THE LAST BARREL STANDING

the Last b :arrel Standing A capital Markets Viewpoint on canadian Oil Sands’ Sustainability Advantage

BY JARED DZIUBA, CFA, BMO CAPITAL MARKETS OCTOBER 2021

CANADA’S OIL SANDS BUSINESS WILL BE A SURVIVOR.

Within the context of an accelerating energy transition, our Capital Markets view is that Canada’s oil sands sector can position itself well for the future given: • its strong ESG leadership track record, • clear evolving technology pathways to net zero, • the inherently low decline, relatively low sustaining capital nature of extraction processes, and • unique existing and developing opportunities to divert bitumen from fuel end use, to non-combusted products. If we are correct, the Canadian oil sands could stand as one of few oil sources outside of OPEC to sustain production, and potentially gain market share, in the global ‘friendly oil’ supply opportunity that we envision as inevitable for the coming decades. While this statement may conjure disbelief from some readers, let’s consider the elements that support the ‘staying power’ advantage of our oil sands. Practicing ESG Since Before It was a Thing. Canada is regularly recognized as a leader in environmental, social and governance practices among the world’s largest oil reserve holders, according to independent evaluations including the Yale/Columbia Environmental Performance Index (EPI), Social Progress Imperative’s Social Progress Index, and World Bank’s Worldwide Governance Indicators. We highlight the sizeable gap in Governance quality between Canada and the rest of the oil-producing world as a critical distinction, as regulatory and corporate oversight is logically a root enabler of successful environmental and social stewardship. Although contrary to the common narrative, these country ratings are reflective of Canada’s largest sectors, including oil and gas production. Indeed, Canada’s leading oil companies also achieve top ESG scores relative to global competitors according to consensus third-party ratings (CSRHub, Bloomberg SRI and MSCI), and these are consistent with our own internal Capital Markets assessment of the sector’s ESG trends.

“Canada is regularly recognized as a leader in environmental, social and governance practices among the world’s largest oil reserve holders.”

Exhibit 2: Canadian Oil & Gas Companies Top Consensus ESG Ratings

Scrutiny Has Made Us … Better. We like to say that Canada’s energy companies have been “practicing ESG since before it was a thing.” The sector has historically faced years of intense scrutiny, some for good reason - early oil sands production practices were certainly novel and crude processes which logically raised concerns about negative environmental consequences. Since then, Industry’s business and operating practices have evolved considerably, including the emergence and dominance of less invasive in situ extraction methods such as SAGD. This same history of scrutiny has shaped the world-class regulatory system and corporate oversight that the oil sands industry has in place today, and our project operators have become more disciplined and taken further action than is typical for the rest of industry - from both operating performance and disclosure perspectives. The Results Are Evident. Our work shows that the oil sands sector has led the pace of improvement in numerous ESG trends over the past decade including progress in emissions intensity, freshwater use and tailings reductions, as well as social/governance progress such as Indigenous engagement, health and safety and ESG-linked compensation. Of headline importance, oil sands emissions intensity has decreased by 44% since 1995. More recently, reported intensity has fallen 27% since 2013 versus just 13% for global oil majors and 15% for legacy U.S. oil producers. Viewed another way, the average oil sands barrel has shaved off >22 kg/bbl versus just 5 kg/bbl for competing oils. As a result, we estimate the typical oil sands barrel now emits just 5% more than the global average crude over its full life cycle from production to end use, while top-performing projects have belowaverage footprints. Oil sands producers have also reduced freshwater intensity by ~7%/ year since 2014 compared to just 3% for the global majors. Water recycling is the main differentiator, averaging 82% in 2019 versus just 29% for U.S. senior oil producers. In situ projects now routinely consume 60% less fresh water than conventional oil operations from hydraulic fracturing and waterfloods.

Mining projects, which often represent the negative image of Canada’s oil sands in the media, have also greatly evolved in fluid tailings treatment and reclamation. Some projects have cut annual tailings volumes in half, and work is advancing on waterless extraction processes that could eliminate tailings while reducing water use and emissions.

“Alberta’s bitumen holds a secret weapon in the transition ... the option to target ... several high growth ‘non combusted’ products.”

