Now that this entire article has been published to Energy and Capital (Part 1 and Part 2) as well as TheOilDrum (Part 1 and Part 2), I am reposting it complete here. I welcome your feedback on it!

Cheers,

–Chris

Tar Sands: The Oil Junkie’s Last Fix

2007-08-24

By Chris Nelder

For this week’s article, I collaborated with energy journalist Roel Mayer, a freelance writer on earth, energy and economy, based in Canada. Roel is a keen observer on energy, and the Canadian tar sands in particular, so he was a natural research partner for this short study on the state of oil production from tar sands.

He was also the one who coined “The Law of Receding Horizons.” For those who missed my previous articles on receding horizons, it is a simple concept: as the cost of energy rises, the cost of everything else made with energy (like building materials) also rises. So an energy project which was expected to be profitable when energy costs were x amount higher than today, turns out to still be uneconomical when you get there.

Shallow oil sand deposits in open pit mining: yes, this was a boreal forest from time immemorial.

And the tar sands of Alberta are shaping up to be the oil industry’s poster child of this phenomenon. With oil well over $60 today, the low-grade sludge called bitumen that we recover from tar sand–actually more like a putty, at room temperature, which is why I refuse to use the whitewashing term “oil sands–should be highly profitable.

But paradoxically, the impending decline of global crude oil production, which is now coming clearly into view, has led to a mad rush to produce the tar sands. And this, in turn, has led to skyrocketing costs…such that now, the real “profit” in producing the tar sands seems to be in government tax breaks, not in actual profit on the resource itself.

In fact, the Canadian tar sands operations are facing a whole host of challenges, beyond economic–so much so, that one wonders why we try to harvest them at all.

In an area the size of Florida, Alberta’s tar sands are said to hold 315 billion barrels of crude oil.

But trying we are: according to the respected energy analytics firm Wood Mackenzie (WoodMac), about $117 billion is going to be spent on the tar sands by 2015.

Let’s look at some of the challenges.

Cost Inflation

In a fine demonstration of the receding horizons paradox, WoodMac issued a report in March entitled “The Cost of Playing in the Oil Sands,” which showed a 55% cost increase since 2005 for a peak flowing barrel of oil derived from the tar sands.

They further noted that in 2006 alone, many of the large tar sands developers announced cost increases and project delays, as they experienced an average 32% cost increase for integrated mining projects, and a 26% increase for in situ projects.

For example, last year Shell Canada shook investors when it revealed that its Athabascan tar sands operation would cost $11 billion Canadian to expand its operation by only 100,000 barrels per day-six times the original cost estimate, which was made only about eight years earlier.

Around the same time, a research report by Merrill Lynch said the cost increase would mean that the Athabasca project would only make about a 10% return on its investment if oil were to remain at least $50 per barrel!

WoodMac analyst Conor Bint issued a clear warning about the tar sands’ receding profitability horizon, saying, “Companies in the oil sands will have to control capital expenditures going forward to ensure that project breakeven prices do not exceed current levels in order to remain profitable.”

And what are the cost-inflating culprits, according to Bint?

The usual litany: labor shortages and skyrocketing material costs. “With the sheer number of oil sands projects together with the future arctic pipelines and conventional oil and gas developments in Alberta, labour demands in Canada will be pushed to their limits.”

Which sort of calls bullshit on their helpful tip that good project management and contractor scheduling will help keep costs in line. No doubt, you must carefully watch your labor hours when your typical field hand is pulling down “combat pay” in the six figures. But that isn’t going to help you a bit when tires, steel, machines, and basic metals are all going through the roof under the crush of increasing global demand, primarily driven by Asia, and primarily due to high oil costs. For example, the price of steel is up 70% in just the last five years.

In a recent essay on the cost inflation of conventional oil projects (“Upstream Economics and the Future Oil Supply”), oil analyst Dave Cohen made the shrewd observation that “the situation presents a classic Catch-22,” where “the cure for industry inflation is a slowdown in upstream activity, whereas the initial goal was to accelerate upstream development to meet growing global oil demand.”

Cohen notes that the cost of finding and producing oil has outpaced the growth in the price of oil. While oil has risen about 32% since 2005, costs have increased about 79%.

