NAFTA Looks at the Oil Sands Bonanza

Canadian Ambassador Michael Wilson has written to US Secretary of Defense Robert Gates warning that an “expansive interpretation” of the Energy Independence and Security Act of 2007 could impede development of Canada’s oil sands because of strict greenhouse gas (GHG) emissions standards included in Section 526 of the law. If the law is interpreted broadly, the US could be precluded from purchasing fuel from the oil sands.

We noted the potential for cross-border conflict on the oil sands issue in the Feb. 20 Maple Leaf Memo. Ambassador Wilson’s letter was first reported by the Financial Times March 9. The FT also obtained a copy of the letter, which is available here. 

Section 526 limits US government procurement of alternative fuels to those from which the lifecycle GHG emissions are equal to or less than those from conventional fuel from conventional petroleum sources. The oil sands are considered unconventional fuels, and producing them emits more greenhouse gas than conventional production.

Ambassador Wilson’s letter is aimed at cutting off the unidentified “some” who argue that the Dept of Defense (DoD) must interpret Section 526 to include all government fuel purchases and any fuel made from other-than-conventional sources.

The US/Canada energy relationship is covered by the North American Free Trade Agreement (NAFTA). Canada became the largest source of US energy imports in 2004, surpassing Saudi Arabia, and its future ability to cover such demand is tied directly to the oil sands. Oil sands production is projected to grow from 1.4 million barrels per day (MMbd) to 3 MMbd by 2015, most of it destined for US consumption.

“Canada,” writes Ambassador Wilson, “does not consider oil extracted from oil sands as alternative fuel.”

Wilson concluded, “Interpreting Section 526 to apply to all commercially-available fuel made in part from non-conventional petroleum could exclude all fuel commercially-available on the US market from being eligible for purchase by the US Government.”

Potential consequences of a strict interpretation of Section 526 include the appearance of US preference for offshore crude from other, less-secure foreign sources. And taking away the world’s largest consumer, the DoD, from the demand equation would have a short-term negative impact on the oil sands, but that demand slack would certainly be made up by China and other emerging economies.

US concerns about energy independence/security and the environment form an obvious nexus of conflict. Tradeoffs will have to be made.

Oil sands production is unquestionably a dirty business, but the Canadians are already taking steps to combat GHG emissions related to it. The Conservative government announced March 10 new rules to govern oil sands facilities.

Those that go into operation starting in 2012 will be required to capture and store the bulk of their emissions of carbon dioxide (CO₂). Existing facilities and those that start operating before the end of 2011 will have to reduce emissions using cleaner fuels according to the rules that will be finalized next year.

Canada has established a target for reducing GHG by 20 percent below 2006 levels by 2020. To that end, the government also will ban the building of new coal-fired power plants starting in 2012, with new generating stations required to have carbon capture and storage capacity ready and deployed. And Ottawa will establish a carbon emissions trading market, including a carbon offset system to help establish a market price for carbon.

Canada won’t be able to meet its target of reducing GHG if it doesn’t compel capture and storage in coal-fired electricity and oil sands. Oil sands production alone is forecast to create 25 percent of Canada’s CO2 emissions by 2020, up from the current level of about 18 percent.

NAFTA has slipped from American attention this week, but it will back in headlines and on cable TV when the general election caravan swings through Ohio in the fall.

It’s certainly a campaign issue, but talk on the trail often has little relationship to what’s done in the Oval Office. Facts are facts (Obama’s people talked to the Canadians, and Harper’s chief of staff discussed a meeting with Clinton’s people), but the recent kerfuffle is more about two people competing for one nomination than it is about substance.

The important thing from a policy perspective is that NAFTA is a multiparty agreement. Any change will require negotiation. And the Canadians have made clear their intention to use their resource leverage.

