By Duncan Sutherland – Exclusive to Heavy Oil Investing News

Heads in the Oil Sand?

Strange things are happening in the oilfield.

I was recently interviewing a veteran oilman who was eager to talk about stricter government controls on greenhouse gas emissions. What was strange was that he saw them as a business opportunity. He is involved with a pilot project that, if successful, would dramatically reduce the carbon emissions associated with heavy oil extraction. Pursuant to this, he thought that small companies will have a much easier time adapting if they develop strategies to reduce emissions before they are forced to. These sentiments are not unique. Companies are realizing that huge changes to the regulatory structures governing the oil and gas industry are increasingly likely.

Liberal leader Stéphane Dion is aggressively rebranding his party through a tax policy proposal he is calling “The Green Shift”. Part of this is to regain the political offensive after months of perceived passivity and defensiveness. Asked when the next election would be, Liberal Finance Critic John McCallum replied “I think it’s quite likely in the fall, but nobody can tell for sure”. Mr. McCallum was much more coy when speaking about whether the Liberals wanted climate change and environmental policy to be a major election theme, saying only that “It is clearly a point of distinction”.

Environmental issues are salient in Canadian politics. Win or lose, Mr. Dion’s manoeuvring will put pressure on Prime Minister Stephen Harper and the Conservative Party.

In January 2009, the United States will inaugurate a new President. Democratic Party nominee Barack Obama and Republican Party nominee John McCain are pledging to enact new policies to address climate change.

As both sides of the world’s largest energy trade relationship are re-examining their policies, the private sector has also been introspective. Business responses have been varied. Oil is an energy-intensive industry and oil sands especially so. Rising fuel prices have therefore provided a natural incentive for companies to reduce their energy use and invest in more efficient and less polluting equipment. Oil sands companies have also been looking at less intrusive ways to extract and upgrade, better methods of site cleanup, and many are in consultation with environmental groups and First Nations communities to develop more environmentally friendly practices. Though some firms have done this as a public relations exercise, or “greenwashing”, more and more players take the view of the aforementioned oilman.

Conversely, some companies are waiting to see how regulations governing their industry change before retooling their business. This is especially true among juniors who have tighter budgets and limited exposure to other sources and markets.

The Green Shift:

As Leader of the Opposition Stéphane Dion has often criticised the government’s environmental policies. The Green Shift represents a preview of how a Liberal government would approach the issue. It is a far-reaching, revenue neutral policy, with its foundation being the introduction of a carbon tax.

If implemented, the price per tonne (metric ton for our American readers) of emitted greenhouse gas would be $10 CDN. The tax is designed to rise by $10 per annum for four years. Crucially, the plan exempts gasoline at the pump from the tax. Other hydrocarbon fuels would be subject to varying levels of taxation based on levels of emissions. The Green Shift also creates new incentives for investment. The two major instruments are accelerated capital cost allowance rates (ACCA) and making the Science, Research & Experimental Development (SR&ED) tax credit 25% refundable.

Though the revenue neutral aspect of the plan includes corporate tax reduction “by an additional one per cent within four years”, the plan stipulates that “The 700 large final emitters … will account for a significant majority of the revenue within the Green Shift”. As many of these 700 firms do oil & gas or mining work, commodities investors have reason to be attentive. Only some oil & gas juniors will be in the top 700, but business models throughout the industry will be forced to adjust.

I managed to catch Liberal Environment Critic David McGuinty and Liberal Finance Critic John McCallum for quick interviews last week. I asked each of them how they would convince the CEO of an oil sands company to come on board with the Green Shift. Mr. McCallum noted recent debates in the U.S. Senate and the French government about introducing carbon tariffs on emissions-intensive products and fuels. His pitch was “The fact that we are taking serious action in this area will prevent their products from being sanctioned or being boycotted”. Mr. McGuinty was more direct, saying “I don’t know a single CEO or member of a board who wants to play Russian Roulette with the atmosphere.”

Both Members of Parliament said that some of the finer points of the policy were being decided. I asked whether a company patenting a process that uses five or ten percent less natural gas for upgrading would qualify for the ACCA. Though both seemed amenable to the idea, neither could confirm that technologies for non-renewable resources would be covered.

The Conservatives declined to comment.

What to expect:

The current Parliament has already exceeded the average length for minority governments. An increased stress on environmental issues may carry the day for the Liberals in an election by draining votes from the far left and centre-right. The Conservative Party knows this. They are already debating how to flesh out the Regulatory Framework for Air Emissions. As it stands the Framework offers much more flexibility to companies. If they are unable or unwilling to cut emissions directly, firms will be permitted to contribute to a technology fund, utilize inter-firm trading of credits or offset programs and count investment in “large-scale and transformative projects” toward the totals. Indeed, one of the chief characteristics of the framework is its malleability. Though it stresses that “regulations finalized in 2009 to come into force as planned on January 1, 2010”, and that “its intention [is] to move from emission-intensity targets to fixed emission caps in the 2020-2025 period”, there remains the important caveat that “any decision in Canada … would take into account developments occurring in other countries, especially the United States”.

Regardless of what plan or combination of plans becomes law, the take home message is that heavy oil companies need clear and practical strategies to clean their operations and they need them soon. Concern about climate change is not going to disappear among the public. All feasible candidates for federal government in Canada and the United States will enact tougher strictures on the operations of oil sands companies. The bright side is that high energy costs have already forced the industry to examine more efficient options. Many, like the oilman I was interviewing, see benefits in being ahead of the regulators.

From an investment standpoint, it is becoming more important to analyze an oil producer’s green strategy and its impact on the business. Companies that have done their homework and developed new strategies for energy efficiency, green research and development, and site cleanup will hit the ground running whatever regulations are introduced. Companies planning to react to legislative mandates will be caught flat footed. As Mr. McGuinty put it, “Burying your head in the oil sands is insane”.

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