Oil prices are dropping precipitously. Since mid-June, when West Texas Intermediate crude peaked at more than $107 (U.S.) a barrel, prices have dropped about 25 per cent and ended Thursday at $82.70. What does that mean for the oil sands? It's not as bad most headlines would have you think. And, it is also exactly what we should expect, given how Alberta has decided to develop the resource.
To understand the impact on oil sands, you need to look not just at West Texas prices, but also the exchange rate and the relative prices of heavy oil. You also need to examine Alberta's royalty regime, and remember that oil sands are long-term plays.
First, how has the long-run outlook for light oil changed? It hasn't moved that much. The 60-month futures contract traded at an average of $86.73 during the mid-June high-point for WTI prices, and briefly exceeded $88 a barrel in early July. At the same point, the forward view on the Canadian dollar exchange rate was in the 92 (U.S.) cent range.
Combined, this implied a long-run view of oil in Canadian dollar terms of about $94.31 a barrel. Last week, at the start of the sell-off, the implied five-year-out value of WTI in Canadian dollars was $95.42. Near the end of the trading day on Oct. 15, that implied price had risen to $97.33 – the long view on the Canadian dollar had depreciated faster than the oil price, over-absorbing the shock.
Second, look at heavy oil differentials – in mid-June, as WTI prices peaked, the difference in Canadian dollar terms between WTI and Western Canada Select was $22 a barrel. This differential has fallen over the past four months and now sits at around $14 a barrel. This, along with significant price drops in lighter products used to dilute bitumen, has seen bitumen prices hold up remarkably well.
Add it all up and, at the mid-June peak, bitumen values were about $40 a barrel lower than Brent crude and that gap has dropped to around $25 a barrel this week. Bitumen is worth less overall than it was in mid-June, but has dropped about 10 per cent less in value than we've seen in WTI prices.
In this environment, oil sands projects hold up very well. If you look at a new in-situ project assuming current capital and labour costs, a long-run natural gas price of $5/GJ and an 87 cent Canadian dollar, a WTI price of $65 (U.S.) would generate a 10 per cent internal rate of return on capital after taxes and royalties. Assuming that today's oil futures prices materialize, the expected rate of return would be about 18 per cent. Those remain fairly robust returns, and well above typical investment hurdle rates for energy companies, which tend to be around 10 per cent.
So, why the panic? If you look at the WTI price in a vacuum, you'll miss two important hedges enjoyed by oil sands investors. First, the Canadian dollar, which Bank of Canada governor Stephen Poloz has referred to as being linked to the oil price like an owner with a dog on a long, retractable leash – they may diverge for a while, but they're going to move together over the long term. The same project that could earn a 10 per cent return with an 87-cent Canadian dollar at $65 oil prices would need to see $75 oil prices if the exchange rate were at par. Second, the royalty regime: Alberta charges a net-revenue-based royalty, so that lower oil prices imply lower royalty payments on each barrel produced. A drop in oil prices of 10 per cent, holding exchange rates and differentials constant, would reduce royalties and taxes payable in some projects by as much as 25 per cent, partly buffering returns against the shock. Of course, these royalty provisions have the inverse impact for the Alberta treasury, which shares some of the price risk with oil sands producers. When prices go down, government revenues can drop too.
Fears that the oil sands are suddenly not viable are overblown, but Alberta has certainly allowed the resource to be developed in such a way that it will always be highly exposed to oil price shocks. When you allow open access development, companies will propose and build until the marginal project barely makes an acceptable rate of return. If that's your model, you can't be surprised when falling prices push a few projects off the map.
Andrew Leach is the Enbridge Professor of Energy Policy at the University of Alberta.
Andrew Leach