other giants, and those deals aren't as easy to put together, or as palatable to shareholders and the federal government.

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But oil sands producers are still attractive investments for other reasons - most notably, lower input costs that are driving profit margins higher. CIBC World Markets analyst Andrew Potter calculated that rates of return have jumped from about 10 to 15 per cent a year or two ago, to 20 to 30 per cent in 2011.

Low natural gas prices are one of the big reasons for the reduction in input costs. Since the last oil price spike, major discoveries in the United States have resulted in a flood of new shale gas and driven down prices. That matters for oil sands developers because natural gas is used to produce the steam that is sent down into the ground to release the oil.

Labour costs are down, too, because of smarter, more methodical development. "The industry learned a lesson when we had this frenzy [a few years ago] almost a race to get your project done, and we had everybody needing 5,000 employees at the same time," said Jennifer Stevenson, portfolio manager at Dynamic Funds.

A recent onslaught of joint ventures has helped to reduce the competition for scarce workers by increasing co-operation among producers. From an investor's perspective, joint ventures may not offer sexy takeout premiums, but they can lift stock prices because development projects move into production much sooner with the added financial heft that comes with two balance sheets.

Joint ventures also put a value on assets, making it much easier for investors to predict where the corresponding companies should trade. "It's always nice to have another validation that the resource is viewed as valuable," Ms. Stevenson said.

Among the larger oil producers, Ms. Stevenson likes Suncor Energy Inc. and Canadian Natural Resources Ltd. because they both have an inventory of projects to bring into production. Suncor, for instance, has its hands in seven different oil sands projects and two of them are joint ventures with giant Total SA. If costs are contained and these projects see the light of day, shareholders will benefit from higher cash flow every few years.

Cenovus Energy Inc. is another hot name right now, said analyst Michael Dunn at FirstEnergy Capital. Operating costs at the company's main project at Foster Creek, Alta., came in at around $10 a barrel in the fourth quarter, one of the lowest in the industry.

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But some analysts warn that big projects are susceptible to cost overruns. "There's one thing you can count on in the oil sands: Things are going to take longer and cost more," Mr. Granger said. Husky Energy's Tucker project is a perfect example: After several years of development, it produced only a relative trickle of 6,100 barrels a day in 2010.

Because of his fear of cost overruns, Mr. Granger prefers conventional oil plays and doesn't invest in the oil sands. If he did, he said he would prefer the smaller developments that only try to produce 10,000 to 20,000 barrels a day.

That concept is picking up traction. "We've come to the point where we can do projects in that scale and still make money off it," Ms. Stevenson said. The last time oil spiked, only the big players had the scale to absorb the massive development costs.

Ms. Stevenson likes Southern Pacific Resource Corp., which is a player in northern Alberta and southern Saskatchewan. MEG Energy Corp., which went public last August, has also attracted attention. Not only did it blow out analysts' expectations by producing about 27,000 barrels a day in the fourth quarter, its steam-to-oil ratio, which measures how much steam is required to get the oil out of the ground, is 2.3. A ratio below three means the company is in good shape.

MEG also recently refinanced some debt and issued new notes. RBC Dominion Securities analyst Mark Friesen estimates that after adding in 2011 and 2012 cash flows, the company will now have $2.8-billion in available funds, double what it needs to develop the next stage of its Christina Lake project.

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Of course, all that of that potential makes MEG look like a takeover target. But Mr. Dunn said no one is sure whether MEG wants to sell. That can deter potential buyers because they would have to be prepared to mount a hostile bid.

Crude Numbers

1.5 million: Oil sands production in 2010 (in barrels per day)

2.8 million: Total Canadian oil production in 2010 (in barrels per day)

3.0 million: Estimated oil sands production in 2015 (in barrels per day)

5.0 million: Estimated oil sands production in 2020 (in barrels per day)

10% - 15%: Typical return on an oil sands project in 2009

20% - 30%: Current forecast return on an oil sands project

Source: CIBC World Markets

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