Lower Oil Prices Threaten the Alberta Oil Sands Players

NEW YORK (TheStreet) -- If oil prices can be maintained, profits for investors can as well. If oil prices continue to fall the profitability of the whole oil patch will be under threat and Canadian oil sands will be under the greatest threat.

At $92.64 per barrel, current prices on West Texas Intermediate appear healthy. But that is the price for oil delivered to a terminal in Cushing, Okla.

The product coming out of Canada, called Western Canada Select, trades at a discount to WTI, currently at $13.50 less, bringing the actual price below $80/barrel.

Supposedly, this still gives major oil sands producers like Suncor (SU) and Cenovus Energy  (CVE)  a gross profit margin of over 79%, but that's down from over 85% at the start of the year. As oil prices decline, in other words, margins are pressured.

While oil sands are easy to find -- the biggest find is well north of Edmonton -- they are expensive to extract. The product is strip-mined, trucked to a processing plant, heated and often combined with natural gas liquids in order to produce something that can be refined like heavy crude oil.

The economics of oil sands are thus different from those of shale oil. Crude requires drilling, and fracking, but then it flows from the wellhead as the resource depletes. Oil sands are mined, then refined. The initial capital spend for oil sands is higher, the recovery time on that capital is longer, but at scale the production is more regular.

Production costs for Western Canada Select could be as low as under $50/barrel. But then you have to get the product to market, and even with current pipelines that can cost $8 to $11 per barrel. This is very profitable for pipeline operators. While shares in Suncor and Cenovus are down over the last three months those in InterPipeline, (TSE: IPL), a Canadian pipeline operator, are up almost 16%.

Still, Warren Buffett's Berkshire Hathaway (BRK.A) began buying Suncor shares last year, increasing its stake this year to nearly 16.5 million shares, over 1% of its common. Buffett is betting that prices will stabilize, production will increase and profit margins will be maintained.

Will he be right?

A report last year from Carbon Tracker questions the assumption. The report concludes that all-in costs on new oil sands production could reach current crude prices within a few years.

Costs in all the new U.S. shale oil plays -- the Eagle Ford, Bakken and Permian Basin -- are now well over $60/barrel. But there are other shale plays to come. Various types of shale lie under most of the U.S., notes Resource Investor. 

Thus crude prices and inventory levels bear close watching. Crude inventories usually hit their low for the year around now, as the summer driving season ends, peaking around November. Last year saw a much larger increase in inventories than normal, and the level of inventory has a big impact on the spot price.

Inventory builds could keep spot prices on oil going down through the year, absent political turmoil and, as conservation keeps demand low, prices may put even more pressure on margins next year. Given the high capital costs of oil sands development, new capital for them may be hard to come by.

The lesson is, oil and profit are not automatically the same thing.

At the time of publication the author owned no shares in companies mentioned in this article.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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