April 26 2023 Interview with Jared Dziuba Part 2

THE GREAT CANADIAN CCUS DILEMMA: Is 2023 a Make or Break Year?

Interview with Jared Dziuba, BMO Capital Markets Part 2 of 2

CHOA JOURNAL - APRIL 2023 I 10

What happened in California that cause the value of LCFS credits to crater?

Recent weakness in the California LCFS market is a consequence of supply/demand imbalance in the market for LCFS credits.

Our understanding is that this has been driven largely by the rapid buildout of renewable fuel facilities eligible to generate credits, which in turn has flooded the market with an oversupply of credits relative to compliance demand (traditional fuel facilities needing to purchase offsets). Exacerbating the issue, California’s LCFS regulation does not require that facilities reside within the state, meaning that facilities elsewhere in the U.S. can qualify if they can prove that their fuel may be marketed for sale within California. The important readthrough to the Canadian market is that policies must be considered and implemented carefully to avoid similar imbalances and creating price signal distortions. We believe that widespread investment in CCUS by Canadian producers, in combination with other transition energy ventures like hydrogen and renewable fuels, presents meaningful risk of similar credit market oversupply. This risk could be further exacerbated by federal involvement in carbon markets such as restricting the oil & gas sector’s ability to trade credits across industries, which has been proposed. Policy frameworks are needed to protect the outlook and certainty around future carbon values for CCUS to support project economics.

"... widespread investment in CCUS by Canadian producers, in combination with other transition energy ventures like hydrogen and renewable fuels, presents meaningful risk of similar credit market oversupply."

Why is 2023 a pivotal, make-or-break year for Canadian CCUS?

Despite building industry excitement, we believe 2023 presents a critical window for Canada and its industry to converge on policy solutions that will enable all parties to meet mutual emissions reduction targets by 2030. Given the long lead time nature of project permitting and development, the Pathways project for example likely must finalize a pipeline application by year-end 2023 and possibly sanction the project by year-end 2024 in order to be operational by 2030.

There are still many hurdles to overcome before we see widespread CCUS development in Canada. However, we expect that at least more clarity for emitters will be established by year end as additional policy gets fleshed out in coming months, including the possibility of positive reinforcements like provincial funding in order to help de-risk CCUS investment.

This could finally bridge investment support for some early stage projects. In fact, we do expect certain small-medium scale buildouts of CCUS could proceed without major further improvements to the policy framework in Canada, especially those with a supplementary revenue source or low hanging fruit opportunities at the low end of the complexity curve. This may also eventually include early projects from Pathways partners, some of which have first mover advantages due to their operating proximity to pore space. Any such progress indicators could be pivotal to supporting investor confidence. "... we do expect certain small-medium scale buildouts of CCUS could proceed without major further improvements to the policy framework in Canada "

What catalysts could shift Canadian project returns in support of widespread deployment?

We are anticipating that additional funding support for CCUS projects may come from the Alberta Provincial government, potentially in some form of royalty cost deduction for decarbonization, a proposed expansion of the Alberta Petrochemical Incentive Program (APIP), or both. In addition, we are cautiously optimistic that Federal policymakers, under pressure from the recent U.S. and European Union policy upgrades, will further bolster their offering to improve competitiveness of Canadian projects given their ultimate importance to meeting mutual emissions reduction goals.

What risk do growing compliance and net zero technology costs place on corporate returns?

We estimate that the financial impact of carbon compliance costs to oil & gas producers is minimal before 2030 at ~2-3% of corporate free cash flow, but it is a growing risk over time and could consume a more noticeable 20% of free cash flow by 2040/2050 without further action to reduce emissions. Similarly, net zero technology investment costs have a negligible impact on corporate returns before 2030, but a growing spread in return outcomes relative to a ‘business as usual’ case by 2040. While returns are still healthy under our commodity price outlook, the impact of net zero costs becomes a much more serious impediment to producer cash flows and returns under the assumption of lower commodity prices, which is a substantial uncertainty and risk over the long life of these projects.

In addition to the financial risk to producers, growing carbon compliance places an extra cost burden on Canadian producers relative to companies operating in other producing regions, ultimately reducing industry’s competitiveness. The Canadian market has already seen substantial investor capital flee to other countries or sectors as a result of these measures and the implications for netbacks versus competing producers elsewhere.

