Oil and Gas Industry Darren Prins Dylan Watson Jorge Cruz Ian Harcus Lisa Banxachai.

Oil and Gas IndustryOil and Gas Industry

Darren PrinsDarren Prins

Dylan WatsonDylan Watson

Jorge CruzJorge Cruz

Ian HarcusIan Harcus

Lisa BanxachaiLisa Banxachai

OutlineOutline

IntroductionIntroduction– Industry overviewIndustry overview– Risk analysisRisk analysis

SuncorSuncor– Corporate ProfileCorporate Profile– Risk ManagementRisk Management

Canadian Oil SandsCanadian Oil Sands– Corporate ProfileCorporate Profile– Risk ManagementRisk Management

Oil and Gas Oil and Gas Industry StructureIndustry Structure

The oil and gas industry is a branch of the Energy IndustryThe oil and gas industry is a branch of the Energy Industry Oil and Gas Industry components:Oil and Gas Industry components:

– Upstream operations (Exploration)Upstream operations (Exploration)– Midstream operations (Refining)Midstream operations (Refining)– Downstream operations (Distribution and sales)Downstream operations (Distribution and sales)

The industry is pro-cyclical (it is positively correlated with The industry is pro-cyclical (it is positively correlated with the business cycle)the business cycle)– Pro-cyclical demandPro-cyclical demand– There have been negative supply shocks (1970’s OPEC and There have been negative supply shocks (1970’s OPEC and

current OPEC quotas)current OPEC quotas) Barriers to entry due to high capital requirementsBarriers to entry due to high capital requirements

Oil Industry StructureOil Industry Structure

Global Industry:Global Industry: Top 10 Oil Producers and ConsumersTop 10 Oil Producers and Consumers


Global Industry:Global Industry: Largest Oil Companies by production (Oil and Gas Journal, 1999)Largest Oil Companies by production (Oil and Gas Journal, 1999)

– State-owned companies are marked with a star State-owned companies are marked with a star **

Oil & Gas Journal, 1999

http://www.gravmag.com/oil2.html

Oil Industry StructureOil Industry Structure Global Industry:Global Industry:

– Technically Recoverable Technically Recoverable Reserves:Reserves: the amount of oil the amount of oil that experts are certain of that experts are certain of being able to extract without being able to extract without regard to cost from Earthregard to cost from Earth

– Only a small fraction of the Only a small fraction of the World’s Technically World’s Technically Recoverable Reserves can be Recoverable Reserves can be extracted at current prices. extracted at current prices.

– Of the known oil reserves that Of the known oil reserves that can be profitably extracted at can be profitably extracted at current prices, more than half current prices, more than half are in the Middle East; only a are in the Middle East; only a small fraction are in North small fraction are in North America.America.

World's Technically Recoverable Reserves (billions of barrels)

7%

93%

North America

Rest of the w orld


Global Industry:Global Industry:– World Oil Demand is World Oil Demand is

projected to grow by projected to grow by over 2 percent in 2004 over 2 percent in 2004 and 2005.and 2005.

– On the supply side, oil On the supply side, oil inventories have been inventories have been low for the last year low for the last year and are expected to and are expected to remain the same for remain the same for 2004 and 20052004 and 2005

Oil Industry Structure Oil Industry Structure (North America)(North America)

US: General aspectsUS: General aspects– The United States is The United States is

the world's the world's largest largest energy producerenergy producer, , consumer, and net consumer, and net importer. It also ranks importer. It also ranks twelfth worldwide in twelfth worldwide in reserves of oilreserves of oil

– During 2002, the During 2002, the United States United States produced around 8.1 produced around 8.1 million barrels per day million barrels per day

Energy Information Administration:

http://www.eia.doe.gov


US: ImportsUS: Imports– US oil demand has US oil demand has

been increasing by 3% been increasing by 3% on averageon average

– Imports from:Imports from: Persian GulfPersian Gulf MexicoMexico CanadaCanada VenezuelaVenezuela




US: Sector OrganizationUS: Sector Organization– Merger activity in the oil Merger activity in the oil

business accelerated business accelerated sharply during 2000 and sharply during 2000 and 2001 (before slowing 2001 (before slowing considerably in 2002 and considerably in 2002 and early 2003). early 2003).

