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Financial Times: Lex Column: Sandy shores

Published: May 18 2007 03:00 | Last updated: May 18 2007 03:00

Canada, sitting on a potential 315bn barrels of recoverable oil, offers a tantalising prospect: a Middle East-sized prize in a reassuringly dull environment. There is just one problem. Canada’s peculiar geology means much of its oil is mixed with sand. These oil sands have to be either mined or heated deep underground to force the oil up to the surface (a process known as “in-situ” drilling). The viscous tar that results then has to be processed before it can be refined.

That makes oil sands expensive. Citigroup reckons they only make sense if long-term crude oil prices are more than $40 a barrel. Fortunately for fans of sands, few expect oil to drop to that level any time soon. The size of the resources potentially on offer means that, although upfront capital expenditure is huge, output – and hence cash flows – should be steady and long-lasting.

The initial investment phase is, therefore, critical. There are two concerns: cost inflation, a scourge of oil industry profits the world over, and uncertainty over the fiscal regime. Canada charges a royalty of just 1 per cent on oil sands revenues until capex has been recouped, but that is under review. Were it brought into line with the standard rate of 25 per cent, smaller, early-stage projects would be hit hard.

Valuations in the oil sands subsector have risen on the back of recent acquisitions by Statoil and Royal Dutch Shell. The latter offers diversified exposure: oil sands will account for less than 5 per cent of Shell’s oil production by 2010. With pure plays, investors should favour in-situ drillers – typically less capital-intensive than miners in early stages of development. Suncor, in particular, is weighted towards in-situ projects and already pays royalties at the full rate on virtually all its existing output. Uncertainty ought, in theory, to delay projects on the drawing board, easing bottlenecks for those already being developed or producing. Investors may need to tread carefully but, unlike Arabian deserts, Canada’s sands are at least accessible.

Copyright The Financial Times Limited 2007

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