Given that the cost of finding and producing conventional oil is in the neighborhood of one-fifth that of producing tar sands, this is not an investment-friendly scenario.

Finance

Naturally, the aforementioned factors are leading to questions about the long-term viability of the tar sands industry, and slowing the pace of financing for its projects.

For not only are costs rising, they’re rising faster every year, across the board: for labor, materials, and energy. And in all likelihood, taxes and pollution-related costs will soon join the list.

Each of these trucks weighs more than two 747 airplanes. “It’s like driving your house downtown.”

For example, Canadian Natural Resources Ltd. said in March it wouldn’t move forward with its plans to build an upgrader plant due to runaway costs, and Synenco Energy Inc. shelved its upgrader in May. Likewise, last year France’s Total SA announced that it was pushing its tar sands project back by three years, again due to soaring costs for labor and materials.

“I don’t think it’s an anomaly,” says Mark Friesen, a Calgary-based analyst at FirstEnergy Capital Corp. “I think it’s an indication of how difficult the environment is. If we’re not careful, more projects may end up being delayed or cancelled.”

Delays are now becoming endemic to tar sands operations. Major equipment such as cokers and metallurgical towers now have waiting times of two years or more, more than double the wait of three years ago. (Now there’s an obvious investment opportunity.)

A shifting landscape of taxation also dogs tar sands ambitions. The removal this year of a significant tax advantage for Canada’s income trusts, which have been among the largest backers of tar sands projects, caused Canadian Oil Sands, one of the largest trusts, to post its first net loss in its 10-year history.

An accelerated capital cost allowance that was initially offered to drive investment in the sands has also been removed this year, which should net the federal government an additional $1.4 billion or so.

But perhaps the biggest financial threat is a change in the royalty rates. For over a decade, Alberta sought to attract financing by offering a mere 1% royalty rate until the initial costs of the projects are paid off, at which point the rate reverts to 25%.

It’s no surprise then that tar sands developers appear to be gaming the system by extending their “initial” investment in phases over a period of years, effectively stretching out the time they can take advantage of the 1% rate.

That rate typically translates to less than 50 cents on a $70 barrel for Alberta’s coffers. On the roughly $15 billion in tar sand revenue in 2004, Alberta took home only $700 million. And the $905 million that Alberta took in last year was actually less than it garnered from lotteries.

Consequently, Alberta is eyeing some additional changes to its tax structure for tar sands. It doesn’t want to be accused of bait-and-switch tactics, but it’s also facing the aforementioned increasing costs for all public services. At the same time, it is looking at an overall decline in income, due to the winding down of its conventional oil and gas operations, which pay up to 40% in royalty rates.

And let’s face it: given the immense challenges ahead of us for liquid fuels, thanks to peak oil, and the desperation of oil companies to find anything worth investing in at this point, a 1% royalty rate seems an outright steal of natural capital from the people of Canada. No wonder that a public consultation process on the taxation of tar sands projects is now under way.

If the royalties on the tar sands were allowed to rise to anywhere near the normal levels for oil-around 40%, not 1%-the entire industry would cease to be. The profit would vanish, simple as that.

Water

Water is another major problem. Tar sands plants typically use two to four barrels of water to extract a barrel of oil. Currently, the water consumption is enough to sustain a city of two million people every year. And after it’s been through the process, the water is toxic with contaminants, so it cannot be released into the environment. Some of it is reused, but vast amounts of it are pumped into enormous settlement ponds to be retained as toxic waste.

These "ponds" are actually the largest bodies of water in the region–big enough to be seen from space–and some of the world’s largest man-made ponds overall, with miles of surface area. It may take 200 years for the smallest particles to settle down to the bottom of this toxic brew, which also contains very high levels of heavy metals and other health-threatening elements.

According to a recent joint study by the University of Toronto and the University of Alberta, the projected expansion of the tar sands projects will kill the Athabasca River, the only abundant source of water in the area. "Projected bitumen extraction in the oil sands will require too much water to sustain the river and Athabasca Delta, especially with the effects of predicted climate warning," the study said. If that amount of water were used, they warned, it would threaten the water supply of two northern territories, 300,000 aboriginal people and Canada’s largest watershed, the Mackenzie River Basin.