– The largest The largest merger/acquisition merger/acquisition announcements came from announcements came from BP and Amoco, Exxon and BP and Amoco, Exxon and Mobil, BP Amoco and Mobil, BP Amoco and ARCO, and, most recently, ARCO, and, most recently, Chevron and TexacoChevron and Texaco


US: ProductionUS: Production– Top producing areas as of 2002:Top producing areas as of 2002:

Gulf of Mexico (1.6 million bbl/d) Gulf of Mexico (1.6 million bbl/d) Texas onshore (1.1 million bbl/d)Texas onshore (1.1 million bbl/d) Alaska's North Slope (954,000 bbl/d)Alaska's North Slope (954,000 bbl/d) California (707,000 bbl/d)California (707,000 bbl/d) Louisiana onshore (274,000 bbl/d)Louisiana onshore (274,000 bbl/d) Oklahoma (181,000 bbl/d)Oklahoma (181,000 bbl/d) Wyoming (150,000 bbl/d). Wyoming (150,000 bbl/d).


Canada: General aspects:Canada: General aspects:– Canada was the fifth-largest Canada was the fifth-largest energy producerenergy producer in the world in 2001: in the world in 2001:

39% natural gas39% natural gas 25% oil25% oil 20% hydropower20% hydropower 11% coal11% coal 5% nuclear power5% nuclear power

– 3rd largest producer of natural gas3rd largest producer of natural gas– 9th largest producer of crude oil9th largest producer of crude oil

Oil sands account for approximately 30% of Canada’s total oil Oil sands account for approximately 30% of Canada’s total oil productionproduction

– According to According to Oil & Gas JournalOil & Gas Journal, Canada's total crude oil reserves , Canada's total crude oil reserves stood at 180 billion barrels as of January 2003stood at 180 billion barrels as of January 2003

– Annual Production Average: 2.9MM bbl/dAnnual Production Average: 2.9MM bbl/d– Annual Consumption Average 2.0MM bbl/dAnnual Consumption Average 2.0MM bbl/d– Exports 2002:1.5MM bbl/d crude (to US)Exports 2002:1.5MM bbl/d crude (to US)


Canada: General aspects:Canada: General aspects:




Canada: ExportsCanada: Exports– Canada is a major source of Canada is a major source of

U.S. oil imports. In 2002, the U.S. oil imports. In 2002, the United States imported 1.97 United States imported 1.97 million bbl/d of oil from million bbl/d of oil from Canada.Canada.

– This makes Canada the top This makes Canada the top petroleum supplier to the petroleum supplier to the United States and the third-United States and the third-largest supplier of crude oil largest supplier of crude oil imports (behind Saudi Arabia imports (behind Saudi Arabia and Mexico, and ahead of and Mexico, and ahead of Venezuela).Venezuela).

– Canada has been the top Canada has been the top supplier to the United States supplier to the United States of refined petroleum products, of refined petroleum products, including gasoline, jet fuel, including gasoline, jet fuel, distillate, etc., since 1996. distillate, etc., since 1996. Energy Information Administration:



Canada: ExportsCanada: Exports

CAPP: www.capp.ca


Canada: Sector OrganizationCanada: Sector Organization– Significant mergers and acquisitions in recent years. Significant mergers and acquisitions in recent years. – In 2001, U.S. firms purchased over $35 billion in In 2001, U.S. firms purchased over $35 billion in

Canadian oil and gas assetsCanadian oil and gas assets including the purchase of including the purchase of Gulf Canada.Gulf Canada.

– EnCana Corp. EnCana Corp. was the result of the merger between was the result of the merger between the 2 largest Canadian oil companies. It is now the 2 largest Canadian oil companies. It is now the the world's largest independent oil and natural gas world's largest independent oil and natural gas producer (by market value).producer (by market value).