Speaking Engagements

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The Roundup

Oil & Gas

Advantage Energy Income Fund (NYSE: AAV, TSX: AVN-U) reported fourth quarter net income of CAD13.8 million (10 cents Canadian per unit), up from CAD8.74 million (8 cents Canadian per unit) a year ago. Funds from operations (FFO) totaled CAD80.52 million, up 28 percent from CAD62.74 million a year ago. FFO on a per-unit basis fell 2 percent to 58 cents Canadian from 59 cents Canadian.

Revenue for the quarter was up 30 percent to CAD165.95 million from CAD127.54 million in the fourth quarter of 2006. For the year ended Dec. 31, 2007, Advantage reported a net loss of CAD7.54 million (6 cents Canadian per unit); in 2006, the fund reported net income of CAD49.81 million (62 cents Canadian per unit).

Full-year FFO was up 26 percent to CAD271.14 million from CAD214.76 million a year earlier; on a per-unit basis, full-year FFO fell 16 percent to CAD2.22 million from CAD2.65 million. Revenue before royalties was up 33 percent to CAD557.36 million from CAD419.73 million.

For 2008, Advantage has sold forward about 51 percent of net natural gas production at an average floor price of CAD7.43 per thousand cubic feet and 38 percent of oil production at an average floor price of CAD94.07 per barrel. Buy Advantage Energy Income Fund up to USD12.

Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF) reported net earnings for the fourth quarter of CAD73.29 million (69 cents Canadian per unit), up from CAD47.01 million (44 cents Canadian per unit) a year ago. FFO for the quarter were CAD68.98 million (65 cents Canadian per unit), down from CAD77.36 million (74 cents Canadian per unit) in the fourth quarter of 2006.

Revenue fell to CAD99.39 million from CAD110.7 million. Production in the quarter was 21,134 barrels of oil equivalent per day (boe/d), down from 22,550 boe/d a year ago.

For 2007, Peyto earned CAD208.9 million (CAD1.98 per unit) on CAD404 million in revenue. In 2006, Peyto earned CAD195.2 million (CAD1.86 per unit) on revenue of CAD439 million. Peyto Energy Trust is a buy up to USD20.

Vermilion Energy Trust (TSX: VET-U, OTC: VETMF) reported fourth quarter net income of CAD43.2 million (62 cents Canadian per unit), up from CAD17.6 million (27 cents Canadian per unit) a year ago. Revenue for the quarter was up to CAD205.7 million from CAD155.7 million as higher oil prices offset higher operating costs.

For the year ended Dec. 31, 2007, Vermilion earned CAD164.3 million (CAD2.48 per unit), up from CAD146.9 million (CAD2.30 per unit) in 2006. Revenue for the year was CAD707.3 million, up from CAD618 million.

Annual production rose 14 percent to 31,325 boe/d from 27,401 boe/d in 2006. Vermilion forecast 2008 production of 31,000 to 32,000 boe/d and an average per-barrel oil price of USD70. Buy Vermilion Energy Trust up to USD40.

Electric Power

Algonquin Power Income Fund (TSX: APF-U, OTC: AGQNF) reported fourth quarter cash available for distribution of CAD19.9 million (26 cents Canadian per unit), up from CAD17.5 million (23 cents Canadian per unit) a year ago. The fund distributed 23 cents Canadian per unit during the fourth quarter of both 2006 and 2007.

Revenue for the fourth quarter of 2007 was CAD44.3 million, down from CAD52 million a year ago. Net earnings from continuing operations came in at CAD8.8 million (12 cents Canadian per unit), up from CAD3.7 million (6 cents Canadian per unit) in the fourth quarter of 2006.

For the year ended Dec. 31, 2007, Algonquin generated cash available for distribution of CAD72.3 million (95 cents Canadian per unit), up from CAD67.5 million (93 cents Canadian per unit) in 2006. Revenue was CAD186.2 million for the year, down from CAD193.2 million in 2006. Net earnings from continuing operations totaled CAD24.8 million (34 cents Canadian per unit), compared to CAD30.7 million (43 cents Canadian per unit) in 2006.