Exhibit 3: Life Cycle GHG Emissions of Crude Oils (kg CO2e/bbl)

Exhibit 5: Leading Global per-Barrel R&D Investment ($million)

Industry-Government Collaboration Means the Best is Yet to Come. The sector’s environmental performance has been enabled by industry-leading technological and process innovation, and a uniquely high level of collaboration, including government funding sources. Oil sands producers have invested more than $11 billion in R&D over the past decade including a record $1.6 billion in 2019 – notably higher than the global majors on a per-barrel basis. We sense that mounting R&D was just starting to bear fruit prior to the pandemic, and a backlog of emerging innovation in the pipeline could be poised to drive future emissions even lower. The Last Barrel Standing. Oil producers almost everywhere are facing increasing pressure to drastically reduce emissions and define credible pathways to ‘net zero.’ Within this context, the average carbon intensity of Canadian oil sands brings the exposure of still being above the average of its competition. So, with Canada’s ESG leadership and R&D strengths in mind, where does the business go from here? In a recent indepth report titled “Survivor Canada: The Unparalleled Position of Canadian Oil in a Transition Challenge,” we outlined a detailed roadmap for how the Canadian oil industry may ultimately be a key survivor in an energy transition. First, there is a clear path to net zero stemming from ongoing R&D leadership and related emissions improvements, the concentrated nature of emissions sources being highly compatible with carbon capture, and transition investments. Secondly, we emphasize that the inherent low decline, low sustaining capital advantages of the oil sands improve the sector’s staying power versus competing sources which face steep declines and reinvestment demands. Finally, Alberta’s bitumen holds a secret weapon in the transition away from fossil fuels – the option to target bitumen away from fuels toward several high growth ‘noncombusted’ products.

“We sense that mounting R&D was just starting to bear fruit prior to the pandemic, and a backlog of emerging innovation in the pipeline could be poised to drive future emissions even lower.”

Pathways to Net Zero via Technology and CCUS. In an attempt to rationalize growing net zero commitments of producers, we can chart a hypothetical roadmap to this ambitious goal starting with planned and possible breakthrough technologies, large scale Carbon Capture, Use and/or Sequestration (CCUS) and investments in biofuels, hydrogen and renewables. Underlying this pathway, it is critical to understand that leading ESG performance is not just about fuzzy feelings – it is also having a measurable impact on the economic competitiveness of companies. The aforementioned ESG performance trends have all contributed to a 45% decrease in core oil sands operating costs since 2013. Oil sands projects also have among the lowest sustaining capital requirements globally at <$10 per barrel, pointing to cash costs <$40/bbl WTI to hold production flat. At the same time companies have adopted capital allocation strategies that emphasize discipline, cash flow harvesting and returns over production growth. These are crucial factors in both financial sustainability and future environmental progress. Assuming limited growth investment the sector could generate $260 billion in free cash flow by 2030 alone, supporting ongoing leadership in R&D and a faster pace of technological advancement versus competitors. We anticipate emissions intensity could improve another 20-30% by 2030 with planned innovations, with upside from breakthrough technologies under development.and a faster pace of technological advancement versus competitors. We anticipate emissions intensity could improve another 20-30% by 2030 with planned innovations, with upside from breakthrough technologies under development.

“Critically, oil sands processes are particularly well-suited to carbon capture given large, concentrated emissions point sources primarily from clean natural gas combustion.”

“... companies are making investments in complementary transition businesses including renewable power, biofuels and hydrogen to reduce onsite emissions or provide offsets.”

The “Alberta Advantage” in CCUS. Despite technological advancement, aggregate oil sands emissions will remain significant, likely above 80 MT/year without more impactful breakthroughs, or carbon capture. Fortunately, Alberta has all the makings of a world leader in CCUS with abundant geological storage, extensive infrastructure and expertise, and a stringent regulatory system to oversee containment. Critically, oil sands processes are particularly well-suited to carbon capture given large, concentrated emissions point sources primarily from clean natural gas combustion. Assuming technologies eventually eliminate mobile and fugitive sources we expect more than 90% of oil sands process emissions may eventually be ‘capturable’ with next generation CCUS, given appropriate policy incentives. To date, lack of a comprehensive policy set has prevented widespread action; however, change may be in the wind with planned increases in the carbon price to $170/T by 2030, a ‘stackable’ clean fuel credit in 2022 and proposed federal CCUS tax credit. Complementary Investments Add, Not Subtract. As a final piece of the net zero puzzle, companies are making investments in complementary transition businesses including renewable power, biofuels and hydrogen to reduce onsite emissions or provide offsets. Suncor has led by example, with direct investments in wind and solar farms, as well as equity investments in biofuels and sustainable aviation fuel producers. We expect more to follow.