Licensed surface water allocations from the Athabasca River and its tributaries. (2005 data, Pembina Institute)

With the tar sands currently producing at the rate of about 1 million barrels per day (mbpd), water levels in the river are already going down. Given such intense water demands, it’s completely unclear how production can be increased to the target of 4 mbpd by 2020.

One of the authors of the study, Dr. David Schindler, who is considered Canada’s top water expert, says that between the climate change-induced reduction in Athabasca flows and the seven major tar sands plants either operating or planned, the river’s water "is fully allocated, possibly over allocated, right now."

Energy

Perhaps the most paradoxical part of the tar sands receding horizons problem is the need for energy.

Typically, tar sands are produced using natural gas to heat the steam that drives the oil out of the sands. It takes a lot of gas to do this: over 1,000 cubic feet–about $8 worth–to produce one barrel of bitumen.

At the current production level of about 1 mpbd, the tar sands operations consume about 4% of Canada’s natural gas supply. So quadrupling production would consume fully 16% of the supply, and completely max out the gas market. Nearly all estimates for tar sands operations over the next ten years exceed the projections for available amounts of natural gas!

Canada’s natural gas supplies are running out fast. Numbers from the EIA and the NEB suggest that its proven reserves of natural gas will be gone in about eight years.

And plans for pipelines to bring natural gas from Alaska and the Mackenzie valley are currently mired in environmental and financial quagmires. The projected costs for the Mackenzie pipeline have risen so fast that the oil companies have put the project on hold, demanding that Ottawa pay a substantial part of the costs. Ottawa so far has refused.

But the entire planned capacity (1.9 bcf/d) of the proposed Mackenzie Valley gas pipeline could only support tar sands production up to about 3 mpbd by 2025.

Professor Kjell Aleklett of Uppsala University, a recognized expert on tar sands, puts it bluntly: "The supply of natural gas in North America is not adequate to support a future Canadian oil sands industry with today’s dependence on natural gas."

After gas, the next obvious choice is nuclear energy–building dozens of nuclear plants to generate the heat needed to create the steam needed to drive the hydrocarbons out of the sand. But by any sober assessment of that alternative, it would probably take on the order of ten years or more to build out that kind of nuclear capacity, with skyrocketing costs. And then you still have the problem of water to turn into steam and cool the nuclear plants.

What’s worse, depending on a host of factors, the total Energy Return On Investment (the energy profit, if you will) for tar sands production is typically only around 5% to 10%. In fact, it has even been suggested that the EROI is negative in some cases. But with the current circumstances of stranded and otherwise useless natural gas, oil over $60, an extremely tight global oil supply situation, and a host of complicating factors like tax relief (which we’ll get to in a moment), it still makes economic sense, if no other kind.

Even if an alternative energy source could be found, there is still the matter of the hydrogen needed to upgrade the produced bitumen into a useful hydrocarbon. That hydrogen is currently derived from natural gas. According to Princeton geology professor emeritus and peak oil author Ken Deffeyes, there is just one alternative source of hydrogen: water. But as we already know, there’s no excess water.

In the interest of scientific fairness, there are some new in situ processes for tar sands harvesting, like "toe heel air injection," which have been demonstrated to produce more bitumen than the traditional process with far lower energy and water inputs. But these processes are still in the experimental phase and have not been proven against the various challenging geological structures in which tar sands are found. They are certainly in no immediate position to become commercially viable, let alone saviors.

Labor

Not only is there a perennial shortage of skilled labor, even at average salaries above $100,000 per year, but a general strike now seems unavoidable this fall. Seven out of 25 key construction unions in Alberta–including carpenters–are contemplating their first multi-trade strike in almost 30 years. They’re no fools; seeing the oil and gas companies racking up record profits in the billions per quarter, they want a bigger piece of the action.

Though wages are high–a journeyman electrician can make $35 an hour–conditions are tough, too. Labor is demanding quality of life concessions, noting the horrors of traveling to and from and living anywhere near the northeastern Alberta work camps, where the living conditions have been compared to the Klondike gold rush days. It’s a rough place of rough men, and crime and drug problems are on the rise.