Lower-than-long-term-average hydrology, lower production and lower average energy rates caused the fourth quarter and full-year revenue declines. The increase in cash available for distribution for 2007 is primarily due to one-time gains related to the termination fee in connection with the offer for Clean Power Income Fund, cash from discontinued operations and adjustments related to the fund’s investment in the St. Leon facility. Algonquin Power Income Fund is a buy up to USD9.50.

Business Trusts

Arctic Glacier Income Fund (TSX: AG-U, OTC: AGUNF) reported a fourth quarter loss of CAD3.7 million (10 cents Canadian per unit), an improvement from a loss of CAD6.2 million (19 cents Canadian per unit) a year ago. Ice is a seasonally sensitive business, so the fourth quarter is typically Arctic Glacier’s weakest period.

Sales in the period were off 9 percent to CAD36.3 million as a strong Canadian dollar took a CAD4.5 million bite. Sales for 2007 were up 14 percent to CAD249.1 million, the gain largely based on acquisitions. The strong loonie decreased US-based sales by CAD11.3 million compared to 2006.

Earnings for the year were CAD20.4 million (54 cents Canadian per unit), a 17 percent increase from 2006. The fund generated distributable cash of CAD43.5 million (CAD1.14 per unit).

Arctic Glacier raised a total of CAD67.8 million in 2007 from equity issues to finance acquisitions, growth capital expenditures and debt reduction. Distributions to unitholders increased 23 percent to CAD42.1 million during 2007. The payout ratio increased to 96.8 percent from 87.2 percent.

As of Dec. 31, 2007, Arctic Glacier’s total debt, excluding convertible debentures, was CAD150.3 million, down from CAD186.1 million a year ago. Arctic Glacier Income Fund is a buy up to USD14.

Newalta Income Fund (TSX: NAL-U, OTC: NALUF) reported 54 percent increase in fourth quarter net income to CAD23.6 million (53 cents Canadian per unit) from CAD15.36 million (41 cents Canadian per unit) a year ago. Much of the increase came as a result of a decrease in Newalta’s estimated future income tax rate.

Revenue for the quarter ended Dec. 31, 2007, was up 12 percent to CAD137.1 million from CAD122.5 million. For full-year 2007, Newalta reported a decline in net income to CAD61.19 million (CAD1.51 per unit) from CAD75.57 million (CAD2.11 per unit) in 2006. Revenue for 2007 was up 13 percent to CAD499.9 million from CAD441 million in 2006, but lower margins, increased costs and higher borrowing costs offset the impact of future income tax recovery on the bottom line.

Newalta said it will maintain an 18.5-cents-Canadian, per-unit, per-month distribution for 2008. Buy Newalta Income Fund up to USD25.

Pipeline

Pembina Pipeline Income Fund (TSX: PIF-U, OTC: PMBIF) reported a 31 percent increase in cash flow from operations for the year ended Dec. 31, 2007, to CAD189.5 million (CAD1.52 per unit) from CAD143.9 million (CAD1.18 per unit). Pembina generated net operating income (NOI) of CAD260.1 million on revenue of CAD389.7 million; in 2006, NOI was CAD215.2 million on revenue of CAD335.8 million.

Average throughput on Pembina’s Alberta pipelines was off slightly to 422,700 barrels per day (bpd), but that figure ticked up to 454,300 bpd during the last month of 2007. Pembina forecast an increase in 2008 cash flow from operations from its conventional pipeline system.

The Syncrude Pipeline transported an average of 310,800 bpd during 2007 and generated revenue of CAD57.1 million; completion of the Horizon Pipeline in midyear should boost 2008 revenue. Operating income from Pembina’s midstream business surged 57 percent to CAD70.3 million, and the factors driving that increase should persist through 2008.

For the quarter ended Dec. 31, 2007, Pembina reported revenue of CAD101.2 million and NOI of CAD65.3 million, up 17.5 percent from a year ago. Pembina Pipeline Income Fund is a buy up to USD18.