In our previous blog, we discussed how energy companies have risen in importance to the investing public and how almost every portfolio has stocks of these natural gas and oil producers. We discussed how the price of energy rose after the Six Day War, but how the price/supply equation of natural gas has changed so radically in the past few years. We talked about the historical relationships between gas and oil and how traders took advantage of these cycles to enrich themselves.

But that concept of the relationship between gas and oil is quickly becoming a passé story. The historical ratio between oil and gas is extinct - never to return. The new reality is that the companies that produce natural gas are in for a rough ride. But companies that produce oil are in for a rougher ride.

The Effect on Natural Gas Companies

Compare the location of older sources of natural gas to the location of newer sources brought into being by fracing. If existing sources of natural gas in Canada are farther away from users of natural gas, and are more expensive to extract from the ground, and more expensive to transport great distances, why would buyers of natural gas continue to deal with these older companies? If natural gas is cheaper to buy, and closer and cheaper to transport when it is closer to home, why import natural gas from Canada. As supply contracts between producers and sellers expire, the demand for Canadian energy will be affected. The changes that are coming are obvious.

Think about AAV-TSX. Their main assets are related to the production and sale of natural gas. They have just established a committee to consider the best way to deal with the company's assets, which is another way of saying that they are having greater difficulty dealing in this new world of cheaper and easily available natural gas. Beware of any company that is in the gas business. Pricing will become more and more competitive, and profits more and more difficult to sustain. These old dividend paying companies will have to reduce their prices, resulting in dividends being reduced, resulting in lower stock prices.

Natural gas dividend-paying stocks are no longer a slam dunk. Instead they are headed for trouble.

Users Will Buy Natural Gas Rather Than Oil - Do You Want to Buy Oil Sands Companies?

So now we have a high price for oil, and a depressed price for natural gas. This unbalanced relationship will continue to worsen until economic realities inevitably take hold. We know that natural gas will not go up in value any time soon, because of its abundant availability, which is primarily because of the new technology of fracing.

Natural gas can usually be utilized for energy production, and now it is much cheaper to use natural gas than it is to use oil. Doesn't take a genius to realize that natural gas will be used more and more to replace the use of expensive oil. As demand for oil reduces, more oil is available because demand is shrinking. Obviously the price of a barrel of oil will fall.

The 1,000 Year Supply of Oil from the Canadian Oil Sands

That obvious reality takes us to the Canadian Oil Sands, considered a mainstay of the Canadian economy, and also considered a stable source of oil with sufficient reserves to supply 1,000 years of demand.

There is a tremendous source of heavy oil in Canada called the tar sands or the Oil Sands. In order to produce this heavy oil, there is a substantial cost. Enormous sums must be spent on infrastructure and on transporting the final product to markets. This is a landlocked area that is remote and not near any major markets. Once the heavy oil-laden sand is dug up from the ground, there are the costs of processing which are very substantial. Heavy oil produced from the Oil Sands is very expensive. It also requires great amounts of water to process, is considered a prime source of carbon hurting the atmosphere, and a major source of ground pollution. Compare this to the formerly plentiful supply of oil from the Middle East, which just gushed out of the ground with little effort required.

When the oil fields were found in the Middle East, depending on when and where the discovery was made, the cost of obtaining that oil could be as low as $3 / barrel. Until the oil shocks of the 1970's, oil sold around $12 / barrel. The spread between cost and selling price was quite profitable to both the suppliers of the oil and the sellers of the oil. These fields still exist and for the most part are still producing oil, yet the reserves are dwindling as demand is increasing.

The answer to the supply issues and dwindling reserves was The Canadian Oil Sands. At $100 / barrel oil, it was profitable to invest the massive sums needed to develop the Oil Sands. Industry started spending the billions of dollars to extract the oil from the sands, with additional new projects being proposed on a regular basis.

The Price of Oil From the Oil Sands

The cost of producing a barrel of oil from the Oil Sands is usually calculated at around $27 / barrel, and total project costs for proposed new projects exceed $60 / barrel. New projects are always being considered because of the vastness of the Oil Sands, and the always increasing demand for oil. But a new issue has arisen - because of the heavy nature of the oil, only certain refineries can efficiently process this crude, and then there is the problem of transportation from the Oil Sands to the refinery. The result is a unique Canadian phenomenon - the Canadian Discount. Buyers pay less for Canadian Oil heavy oil. Currently this discount can be as high as $30 / barrel.

In other words, if the average selling price of oil elsewhere is $100 / barrel, Oil Sands oil is being sold at $70 / barrel. This enormous discount is making many projects marginal at best. Add to this that there is a large shortage in pipeline capacity from the Oil Sands to markets. You surely have heard about the political storm in the USA from the failure to approve the new pipeline that would take Oil Sands oil to the southern USA.

Also consider that the USA this year is importing approximately ½ as much oil as it did a decade ago. US oil imports are shrinking significantly while domestic production of gas and oil is growing significantly. Obama made a point of saying in his inaugural speech that the US today has greater reserves than at any time in its history. THIS IS A DRAMATIC STATEMENT.

The Effects on the Oil Sands

These factors are severely affecting companies producing oil in the Oil Sands. The cost of producing the oil is coming closer to the selling price of the oil - not a great economic model. To worsen the situation, even when demand is there, there is no way to get the oil to the buyers. More of this production is going into storage until it can be sold. Producers have recently been forced to ship oil in freight trains in addition to the much more efficient pipelines. Doesn't bode well for the Oil Sands.

The Effects of the Discount From the World Price Paid to Oil Sands Producers

The discounts on Canadian heavy crude are forcing companies including Suncor Energy Inc. to delay plans worth billions of dollars and depressing their bottom lines. Major projects planned to increase the supply of oil from the Oil Sands are being shelved or re-evaluated. Most recently, Suncor - one of the largest producers of oil from the Oil Sands - has announced 'delays' in its new Oil Sands projects.

Pretty obvious what is going on.

So if you are investing in stocks of companies that produce oil from the Canadian Oil Sands, perhaps you should take a hard look at the sector.

Next we will examine the lack of common sense in the proposal to build natural gas liquefaction plants, and the shortsightedness of those that wish investors to fund the construction of new pipelines and methods of exporting natural gas.

The views expressed in this blog are opinions only and are not investment advice. Persons investing should seek the advice of a licensed professional to guide them and should not rely on the opinions expressed herein. This blog is not a solicitation for investment and we do not accept unsolicited investment funds.