Canada: Sector OrganizationCanada: Sector Organization

CAPP: www.capp.ca


Canada: Exploration and Canada: Exploration and ProductionProduction– The industry is based primarily The industry is based primarily

in in AlbertaAlberta The The Athabasca Oil Sands Athabasca Oil Sands

depositdeposit, in northern Alberta, is , in northern Alberta, is one of the two largest oil sands one of the two largest oil sands deposits in the worlddeposits in the world (Oil (Oil Sands)Sands)

– Atlantic CoastAtlantic Coast: Mainly in : Mainly in NewfoundlandNewfoundland

– Pacific Coast:Pacific Coast: T The British he British Columbia government is Columbia government is pushing to lift a 30-year-old ban pushing to lift a 30-year-old ban on exploration in the Pacific on exploration in the Pacific Ocean in order to begin Ocean in order to begin production by 2010production by 2010..


Canada: Main ProducersCanada: Main Producers– EnCanaEnCana– SyncrudeSyncrude (a joint venture of eight companies with Canadian Oil (a joint venture of eight companies with Canadian Oil

Sands Investments Inc. having the largest stake) is Canada's Sands Investments Inc. having the largest stake) is Canada's largest producer of crude from oil sandslargest producer of crude from oil sands..

– SuncorSuncor,, the first company to begin processing Alberta oil sands the first company to begin processing Alberta oil sands in 1967, completed in 2001 its Project Millennium, which increased in 1967, completed in 2001 its Project Millennium, which increased production capacity to 225,000 bbl/dproduction capacity to 225,000 bbl/d

– Shell Canada LimitedShell Canada Limited– Chevron Canada LimitedChevron Canada Limited (a wholly owned subsidiary of (a wholly owned subsidiary of

ChevronTexaco Corp.) ChevronTexaco Corp.) – Western Oil Sands IncWestern Oil Sands Inc

– Canadian Oil Sands Canadian Oil Sands

Oil and Gas Industry Structure Oil and Gas Industry Structure (North America)(North America)

Canada: Natural GasCanada: Natural Gas– Canada is the third Canada is the third

largest natural gas largest natural gas producer (after the producer (after the United States and United States and Russia) Russia)

– Second largest natural Second largest natural gas exporter (after gas exporter (after Russia)Russia)..



ProductsProducts

Products Being Products Being Produced:Produced:– Oil:Oil:

GasolineGasoline KeroseneKerosene Jet FuelJet Fuel LubricantsLubricants

– Natural GasNatural Gas Major SubstitutesMajor Substitutes

Nuclear PowerNuclear Power HydrogenHydrogen HydropowerHydropower CoalCoal MethaneMethane Solar energySolar energy

Galons obtained from the destilation of a 42gal. barrel

11

5.3

20.4

5.3

0 0

21

2

9

3 34

0

5

10

15

20

25

Gasoline Kerosene gas oil anddistillates

heavierdestillates

Jet Fuel Lubricants

Product

Gal

on

s

1920

Now

RegulationsRegulations

Global:Global:– The United States maintains energy sanctions The United States maintains energy sanctions

against several countries, including Iran and against several countries, including Iran and LibyaLibya

– OPEC regulate its members oil productionOPEC regulate its members oil production

RegulationsRegulations

Canada:Canada:– Government:Government:

Efficiency and market regulations (National Energy Efficiency and market regulations (National Energy Board and Office of Energy Efficiency of Natural Board and Office of Energy Efficiency of Natural Resources Canada)Resources Canada)

Environmental Regulations (Environment Canada)Environmental Regulations (Environment Canada) Property Regulations (Provincial Government and Property Regulations (Provincial Government and

Federal Government)Federal Government)

– Self-regulation:Self-regulation: Canadian Association of Petroleum Producers Canadian Association of Petroleum Producers

(CAPP)(CAPP)

Major RisksMajor Risks General Business risk General Business risk ((production and sales uncertaintyproduction and sales uncertainty)) Financial and commodity market risk: Financial and commodity market risk: (interest rate risk, (interest rate risk, FX riskFX risk and and

in the form of volatile oil and natural gas in the form of volatile oil and natural gas pricesprices)) Excessive Excessive Cash Flow fluctuationsCash Flow fluctuations Credit risk and liquidity risk: Credit risk and liquidity risk: (Counterparty failures (airlines, etc.))(Counterparty failures (airlines, etc.)) Operational Risk: Operational Risk: ((PricingPricing)) Legal risk: Legal risk: (contract enforcement, i.e. OPEC)(contract enforcement, i.e. OPEC) Environmental RegulationsEnvironmental Regulations: Kyoto Protocol and growing : Kyoto Protocol and growing

environmental concerns (environmental concerns (Canada ratified the Protocol in December Canada ratified the Protocol in December 2002)2002)

