Why Canada's Oil Sands Look Like a Shaky Investment

A new study (PDF) examining the economics of Western Canada’s oil sands finds that even if the Keystone XL pipeline gets built, it’s unlikely that extracting the heavy, tar-like oil around Alberta will remain commercially viable over the next decade.

The report, written by two former Deutsche Bank (DB) analysts and titled Keystone XL Pipeline: A Potential Mirage for Oil-Sands Investors, calculates that producers in Western Canada will need to fetch at least $65 a barrel to attract new investments and ensure that current projects remain profitable. During the past month a barrel of Western Canadian Select (WCS), the main benchmark used to price Canada’s heavy oil, has averaged just $58.

A few forces are at play. Canada’s heavy crude is already among the most expensive to produce in the world. But it’s also stuck. While that’s partly a function of the crude’s physical attributes (it’s heavy and thick and hard to move), the biggest problem is that there are simply not enough pipelines to transport it thousands of miles out of Western Canada and down to U.S. refiners. As a result, much of the oil is finding its way out of Alberta on trains and even trucks, which can be two or three times more expensive than sticking it into a pipeline. Those extra transportation costs push down the price at the well.

STORY: Canada's Tar Sands Oil Boom Yields Toxic Wastewater Lakes

While the Keystone XL would help raise prices, it’s no panacea. The project plans to move about 800,000 barrels a day from Western Canada down to the U.S. Gulf Coast, where the oil could command a higher price. A Keystone approval would certainly spur more investment in Western Canada and boost oil-sands production, but since there’s already so much pent-up demand to get oil out of Alberta, the 1,700-mile pipeline’s capacity would likely get maxed out, and things would quickly revert back to the situation we’re in right now: producers using expensive options such as trucking and railroads to move their crude.

Of course, without Keystone XL, the Western Canadian oil-sands industry seems doomed to a long struggle. Prices will remain low, and companies won’t have the incentive to spend money to build new projects. Unable to reach the Gulf Coast, heavy Canadian crude would continue to pool around the middle of the U.S., which would only further depress its price.

Although they’re vastly different types of crude, the price of WCS is roughly correlated to the price of West Texas Intermediate (WTI), the benchmark that determines the price of light, sweet crude in the U.S. In the past three years, the U.S. shale boom has created a glut of oil stuck in the middle of the country, lowering the price of WTI significantly. While both Canadian and U.S. benchmarks have rallied over the past week, their prices are well below where they were just a few months ago. WTI is off 13 percent since September. Since July, WCS is off almost 30 percent and is currently trading at a $40 discount to WTI.

The real value of the Keystone XL is that it would deliver oil-sands crude down to the Gulf Coast, where it could compete with Mexican crude priced against the Maya benchmark. Heavy Mexican oil enjoys a $20 premium over its Canadian rival and is trading at about $87 a barrel. Even if the Keystone XL gets approved, just getting Canada’s crude down to the Gulf is barely enough to make it worthwhile. Mark Lewis, one of the new Keystone report’s co-authors, estimates that between the transport costs and the extra lubricants needed to coax the oil through thousands of miles of pipeline, it would cost about $18 a barrel to get that tar-sand crude from Western Canada down to the Gulf Coast on the Keystone XL.

Even if refiners do choose to buy tar-sand crude over its Mexican rival, those costs eat up a lot of that margin producers make by getting a higher price. As a result, the best the Keystone XL can do is “shift projects from being unprofitable to being marginally profitable,” according to the report.

And of course, all of this is done purely on a market basis, without even taking into consideration what many believe to be the oil sands’ biggest liability: environmental risk. A carbon tax—which, granted, we’re still a long way from—would add about $2 to a barrel of Western Canadian heavy crude. And that’s a conservative estimate, says Lewis, who mentions the possibility of President Obama using a carbon tax as a concession to his base if he were to approve the Keystone XL.

This all has huge ramifications for companies mulling investments in the region. “It would be very risky indeed to invest in a new project today,” Lewis says.