Inherent Sustainability Advantages. There is also a vitally important fundamental differentiator supporting the longevity of oil sands supply: Oil sands extraction is a completely different process than conventional oil drilling and, as such, comes with several inherent sustainability advantages. Oil sands is essentially a ‘manufacturing’ process with very low declines and therefore low replacement risk and sustaining capital demands; conversely, major conventional production sources face very high declines, high replacement risks and cost over time. With sustaining capital needs of just <$5-10/bbl versus $20-25/bbl for conventional oil, Canadian oil sands companies have by far the lowest sustaining capital ratios in the business (sustaining capex over cash flow). This means that the oil sands can be viewed as one of the most economic sources of sustained long-term supply globally and should support its ‘staying power’ versus conventional oil sources which will face much more reinvestment pressure in a transition world. The cumulative land and water use implications are also significant: a modern SAGD project will disturb just one-fifth of the land and consume one-third the freshwater as a similar-scale tight oil project over its lifetime. We suspect land and water concerns will only increase. The Road to Fossil-Free Transport is Paved with Asphalt. Finally, oil sands bitumen contains an unusually high asphaltene content of 14-20% compared to 1-4% for most competing light oils. These ‘bottoms of the barrel’ give bitumen its relatively high production emissions profile, but ironically may also promote its use in several non-combusted products, for example, asphalt now and carbon fibre in the future – all markets that will see material growth on the back of population, mobility and infrastructure spending trends. Regardless of energy source, demand for road vehicles is widely expected to double by 2050 in support of massive infrastructure spending. As such, asphalt demand may grow by at least 3.6%/year to exceed 200 MT by 2030. Bitumen may also be well suited for producing carbon fibre if, as targeted, costs can be driven down to 1/10th those of current processes, while the U.S. Department of Energy has suggested a 50% reduction in cost could drive market expansion >10x. This little-known potential opportunity may play a vital role in the sector’s long-term sustainability as it suggests meaningful alternative markets may be available for bitumen in the event of long-term fossil fuel demand destruction. While still in its infancy, R&D is advancing rapidly and there are indications that non-combusted markets could potentially absorb >30% of bitumen supply, greatly reducing the downstream and end-use (Scope 3) emissions that comprise the largest portion of oil sands’ overall carbon footprint.

“This means that the oil sands can be viewed as one of the most economic sources of sustained long-term supply globally.”

Exhibit 6: Corporate Sustaining Capital Ratios (Sustaining Capital/Cash Flow)

Exhibit 7: Global Oil Supply Gap – Demand vs Decline (000 b/d)

Pivotal Moment to Capture Long-Term Opportunity. Our outlook for long-term global oil demand is more constructive than what is headlined in various hypothetical ‘net zero’ narratives. However, even in a transition where hydrocarbon-sourced fuel demand falls precipitously, we still see the need for substantial upstream investment to offset steep declines in global conventional oil production. It is logical to expect ESG friendly sources will play a meaningful role in such investments. If we are correct about the Canadian oil sands’ uniquely sustainable supply position, this sector could stand as one of few regions outside of OPEC to actually grow its market share over the next two decades. This is a pivotal moment, and an opportunity for the sector to double-down on its efforts and gain policy support for initiatives toward the mutual net zero goal. Government-industry cooperation and industry’s ambition have never been stronger, and we are increasingly optimistic that progress toward the sector’s goals will accelerate and maintain a leading pace. Our view: After all has been said and done, Canada’s oil sands industry will be a survivor.

This article is based on excerpts from a larger report ‘Survivor Canada: The Unparalleled Position of Canadian Oil in a Transition Challenge’ published by BMO Capital Markets, June 2021. For a full copy of the report, please contact journal@choa.ab.ca.

“Government-industry cooperation and industry’s ambition have never been stronger, and we are increasingly optimistic that progress toward the sector’s goals will accelerate and maintain a leading pace.”

Jared Dziuba, CFA Director, Oil & Gas Equity Research, BMO Capital Markets

Jared has extensive experience covering the Canadian large-cap, emerging oil sands and international energy sectors. In his current role as Oil & Gas Market Specialist, Jared oversees the evaluation and execution of industry thematic research and special projects. Recent studies include perspectives on the ESG performance of the Canadian oil sand sector, the opaque world of Natural Gas Liquids (NGL’s), Non-OPEC project supply and Electric Vehicles & Oil demand.