• Oil sands have a bad reputation due to the high carbon intensity of their production process

• However, in a world where new greenfield fossil fuel development is becoming harder and less attractive to finance, Canadian oil sands’ huge reserves and low sustaining capital costs offer unexpected advantages

• A robust regulatory environment and clear alignment between meaningful decarbonisation and future returns offers a compelling incentive for real progress

In 2023, all-time high oil demand of 102 mbpd (million barrels per day) represents around 30% of global energy consumption. According to the IEA’s Net Zero pathway, oil demand must fall to 72 mbpd in 2030, before declining to just 24 mbpd in 2050. Whilst we believe the transition will take longer than the IEA expects, the direction of travel is clear and ultimately for the good of the planet. This outlook is deterring oil companies from making significant capital investments, a state of affairs sustained since 2016. The ‘big five’ SuperMajors, which comprise 11% of global oil and gas production, spent $10 on capex for every barrel of oil produced. This compares to an average of $18 in the decade from 2004-2014 when production declined by 1.5% per year. Meanwhile, today’s exploration capex of $1 per barrel is at an all-time low in real terms. 

The Canadian oil sands constitute the fourth-largest oil reserve in the world, of around 165 billion barrels. The overwhelming majority of this is found in the province of Alberta across three basins – Athabasca, Peace River and Cold Lake. Oil sands are a loose sand deposit which contains a very viscous form of petroleum known as bitumen. When bitumen is deposited at shallow depths, it can be surface mined. However, about 80% of Alberta’s recoverable bitumen reserves are buried too deep to mine and can only be recovered by drilling wells. This is referred to as “in situ” recovery. The Hosking Partners portfolio has holdings in three of the six largest operators (by both market cap and reserve depth) across the Canadian oil sands.

Global energy consumption on a per capita basis can be expected to grow by around 1% annually over the next three decades. Estimates of this figure vary considerably, but around 1% represents a reasonable average that is in line with the long-term rate of 1.2% from 1990 to the present day. Due to the energy- and capital-intensive nature of the energy transition, sources of oil that require relatively low levels of capital to sustain production are becoming increasingly important, because they allow more development capex to divert to renewables without deepening overall energy shortages. 

In this context, the unique cost structure of Canadian oil sands makes them a particularly attractive resource. Oil sands projects require substantial up-front capital investment. However, once these investments are in place the assets are able to maintain and even slightly grow production year after year for decades, with a relatively low marginal cost per barrel.  This is a function of the geology of the deposits and the methods of extraction, which results in a low decline rate of just 5-10% per year. The outcome an extremely long asset life and zero exploration risk. This is in sharp contrast to US shale oil, which is less costly to start up, but where decline rates can be up to 40% per year per well. This results in shorter reserve lives and greater reliance on treadmill-like exploration activity to sustain production. 

The high cost of production commonly quoted for oil sands includes capex costs for the development of greenfield sites that are unlikely to be built. The Alberta Energy regulator estimates the minimum dollar oil price needed to recover all capital expenditures, operating costs, royalties, taxes and earn a specified return on investment is $73-82 for a new mine and $43-51 for an in-situ site, which is expensive by industry standards. However, in reality long lead times (>10 years), large upfront capex (~$10bn), the lack of shareholder support, and burdensome permitting means major greenfield projects are simply not viable in today’s environment. Indeed, the operators we have spoken to say we are unlikely ever to see another large oil sand mine developed in Canada. 

Given capital investment is now sunk, operators will continue producing as long as the prevailing price is above the marginal cost of an additional barrel. Oil sands’ operating costs have improved dramatically over the last 20 years and now sit at around $20 per barrel at some of the largest sites. While it is true that US shale producers still have an operating cost advantage, ranging between $10-15 per barrel, when you factor in the higher capital costs required to sustain shale production, the significance of the gap becomes less meaningful. For example, two of the largest Canadian operators can sustain their current production by spending $4-8 per barrel per year, more than 50% less than average US shale operator, who needs to spend between $10-15. Furthermore, the majority of the Canadian players have lowered their cash breakeven to around $35, which is on par with the most efficient US players. Importantly, this includes capex to sustain current production as well as covering the dividend. Moreover, the low marginal cost of expansion projects at existing sites means that Canadian oil sands production is expected to increase by ~600,000 b/d by 2030. More than four-fifths of the growth is expected to come from the ramp-up, optimization and completion of projects where capital has already been invested. 

But what about emissions? Due to the energy intensity of the production process, oil sands are higher carbon intensity than conventional oil sources. In-situ sites use super-heated steam to reduce the viscosity of the bitumen and allow it to be extracted. Furthermore, most mined bitumen requires the added step of upgrading to break down the heavy hydrocarbons into lighter components which can be transported by pipeline and sold as synthetic crude oil. Both of these steps consume considerable amounts of energy, which generates CO2 emissions. While CO2 intensity has fallen by 21% since 2009, emissions nevertheless remain above global averages. As the world moves towards Net Zero, the most carbon intensive barrels of oil are at risk of curtailment, especially if carbon pricing becomes commonplace. This reasoning continues to weigh on oil sands valuations, despite the seemingly attractive financial profile outlined above. However, we believe that the reality of how this unfolds may be more nuanced than it first appears, for several reasons. 

