Suncor Energy's Huge Bet on Oil Sands Might Be a Bad Gamble

By Markets Fool.com

Image source: Suncor Energy.

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Suncor Energy (NYSE: SU) has made several acquisitions over the past year to boost its positions in Canadian oil sands, taking majority interests in the Syncrude and Fort Hills oil ventures. The company hopes oil sands production will make up nearly 90% of its expected 800,000 barrels of oil equivalent per day (BOE/D) of total production in 2019. Being a well-diversified, integrated oil company, Suncor will receive a large portion of its cash flow during this time frame from its refining and marketing businesses. In terms of production, though, this is practically the definition of putting all of its eggs in one basket.

Here's why Suncor's bet on oil sandswill likely boost future production but remains a risky play in the constantly evolving oil market.

Strengths of the oil sands

Suncor's decision to invest $6 billion to expand its Canadian oil sands positions over the past year really comes down to the concept of strengthening a strength. Prior to its recent acquisitions, Suncor was already one of the biggest operators in the region, producing over 400,000 BOE/D from its "Base Oil Sands" operations. The majority stakes in the Syncrude and Fort Hills ventures should add nearly 300,000 BOE/D to that total by 2019.

These investments in this region aren't without merits. Canadian oil sands have some of the largest proven reservoirs in the world, with about 166 billion barrels of recoverable reserves. Because of the quantities and the methods of extraction -- either via steam injection into underground wells or strip mining the top 100 feet or so of land -- oil sands positions have exceptionally long lives. The Fort Hills mine, for example, is expected to last for 50 years.

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On top of that, oil sands mines require a good deal of upfront costs, but once complete, they can run for long periods with greatly reduced capital expenditures. This is one reason Suncor seems so intent on expanding its current positions. While some analysts say the breakeven point for established oil sands positions is about $25 per barrel, the consensus is that $40 is the minimum price to begin seeing profits. New operations, though, such as Fort Hills, might be as high as $90 per barrel. On average, Suncor expects oil sands operating costs per barrel at $27 to $30 in for the remainder of 2016, and Syncrude operating costs to be $41 to $44 per barrel..

Compare this to the shale oil regions such as the Permian Basin and Eagle Ford in Texas, where breakeven prices at some locations can reach as low as $22 per barrel. Whileshale can potentially be a cheaper option. However, shale wells have much shorter lives than oil sands wells and require constant investment. Oil sands require most of the investment upfront. That investment, though, means Suncor can have proven production for decades to come.

Risks of oil sands

Despite the large amounts of reserves and the long life of the fields, Suncor's heavy bet on oil sands comes with plenty of risks. Perhaps the most challenging of these risks is the basic disadvantage of location. A large portion of Suncor's oil is shipped to Gulf Coast refineries, and it's much cheaper to get product to those refineries from oil fields in Texas or Mexico. It can cost anywhere from $10 to $20 per barrel to ship from Alberta to the Gulf. That means it requires Canadian oil sands producers to discount their oil by $10 to $20.

Further hurting Suncor's oil production in Canada is the fact that oil sands primarily produce a synthetic crude blend or a highly viscous, tar-like crude. In order to transport the latter option, producers have to mix it with an ultra-light oil. The product creates what is referred to as Western Canadian Select (WCS). Because WCS remains a heavy oil and is more difficult to refine into petroleum products, it can be more expensive for refineries that aren't specifically designed for that purpose. This further discounts crude from oil sands producers because refineries prefer to use the cheapest option to earn the highest margins.

The higher transportation costs and heavy oil contribute to average oil sands production requiring much higher average operating costs per barrel. In the first quarter, for example, EOG Resources (NYSE: EOG), with large positions in Texas, averaged $11.96 per barrel, while Suncor is expecting average 2016 oil sands costs to be $27 to $30 per barrel.

This also means WCS sells at a significant discount to West Texas Intermediate (WTI) crude -- the U.S. benchmark -- which is one reason breakeven in the oil sands is higher than breakeven at other North American locations.

Foolish bottom line

Whether or not these investments pay off in the future will ultimately come down to oil prices and if Suncor can continue to incorporate efficiencies to bring production costs down. The company has managed to reduce oil sands costs by as much as 35% over the past three years. Suncor has made further improvements and efficiencies a key aspect of its operations.

If oil prices stay depressed, though, as they did in the first quarter -- which contributed to $400 million in net losses from Suncor's oil sands operations -- the company could struggle to return to profitability. Further, its main focus in oil sands opens it up to unforeseen events such as the Canadian wildfires that crushed second quarter production and made operating costs skyrocket.

There is a lot to like about Suncor's strong oil sands positions, but low oil prices, high operating costs, and the difficulty of getting production to refineries make the latest investments a high risk endeavor.

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David Lettis has no position in any stocks mentioned. The Motley Fool owns shares of EOG Resources. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.