Other: Other: – Accidents:Accidents: Plant, equipment and frontline employeesPlant, equipment and frontline employees– Lack of diversification Lack of diversification (assets and current and future investments)(assets and current and future investments)– Exploration and DevelopmentExploration and Development

Risk MeasurementRisk Measurement

Sensitivity analysis:Sensitivity analysis:– On cash flows sensitive to:On cash flows sensitive to:

Oil and gas pricesOil and gas prices Interest ratesInterest rates FX changesFX changes

– Further developed with:Further developed with: Probability calculations for movements in prices, Probability calculations for movements in prices,

interest rates and FX.interest rates and FX.

Available products and techniques Available products and techniques for risk managementfor risk management

Derivatives are at the center of the risk management for Derivatives are at the center of the risk management for these companies:these companies:

Major Products for risk management:Major Products for risk management:– Energy Futures traded in COMEXEnergy Futures traded in COMEX– FX Futures traded in CMEFX Futures traded in CME– OTC Forward contracts (oil, gas, etc)OTC Forward contracts (oil, gas, etc)– Interest rate and FX SWAPSInterest rate and FX SWAPS– Options: Costless CollarOptions: Costless Collar

Other products used for corporate purposes:Other products used for corporate purposes:– Managerial Stock optionsManagerial Stock options– WarrantsWarrants– Puts (used in stock repurchase programs) Puts (used in stock repurchase programs)


Costless Collar:Costless Collar:


Costless Collar:Costless Collar:– A A collarcollar (or (or fencefence) is a spread ) is a spread

comprising a long (short) call comprising a long (short) call and a short (long) put, both and a short (long) put, both out-of-the-money out-of-the-money and for the and for the same expiration. The strikes same expiration. The strikes can be chosen so that the can be chosen so that the purchase (sale) price of the purchase (sale) price of the call exactly offsets the sale call exactly offsets the sale (purchase) price of the put so (purchase) price of the put so the spread is a the spread is a costless collarcostless collar..

Hazards from risk management Hazards from risk management activitiesactivities

Decreased earningsDecreased earnings Liquidity pressureLiquidity pressure Potential loses from Potential loses from

hedginghedging

Corporate Profile• Integrated energy company (Canada/US)• Core business is Oil Sands

– Fort McMurray, Alberta• Market capitalization: US$11.790 Billion• 3400 employees• Oil Sands, Natural Gas, EM&R

Growth Strategy• Developing and Expanding Oil Sands

– facilities to increase the production of crude oil

• Controlling costs

• Reducing natural gas price risk – producing volumes exceeding internal demand

• Developing new marketing – further integrate Suncor’s upstream and downstream business

• Managing environmental and social performance

Financial Statement Analysis

• Income Statement

• Balance Sheet

• Statement of Cash Flow

Financial Highlights

Project Millennium

Financial HighlightsNet Earnings

89%

4%

7%

Oil Sands

Natural Gas

Energy Marketing andRefining

Cash Flow Provided from Operations

85%

9%6%

Oil Sands

Natural Gas

Energy Marketing andRefining

Cost Structure

Pipeline Network – Oil Sands Production

Sensitivity Analysis

Risk Exposure• Fluctuations in prices of:

– crude oil– natural gas

• Currencies exchange rates– Canadian $ earnings to US $

• Interest rates– cross-currency

• Counterparty Credit Risk– High credit rating counter-parties

• Environment legislation– KYOTO

Risk Management Philosophy• Suncor cannot predict or control prices• Reduce exposure to market volatility and support the

company’s ability to finance growth (artificial spot price range)

• To manage interest or currency-sensitive assets and liabilities (ex. Bonds)