Long asset life and a front-loaded capex profile means that Canadian oil sands represent one of the only oil resources in the world that can sustain current levels of production without further development. Several major organisations – most significantly the IEA – have stated that no new oil and gas development can be supported in a Net Zero scenario. Perhaps counter-intuitively, in that scenario Canadian oil sands may emerge as a potential winner. Less exposed to the consequences of ever harder-to-access bank financing – required elsewhere simply to sustain production – the oil sands producers can quietly continue supplying oil markets, even as the overall size of oil’s portion of the global energy pie gradually shrinks. The runway here is measured in decades rather than years, and the minimal development capex needed means more cashflow can be returned to shareholders throughout. 

Despite high carbon intensity at time of writing, Canadian oil sands are perhaps uniquely positioned to be able to deliver meaningful emissions reductions over coming years. Recognising the requirement to maintain a long-term regulatory and social license to operate, the six leading Canadian oil sands producers have joined forces in the first collaborative basin-wide decarbonisation initiative in the world. Termed the Pathways Alliance, this is targeting net zero Scope 1 and 2 emissions – i.e. those emissions generated as part of the production process and as a consequence of associated electricity demand – by 2050.

This Pathways Alliance aims to reduce oil sands emissions in three phases. The first phase sees the construction of the largest carbon capture and storage network in the world. It will capture CO2 from more than 20 oil sands facilities and move it via a 400km pipeline to an underground storage hub. This will reduce CO2 emissions by a third by 2030 and is expected to cost C$16.5 billion, the majority of the C$24.1 billion committed to be spent by the Alliance before 2030. If this reduces emissions by around 20 million tonnes per year as claimed, then it will achieve a carbon abatement cost of around $25 per tonne, assuming a 30-year productive asset life. This compares to carbon abatement costs of around $400 per tonne today for Direct Air Capture projects. The second and third phases will reduce emissions via a mosaic approach encompassing efficiency, offsets, and most notably new solvent and steam-reducing extraction technologies that could lead to significant further reductions in both emissions and operating costs. 

Canadian oil sands production is concentrated in just six operators that account for around 95% of production. This makes coordination of this complex carbon capture project easier. Indeed, the CEOs of the six operators conduct a weekly call to personally monitor and discuss progress of the Pathways Alliance. Furthermore, all of the assets of the major players are concentrated in Canada’s fourth largest province, Alberta, with the total deposit occupying just 140,000km2 of land with the major processing facilities even more tightly situated. This relative proximity – by contrast the Permian Basin in the US alone occupies over 220,000km2 – combined with the low decline rate of the assets, supports the economics of large carbon capture facilities, and allows a single pipeline to serve all six operators. This is in stark contrast to conventional oil companies that operate thousands of well heads, diversified across different basins and geographies, who continually need to drill new wells, with obvious consequences in terms of the amount of emissions-controlling equipment required, and its operating cost if it is being constantly redeployed.

Meanwhile the Canadian government has committed to supporting the project to meet its own emissions commitments. In March 2022, the Canadian government unveiled its new climate change plan to reduce greenhouse gas (GHG) emissions by 40% below 2005 levels by 2030 and achieve net-zero emissions by 2050. This includes reducing emissions from the oil and gas sector – which account for 27% of the country’s emissions – by 42%. The government has already announced a generous investment tax credit for 50% of carbon capture project costs until at least 2030 to accelerate investment, and the companies expect there is more to come. 

Furthermore, Canadian oil sands offer critical geopolitical stability. In a world where OPEC+ is as much a political actor as an economic one, where conflict routinely disrupts energy flows, and where regional spheres of influence are an ever-increasing reality, Canada has slowly but surely delivered the world’s most consistent oil production growth over the past 20 years (as depicted in the production chart on the previous page). The main alternatives for new oil sands production are found in geopolitically volatile countries such as Russia and Venezuela, so Canada’s geographic and political stability seems a major positive as the West and its allies prioritise energy security and diversify their imports away from strategic adversaries. 

For us as investors, the transparent and well-regulated nature of the Canadian oil sands producers means we can track progress towards decarbonisation targets and – through active ownership – hold management to account if they fail to deliver. The same cannot be said for all oil producers. Indeed, the large majority (80%) of the world’s proven oil reserves are owned or controlled by national governments who may be non-democratic and therefore unaccountable. Of the 3.2 billion remaining barrels – which are accessible for private sector investment – 52% are found in Canada’s oil sands. 

Canadian oil sands therefore represent a relatively unusual example of an industry where financial and ESG considerations are clearly and relatively unambiguously aligned. Because the significant up-front investment required to reduce emissions is more attractive if associated asset lives are in the 30 to 50 year range, in oil sands the goal of decarbonisation is aligned with the long-run operating runway. Compare this to the incentives for a shale operator to maximize short-term cash flows given the well often runs dry after a few years. If the Canadian oil sands producers want to continue to be a viable source of oil as the federal minimum carbon tax rises from C$50 today to C$170 in 2030, then successful decarbonisation becomes very material to future margins. Combined with attractive fundamentals, geopolitical stability, and regulatory support, we believe that even the most cautious ESG-focused investors should give Canadian oil sands a second look.