Keystone Extraction

The NDP put forth a motion in the House last week which states that, “the Keystone XL pipeline would intensify the export of unprocessed raw bitumen and would export more than 40,000 well-paying Canadian jobs, and is therefore not in Canada’s best interest.”

This motion provided me with the motivation to dig into a question – if you had a given amount of capital to spend in the oil sands, would an oil sands mine alone or an integrated project with an upgrader generate the largest value-added return on investment, including total wages, royalties, taxes, and profits, and how would these be distributed?

To tackle this question, I ran two iterations of an oil sands project model based loosely on Suncor’s Fort Hills project combined with upgrader assumptions based on Suncor’s now-cancelled Voyageur project.

I’ve made some pricing assumptions as follows:

First, suppose that oil prices follow the Sproule Associates forecast for October 31, 2013, with West Texas Intermediate oil prices at $87 per barrel plus inflation, and a discount for Canadian heavy oil of 16% along with additional discounts and premia reported below.

Pricing Assumptions ($2013)
Edmonton Par discount to WTI (%)
WCS discount to Edmonton Par (%)
SCO premium to Edmonton Par (%)7
Condensate premium to Edmonton Par (%)6
Diesel premium to Edmonton Par (%)25%
Project diluted bitumen discount to WCS (%)

Next, suppose you can build an oil sands mine for $84,000 per barrel per day of capacity, roughly what Suncor says it will cost to build the Fort Hills project.  Further, suppose you could add an upgrader to the project for an additional $50,000 per barrel per day of capacity. I’ve set the upgrader cost really low, given that Suncor’s Voyageur upgrader, which would have been about the scale we are talking about here, was slated to cost at least twice that amount. Further, assume that you can operate the mine for an average cost of $20 per barrel of bitumen production, with an additional cost of $9.80 per barrel for the upgrader (including both energy and labour costs). Sustaining capital costs are $3 per barrel for the mine, with an additional $2 per barrel for the upgrader.  The total ($2013) costs for the project, including royalties and taxes conditional on the assumed prices are as follows:

Total Costs ($2013)
Capital and Debt Costs$mm            42,080        42,080
Operating costs$mm          100,521        95,677
GHG compliance costs$mm                 170            186
Royalties$mm            71,665        46,063
Taxes$mm            25,719        14,430

As you can see from the table above, the projects are equivalent in terms of total project capital expenditure.  Finally, for tax purposes, I assume that the projects use Class 41 capital cost allowance for 95% of capital expenditures, with the balance attributable to Canadian Development Expense deductions.  The Alberta Royalty Regime is applied, and the projects both pay royalties on bitumen subject to the bitumen valuation methodology, and the payout calculation is done with a long term bond rate assumed at 3%. Debt is assumed to cover 50% of the up-front capital costs of the projects, at a rate of 5.5%. GHG emissions policies are assumed to follow the Alberta Specified Gas Emitters Regulation in perpetuity.

Project Economics
Cumulative Bitumen Productionmmbbl49923208
WTI-equivalent supply cost ($2013)$/bbl72.2078.24
IRR (%)%12.30%11.70%
Free Cash Flow, $2013$/bbl14.918.95
Free Cash Flow, $2013$mm74,36560,799
NPV (10%)$mm14,22111,256

The after-tax `economics’ for the two projects for the investor, shown above, look fairly similar at first glance. The standalone mine provides an after-tax rate of return of 12.3% and earns a break-even 10% rate of return on capital at a WTI price of $72.20 per barrel. The upgrader and mine combined earns a slightly smaller rate of return, at 11.7%, and requires an oil price of $78.24 to make a 10% rate of return. Subtle differences, but not huge and likely not large enough that you could say that one would proceed while the other would not (although, keep in mind that my upgrader costs are likely too low).

On a per-barrel basis, the numbers are equally ambiguous – in fact, the upgrader looks better. Revenues per barrel are, of course, higher with the upgrader with an average of $80.80 per barrel of produced bitumen vs. $62.93 for the mining project alone. Average costs (capital, debt, and operating costs combined) are higher for the integrated project, at $43 per barrel versus $29.15 for the mine, while royalties and taxes are similar at around $19 per barrel of produced bitumen in both cases. The result is that the upgrader earns higher cumulative cash flows, by $4.10, per barrel of bitumen produced.

Keep in mind though that the project with an upgrader earns higher cash flow per barrel, but for an equivalent initial investment (and for roughly equivalent total labour supply over the life of the project) it produces far fewer barrels – 1.7 billion fewer barrels, to be exact. So, over the life of the two projects, the total royalties and taxes collected from bitumen extraction versus mining and upgrading combined would be lower by $36.6 billion, while the profits to the producer would be lower by $13.4 billion. Combined, for a similar capital investment and with similar associated jobs, the bitumen extraction project returns $50 billion more in royalties, taxes, and profits.

So, if you had $42 billion to invest in the oil sands and had the land base, I think you’d have a hard time convincing your board to build an upgrader rather than a larger mine. From a labour perspective, it’s likely close to a wash. For governments, the answer is clear – if labour and capital are constrained, there’s a distinct preference for extraction over integration.

Photo Credit: Extraction and Upgrading/shutterstock