Why isn’t the cost of net zero a major detriment to investor returns?

Despite the fact that net zero costs are significant and certainly erode corporate returns on capital relative to a business as usual case, the impact is negligible before 2030, and we still expect net zero corporate returns to be quite healthy at >20% under our current long-term commodity price forecast.

Similarly, net zero cost erosion does not necessarily impede on free cash flow enough to change the positive outlook we have for cash returns to shareholders in the form of dividends and share buybacks. As mentioned, most producers are expected to generate surplus free cash flow despite projected growth in cash returns even if bearing full cost of net zero technology.

"The Canadian market has already seen substantial investor capital flee to other countries or sectors as a result of these measures ."

What will Net Zero cost industry, and how will it impact its financial position?

The potential cost of carbon compliance and/or net zero technology investment is significant – we estimate more than $140 billion for Canadian oil sands producers alone. That said, we expect that oil and natural gas prices will remain strong for the foreseeable future, ironically stemming from sustainability pressures on producers and historical underinvestment in upstream supply. As a result, we project that surplus industry free cash flow could exceed $120 billion by 2030 alone. "... the question is not whether industry can fund [net zero], but whether projects generate acceptable returns."

Unfortunately, this has become a major source of contention clouding policy given the public perception that industry can, and therefore should, fund decarbonization. The problem with this logic is threefold: First, it ignores the uncertainty and risk inherent in commodity markets. While the outlook for industry free cash flow is robust under our long-term oil price assumption of $80/bbl, this funding position deteriorates quickly at lower price assumptions.

Second, it conveniently overlooks the fact industry is already contributing immense amounts of ‘windfall’ tax to governments as a function of Canada’s progressive petroleum fiscal regime. We estimate that Canadian government take from the oil and gas industry could exceed $250 billion over the next five years, including $80 billion in federal income tax. Finally, emitters (most of which are publicly held) clearly have a duty to protect shareholder capital. So the question is not whether industry can fund it, but whether projects generate acceptable returns.

"There are two main, polar opposite schools of thought around who should bear the cost of decarbonization."

Without competitive policy there is substantial risk of monetary and intellectual capital leakage to other regions. “Based on our industry discussions, we already sense that investment and intellectual capital are being re-directed to non-Canadian opportunities”. Can you elaborate?

Several emitters and CCUS technology companies that we have spoken to have expressed that their investment focus has been redirected toward opportunities in the U.S. following release of the latest IRA policy and given the complexity and ongoing uncertainty associated with the current Canadian policy framework. In addition, there has been a notable increase in project sanction and development activity in the U.S. over the past year relative to Canada.

"Canadian producers already contribute immense ‘windfall’ tax as a function of progressive fiscal systems (>$250 billion over five years). We argue these funds are more appropriate to leverage in funding social costs like decarbonization than shareholder capital." Why do you argue this?

There are two main, polar opposite schools of thought around who should bear the cost of decarbonization. On the one hand (and our perspective), industrial decarbonization is a societal issue because at the end of the day, emissions are driven by underlying consumer demand for products. In theory the burden of climate change costs should logically fall on consumers until consumption habits shift. Of course, many social costs including welfare and healthcare are supplemented by government tax revenues in order to preserve household wealth and support the economy. On the other hand, many policymakers and environmental lobby groups claim that industry is to blame for emissions, and that investor capital should be sacrificed. Again, the risk of this thinking is both capital (monetary and intellectual) and carbon leakage to other (potentially less responsible) producing regions which may ultimately hinder Canada’s progress toward emissions goals. In the end it may be a moot point as we suspect consumers ultimately pay the price via fuel and product costs, regardless of who actually funds decarbonization.

Jared Dziuba, CFA, Analyst BMO Capital Markets Jared Dziuba, CFA, has over 15 years experience as an equity research analyst with BMO Capital Markets, covering a full spectrum of subsectors within the global oil & gas industry. In his current role, Jared oversees the execution of industry thematic research, providing insight to BMO’s institutional investor clients on emerging trends that influence the long-term investment prospects of the energy business.

Interviewed in March 2023 by Owen Henshaw, Innovation Engineer at Cenovus and Board member of the Canadian Heavy Oil Association.