According to one former oil sands worker, a mobile home trailer is going for $425,000. Workers are bunking in residents’ basements and parking on their lawns, for lack of anywhere else to sleep or park. And sometimes the fumes coming off the slurry ponds are so bad that the schools have to be shut down. Stores have to shut down for several hours a day for lack of employees. There is a desperate shortage of schools, hotel rooms, police, firemen, and just about everything else that makes a town.

Indeed, the mayor of Fort McMurray, the largest city in the Athabascan region, warned that she could not promise a community that was safe and functional, and had no idea how the expected thousands of additional workers could be housed.

Environment

Naturally, the biggest hit from tar sands operations will be taken by the environment–the one player in this drama that can’t speak for itself or charge anyone anything for the damages it suffers.

Former Alberta premier Peter Lougheed recently warned that a clash over the environmental cost of the oil sands is inevitable, and that this will be fought all the way to Canada’s Supreme Court. A primeval boreal forest the size of Florida is being utterly destroyed beyond repair, while highly toxic sludge ends up in gargantuan tailings ponds even though laws stipulate that the land must be returned to its original state.

So far, the industry pays next to nothing for causing this environmental destruction, but it seems certain that this won’t last, particularly in view of stricter federal environmental legislation.

The Junkie’s Last Fix

Now, the above story wasn’t easy to piece together. The press is almost universally in favor of anything that sounds like "more oil," no matter the cost. Nearly all we hear about is X billion in new investment announced by Y Company. We don’t hear too much about the cancellations, delays and cost overruns. A full reckoning is rarely attempted.

But that’s what we’re here for.

So let’s reckon this.

What we have here is arguably the most environmentally destructive activity man has ever attempted, with a compliant government, insatiable demand and an endless supply of capital turning it into "a speeding car with a gas pedal and no brakes." It sucks down critical and rapidly diminishing amounts of both natural gas and water, paying neither for its consumption of natural capital nor its environmental destruction, to the utter detriment of its host. And all to eke out maybe a 10% profit, if it turns out that the books haven’t been cooked, and if the taxation structure remains a flat-out giveaway.

All of that, just to produce enough oil to offset the declining conventional oil production in the rest of Canada. Maybe.

And that, my friends, is what I call the oil junkie’s last fix. An act of sheer desperation to stave off just a little longer that inevitable day when we are forced to realize that the fossil fuel game is truly over. No more rabbits in the hat. Done.

In the July 2006 issue of Rolling Stone, Al Gore called the tar sands "crazy," a huge waste of energy and an eyesore on the landscape of Western Canada. "For every barrel of oil they extract there, they have to use enough natural gas to heat a family’s home for four days," Mr. Gore told the magazine. "And they have to tear up four tons of landscape, all for one barrel of oil. It is truly nuts. But you know, junkies find veins in their toes. It seems reasonable, to them, because they’ve lost sight of the rest of their lives."

Moving On–To Profit

For those of us who have not lost sight of the rest of our lives, can we move on?

There is another possible path than this fossil fuel death march!

It’s called renewables. If we start now, and commit ourselves absolutely to transforming our infrastructure to an all-electric regime powered by renewables within say, 50 years, I think we just might have enough traditional gas in the tank to make that happen. And still have a little left over for the highest uses of petroleum, like making plastics and other needs that renewable electricity cannot satisfy.

But there is no time to lose.

That’s why the wind and solar industries as a whole are posting 25%-plus growth rates and–let me assure you–profit far in excess of a lousy 10%, and without risking $100 billion to make it!

That’s why geothermal stocks like Raser Technologies are posting 100% gains in a year:

And that’s why you really should consider joining us for the Angel Research "Profit from the Peak" Summit in Philadelphia next month. I’ll be speaking on the big picture of energy, and what I believe are the truly viable investments for the future of energy, above and beyond the hype. It’s not too late to sign up for the conference. You can learn more about it here.

Until next time,

Chris

Many thanks to Roel Mayer for his contributions to this piece.