• Has Audit committee that works with BOD– Assess hedging thresholds in light of price forecast

and cash

Hedging Instruments Used• Swaps

– Crude Oil – Hedging Program– Interest Rate

• Swapping floating rate and fixed rate interest payments

– Foreign Currency

• Options– Costless Collar

Crude Oil Hedges

Crude Oil Hedges

Crude Oil Hedges

• Hedged 3-4 years out; convenience yield

Interest Rate/Foreign Exchange Swaps

Hedged 9 years out; term structure of prices of currency constant

Adverse Hedging Effects• Decreased earnings by:

– $160 million (2002)– $148 million (2001)

• Reduce potential benefits of favorable changes in commodity prices and exchange rates

• Artificial spot price range created by the hedging program

Executive Compensation• Executive Stock Plan

– Granted 1.8 million options to executives– 10 year life, exercisable immediately– Exercise price=market value at expiration

• Old Plan (1997-2002)• Cash payments of $34 million to employees

Executive Compensation• New Stock Option plan (SunShare)

– Granted 9 million options to all eligible staff• 10 year life, 10 year vesting period• Accelerated vesting by meeting performance

targets• Issued at-the-money (zero expense)

– Possible adverse affects due to lack contingency

Executive Compensation

• Monitor expected future price fluctuations in the oil spot–Adjust hedge position accordingly

• Maintain natural price hedge in NG• Re-evaluate hedging ratios and hedging instruments used

–FX risk, Interest Rate

Pure Investment Intensive Progress

Corporate Profile

Canadian Oil Sands Unit Trust– An open-ended investment trust– Sole income producing asset is its percentage

ownership share in Syncrude– Syncrude is the world's largest producer of crude oil

from oil sands – Produces 13% of Canada’s petroleum requirements

Source: www.cos-trust.com; Poitras, Case Studies in Fundamental Analysis, 2004

http://www.cos-trust.com/

Corporate Profile

• Oil Sands Project: Syncrude– Syncrude is a joint venture partnership – The largest 3 share ownership:

• Canadian Oil Sands 35.49%• Imperial Oil Ltd. 25.00• Petro-Canada 12.00

– Syncrude: averages 230,000 barrels/day– Canadian Oil Sands: 66,793 b/d in 2003

Source: www.cos-trust.com


Corporate Profile

• Other Oil Sands Project (Competitors)– The Athabasca Oil Sands Project

• Shell Canada and Chevron Canada • Produces 155,000 barrels/day

– Suncor Energy Inc. (original oil sands project)

Source: www.cos-trust.com


Corporate Objectives

• 3 main objectives– Investment grade credit rating

• but also sustaining stable distribution, and • minimize discretionary equity financing

– Acquisition of oil sands assets– Lowest overhead cost structures

Source: 2002 Annual Report

Growth Strategy

• Expansion internally and externally through acquisition

• Remain in oil sands business


Financial Structure

• A unit trust

• Has characteristics of a common stock– Marketable and transferable– Variable cash flow dependant on return of a

real asset (% share in Syncrude)

• Features of an unincorporated mutual fund– Income passes to unit holders (fully taxable)– Distribution not taxable at trust level

Financial Statement Analysis

• Income Statement

• Balance Sheet

• Statement of Cash Flow


Cost Structure• Debt-to-equity

– Debt structure stands at approx. 35% - 40%

• Revenue– One product: crude

oil

• Operating costs– Approx. 50% of

revenues


Sensitivity Analysis


DateNumer of Options

Weighted Average Exercise Price

Outstanding at January 1,2003 256,000 38.67$ Granted 127,900 39.32$ Surrendered (60,000) 39.08$

Outstanding at December 31,2003 323,900 38.85$

Exercisable at December 31, 2003 65,330 38.55$

As of December 31, 2003:

Source: SEDAR - Interim Financial Statements, Jan 29, 2004


• On October 2, 2003: – Options no longer issued – Purchase of units in the secondary market

• October 23, 2003: – The directors surrendered all options in

exchange for Trust units (value of approx. $1 million)

• Cash compensation


Risk Management Philosophy

• The Trust hedges to protect the cash flow needed to fund its capital programs, while maintaining some exposure to the upside in the price of crude oil

