MEG’s Bitumen-by-Barge Winning Over Investors: Corporate

MEG Energy Corp.’s plans to avoid a pipeline bottleneck and record discounts for Canadian crude by shipping oil by rail and barge are being rewarded by investors.

MEG, based in Calgary, is the second-best performer on the Standard & Poor’s/TSX Energy Index, rising 15 percent this year and beating other oil-sands competitors including Suncor Energy Inc. and Cenovus Energy Inc. The gain comes as MEG’s only product, Canadian heavy crude, stands $30.50 below the U.S. benchmark.

“We see a step change in production and cash flow as it more than doubles capacity and starts to ramp up transportation to the Gulf of Mexico that will result in dramatically higher pricing,” said Andrew Potter, an analyst at CIBC World Markets in Calgary, in a note. Potter says MEG is one of the bank’s “top overall picks for 2013.”

MEG and other bitumen producers operating in Alberta are wrestling with lower demand from their main U.S. market as rising shale oil from reserves like the Bakken in North Dakota flood refineries with oil supplies. A lack of pipeline capacity is also limiting Canadian oil companies’ access to other markets with higher prices such as China.

Western Canada Select traded at $42.50 a barrel less than West Texas Intermediate on Dec. 14, the most since Bloomberg began keeping records. The discount has since narrowed to $31.50 a barrel on Feb. 1. The lower prices spurred MEG executives to find ways to avoid the bottlenecks.

‘Creative Solution’

“Many of us spent considerable time assessing the price differentials between Canada and the North American mid-continent and international markets,” said Don Moe, MEG’s vice president for marketing in a Jan. 31 conference call with analysts.

The “creative” solution Moe and colleagues devised involves constructing a storage tank facility, a rail terminal and setting up contracts with barge and railways to get future production to markets where the company can match the price of Mayan crude, a heavy blend comparable to Canadian oil-sands output that traded recently at about $108, 64 percent more than Western Canada Select, according to data compiled by Bloomberg.

MEG will use barges to transport oil via the U.S. inland waterway system, which includes the Mississippi River and connecting waterways, to the Gulf of Mexico, said Moe. The stock fell 0.3 percent to C$35.04 at the close of trading in Toronto today.

MEG could have earned $15 more per barrel in the fourth quarter if the new logistics arrangement, which will cost “well under” $10 a barrel, had been in place, he said.

‘Wake-up Call’

“People tend to underestimate the length of time that these arbitrages can exist and they can underestimate the costs that it can take to overcome these arbitrages and the level of complexity,” said John O’Connell, a portfolio manager at Davis Rea in Toronto, which has C$600 million ($600 million) under management. The discounts have been a “wake-up call” for the Canadian industry, he said.

MEG, which produces bitumen using steam-injection technology, spent C$8.95 per barrel in the fourth quarter to extract the tar-like substance from below the frozen soil of northern Alberta. The company reported a loss of C$18.7 million compared with profit of C$91.1 million a year earlier.

Bitumen is processed into fuels such as gasoline and diesel using a combination of upgraders and refineries.

While MEG, with production of about 32,000 barrels a day in the most recent quarter, is adjusting to the pricing, others have not. Larger producers are constrained by limits on volumes of oil that can be moved by rail or barge.

‘Extreme Weakness’

Cenovus on Jan. 8 said it plans to expand shipments by rail this year to about 10,000 barrels a day to counter price discounts. That’s a fraction of the company’s expected daily production of between 180,000 to 196,000 barrels a day this year, a figure that will rise to 500,000 barrels by 2021.

Pipeline bottlenecks are costing producers as much as $33 billion a year, according to a report by the Canadian Imperial Bank of Commerce.

Fourth-quarter financial results from oil-sands producers will be “the calm before the storm,” said CIBC’s Potter in a Jan. 30 note. Earnings for the first three months of 2013 “could show extreme weakness for bitumen producers,” he said.

Cenovus, which can counter price discounts with its part ownership of two refineries, reports fourth-quarter results on Feb. 14. The Calgary-based company will report a 26-percent gain in net income for the quarter, according to the estimate of five analysts compiled by Bloomberg.

Smaller Producers

“In the short term, I think it’s a big deal for those firms that don’t have downstream,” said Vijay Viswanathan, director of research and portfolio manager at Mawer Investment Management Ltd. in Calgary, which has about C$14 billion in assets under management. “My sense is that those that are not as strongly positioned, the smaller producers that don’t have as healthy balance sheets, will probably find it difficult.”

Canadian Oil Sands Ltd., the largest owner of Syncrude Canada Ltd., on Jan. 31 said net income fell to C$221 million in the fourth quarter from C$232 million. The company saw profit margins erode in the final months of 2012 as the realized selling price per barrel slipped 14 percent to C$89.99 from the year-earlier quarter.

Suncor, the largest Canadian oil sands producer by market value, will likely say fourth quarter net income fell 26 percent, according the estimate of five analysts complied by Bloomberg. The company announces quarterly results after the close tomorrow.

The discount is also being felt more broadly by the Alberta government. Premier Alison Redford on Jan. 24 said the province will collect C$6 billion less revenue in 2013 as a result of the low price for Canadian heavy oil.

Keystone XL

TransCanada Corp. is waiting for approval from the U.S. State Department to begin construction of its $5.3 billion Keystone XL pipeline that would link oil-sands production to refineries on the Gulf Coast, and Enbridge Inc. is in the middle of regulatory hearings for its Northern Gateway conduit through British Columbia to the Pacific Ocean. Even with a green light, the earliest Keystone XL would be shipping crude is 2015 and Gateway would come online about two years later.

With the prospect of a persistent discount, keeping costs in check will also determine which companies will best survive the current pricing gaps, said Bruce Edgelow, vice president of energy at ATB Corporate Financial Services.

“At the end of the day, what’s going to really count is the same thing that’s always counted, the low-cost producers get rewarded,” he said in an interview from Calgary