Heavy Oil’s Turnaround Results in Huge Sleeper Value for Alberta Oilsands

AOS_Heavy_Oil

Where has the price of oil almost doubled in six months? In Alberta, where the heavy oil price traded at $48 a barrel some days in December 2012, and now is over $91/barrel. 

You would never know it from looking at heavy oil stocks, however.  They’re only just now starting to move up.  It’s clear that despite a very profitable run recently, investors have an outdated mindset on heavy oil stocks—they’re still thinking December-January prices.

But the sell off is over—for good. Heavy oil is coming back to life and investors should be having a second look at this very profitable sub-sector of the energy markets.

AOS--rail shipments of oil

The big difference for heavy oil has been increased rail capacity. In 2012, 1 million barrels per day (bbl/d) were transported to refineries by rail, truck, and barge, representing a 57% increase from 2011.In Canada, the percentage of oil shipped through oil-by-rail methods tripled between 2011 and 2012. Since 2009, Canadian rail shipments increased from 6,000 carloads to 14,000 this year.

There aren’t signs of this stopping, as the US State Department has predicted another increase of 42% by 2017.

This rail revolution has allowed oil to be shipped to refineries all over North America, not just to Chicago or the Gulf Coast. Heavy oil producer Cenovus Energy [CVE] already expects to be transporting as much as 30,000 bpd by rail by the end of 2014.

With the currently high heavy oil price, some rail transport is actually less economic. But this form of transport has become such an accepted part of the oil market that as soon as the heavy oil price even dips a bit, rail transport will pick up the slack and help stabilize the price.

So while January’s prices fetched an abysmal 50% of the World (Brent) crude price, more recent figures between 80-85% are becoming the norm again—and should stay that way.

In fact, sometimes heavy oil even traded at a higher price than light oil in the Gulf this year—and that could happen again.  Light oil doesn’t have a lot of refining capacity in the US—meaning that once all that new US domestic shale oil fills up refining capacity, it could drop enough in price to be below heavy oil. (Watch for that in Q1 2014.)

While heavy oil pure plays stand to benefit, so to do juniors with exposure to the sector that will resume development of their heavy oil assets.

One interesting place for investors to look is Alberta Oilsands [AOS.V] and its Algar Lake heavy oil asset.  AOS has spent $65 million building a 500 million barrel reserve base since 2007, with a PV10 of $823 million.  Despite this, the company trades at a valuation of just $4 million net of cash today!

In addition to all of that and what we believe may represent latent "sleeper" value is the company's 3rd oil sands asset - its Algar Lake heavy oil asset.

AOS has recently attracted a private partner to joint venture Algar Lake, whose management team has been responsible for the discovery from scratch of two 1 billion+ barrel oilsands finds, and the subsequent sale of both projects to majors.  This group is attracted to Algar, we believe for the following reasons:

  1. It’s a big asset—51 square miles, or sections, as the industry calls them.  That gives investors a lot of leverage if the play works out.
  2. This type of heavy oil is called cold flow, and it’s cheap to drill—this is NOT oilsands. An Algar Lake well would only cost roughly $500,000.  Management believes they could have payback on a well in under 12 months.  Fast payback is essential for a junior; they need to get that well paid off and use that money to drill a new well right away.  5 wells are being drilled by AOS' partner this winter.
  3. One of the largest heavy oil plays is only a few kilometers away—Pelican Lake, operated by Canadian Natural Resources Ltd. — set to produce 80,000 bopd by 2015. http://www.cnrl.com/operations/north-america/north-american-crude-oil-and-ngls/pelican-lake-crude-oil.html
  4. AOS bought Algar Lake early, and was able to bring in a partner on very accretive terms.

The company acquired the asset in 2007, before access to the region through crown sales became virtually impossible. Now, AOS is quite content knowing that there is a demand for access to these types of formations.

“Algar Lake has the potential to be a cold flowable asset, which is a game changer,” says Binh Vu, Interim CEO of Alberta Oilsands.

Cold flow heavy oil is the most profitable oil in all of North America. CNRL says that Pelican Lake is their most profitable asset.

Today, the asset is the largest polymer flood operation in the world. CNRL anticipates a 3.5x increase in expected recovery, thanks to their stimulation efforts.

The sheer success of the project has spawned others looking to capitalize on this highly profitable region—and Algar is right in the middle of it.

“Three projects just to the east of Algar Lake are already underway,” says Vu. “And Pelican Lake—the largest cold flow heavy oil field in Alberta—is a short drive to the southwest.”

It must be noted that CNRL is a major, whereas Alberta Oilsands is a junior. Thus, high return wells tend to benefit a junior’s growth more than a major’s.

Steam Assisted Gravity Drainage (or SAGD) CAPEX costs hover in the $30,000 per flowing barrel range, whereas AOS’ potential cold flow asset would be much less - probably 1/4 of that. The OPEX per barrel of production is typically as little as half as for those needing energy input for steam.

With high heavy oil pricing, a big property and a partner paying most of the freight, and 500 million barrels of booked SAGD resource already—which cost $65 million to prove up—the fact that AOS is trading at cash value has very limited downside.

Then throw in the fact that there is almost no crown land availability in the region. Algar’s acreage falls within the province of Alberta’s oil sands area boundaries, which are very crowded. Now, the only entry for potential participants in the region to gain access is through a farm-in, JV or acquisition.

According to Alberta's Ministry of Energy: “Within the Oil Sands Area boundaries, lands may not be available for development due to access restrictions, Parks and Protected Areas, Military Reserves, and Department of Energy Mineral restrictions.”

Alberta Oilsands accrued their land long before there was an issue. Now it’s time for the company to start seeing the value accrue.

With low drilling costs, it’s possible AOS could put multiple drills in the ground to achieve online production quickly and profitably. And they’ve got room to move.

Management is studying different practices and suggests drill hole spacing could be as low as 20 acres —that’s a staggering 1500+ wells over 51 square miles (32,640 acres), assuming geological continuity.

Three historic exploration wells were drilled on AOS' Algar Lake ground between 1958-1960 - and the geological information that they have provided, looking like a facsimile of nearby operations, has been enough to warrant attention and anticipation from AOS and its partner.

“Because of its location, and cold flow production potential, the Algar Lake asset may eventually draw buyout interest from our neighbors,” says Vu.

With projects on both sides, Algar is now central from an exploration standpoint. Management believes that while still factoring for risk, by connecting the dots, the project’s success truly just hinges on getting the work done.