• No formal committee dedicated to risk management or a risk management officer

Source: MD&A, 2002 Annual Report

Risk Management Philosophy

• Comprehensive Insurance program– Mitigates risk of Trust’s share of Syncrude

assets from physical damage

• Oil and natural gas price hedging– Reduce exposure to price volatility

• Hedging to protect cash flow

• Hedging of US denominated crude oil prices and Cnd-US FX rates

Source: MD&A, 2002 Annual Report

Risk Exposures

• Commodity Price risk– Crude oil prices:

• Highly leveraged by price of crude oil (sole product)• SSB product is sold for floating prices calculated

with reference to the WTI futures contract

– Natural gas price: • As a consumer, input to production• Syncrude has long-term purchase commitment;

COS share is 21.74% or $39 M

Risk Exposures

• FX risk– Fluctuations in US-Cdn currency exchange

• Revenue from oil sales based on price benchmarked in US dollars

• Pay interest in US dollars on US denominated debt

• Interest Rate risk– Impact on period when they draw on credit

facilities

Risk Exposures

• Operational Risk– Exposure to value of Syncrude Project– Lack of diversification– Syncrude expansion project– Unscheduled maintenance/outages– Business and physical loss insurance– Technology

Risk Exposures

• Regulatory environment– Kyoto: COS estimates it will cost $0.20 -

$0.30 per barrel for the first commitment period between 2008 -2012 (worse case)

– They have steadily reduced emission levels over the past 10 years

Risk Exposure

• Credit risk– Limit exposure to any one customer– Sale revenue receivables settled in the month

following the sale– Select counterparties of high credit rating for

swaps and contracts

Source: 2002 Annual Report; Q4 2003 Report

Hedging Position

Derivative Instruments


Hedging Position

• Crude Oil Hedging Program– Hedges both US$ denominated crude oil

prices and US-Cnd FX rates– To reduce revenue and cash flow volatility– 2 methods:

• US$ WTI forward contracts + foreign currency • C$ WTI forward contracts


Hedging Position

• Crude Oil Hedging Program– In 2002, loss of $10.7 M due to increase in

WTI price– Increasing position in Q4 2002 using

• Combination collars and swaps• Entire incremental production from Stage 3

expansion

– 61% in 2003; 21% in 2004 (up to 50%)


Hedging PositionCrude Oil Hedging Program


Hedging Position• Natural Gas Hedging

– Forward contracts on natural gas– 60% of forecast consumption in 2002– Resulted in hedging gains for 2002 of $5.2M– As of Jan. 2004, no natural gas hedges in

place


Hedging Position• Natural Gas Purchase Commitments

– Syncrude has long-term natural gas purchase contracts (subject to an annual price re-determination)

– Based on NYMEX natural gas futures– Syncrude to pay min. $180 M annually – COS 21.74% share is approx. $39 M– The contracts expire at varying dates until

2004


Hedging Position• Foreign Currency Hedging

– Contracts to fix exchange rate in future– Unwinding current positions– In conjunction with crude oil price hedging– Realized gains recog. when forward expires– Deferred gains of $16.5M (22M as of 2003)

to 2006 and beyond


Hedging Position

Foreign Currency Hedging


Hedging Position

• Interest Rate Hedging– 7.625% fixed Senior Notes to a 5.95% fixed

rate US dollar payment– Reduction of $1.8M interest payments in 2002

and 2001– Gains/losses recognized in period the swaps

are settled


Hedging Position

• Interest Rate Hedging


Hedging Position

• http://www.cos-trust.com/files/investor/pdf/COS_Q4_2003_FINAL.pdf

• Unrecognized gains/lossesAs at Dec 31, 2003, unrecognized– loss of $69 M on crude oil hedges – gain of $50 M on FX hedges– gain $5 M on interest rate swaps


http://www.cos-trust.com/files/investor/pdf/COS_Q4_2003_FINAL.pdf






Recommendation

• To maintain hedging strategy on crude oil, natural gas and interest rate

• Re-evaluate optimal hedge-ratio on crude oil– Production increasing but prices increasing

• Re-evaluate position and FX hedging strategy – Unwinding of position– Speculation or hedging?

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