MSN Money - 11/5/2006

Today's energy riddle: When is a barrel of oil not a barrel of oil?

When that barrel is buried in Canada's oil sands. At least according to the accountants at the U.S. Securities and Exchange Commission.

Estimates say Alberta's oil sands could hold reserves of 175 billion barrels of oil. That's enough to rank Canada 2 in oil reserves behind Saudi Arabia's reserves of 263 billion barrels.

Except that for accounting purposes, says the SEC, Saudi Arabia's oil meets the definition of proved reserves while most of Alberta's oil simply doesn't count. And oil companies, according to the agency, can't include it on their financial statements when they list their proved reserves.

Which creates chaos like this: On Monday, Royal Dutch Shell (RDS.A, news, msgs) announced that it had bid $2.2 billion for Canadian oil producer BlackRock Ventures (BRVTF, news, msgs), the owner of 268,000 acres of oil sands in Alberta. Those sands contain 142 million barrels of proved and total estimated reserves of 1 billion barrels. However, only the proved reserves can be booked by Shell under SEC guidelines. The difference between 142 million proved barrels and 1 billion estimated barrels is huge. Royal Dutch paid $15.50 a barrel for proved reserves, a very high price for oil still in the ground or $2.20 a barrel for total proved and estimated reserves, depending on which accounting rules you use.

Royal Dutch is fighting to convince investors that it can replace all the oil it pumps with new reserves. In announcing its first quarter 2006 results on May 4, Royal Dutch said that, because of SEC accounting, it was no longer promising to replace 100% of proved reserves for 2004-2008.

Healthy skepticism
In chaos, experienced investors know, lies opportunity -- as long as you remember that you shouldn't accept oil companies' claims of estimated oil resources at face value. Royal Dutch Shell earned investors skepticism in 2004 when it removed 4.5 billion barrels of oil from its 2002 proved reserves and 1.4 billion barrels from its 2003 proved reserves due to accounting errors.

But let's focus on the SEC's accounting rules. Oil companies can put oil resources on their books as proved reserves only if the oil is currently under production and has been shown to be economically and legally producible under existing conditions. All other oil resources -- call them "recoverable reserves," "probable reserves," or "recoverable resources" -- are more uncertain than proved reserves. Investors should mark them down in value because of that uncertainty before calculating the value of an oil company.

In a lot of instances that's a sensible rule. It discourages fly-by-night oil operators from selling investors stock backed by grandiose estimates of their oil and gas reserves when that oil and gas can't be produced for economic or technical reasons. The promoters of stocks like these come out of the woodwork when oil and natural gas prices are high, as they are now. My mail and e-mail is full of newsletters touting the reserves of oil and gas companies that I've never heard of. At least the strict SEC rules mean there's a reasonable likelihood that the financial statements oil companies file with the SEC aren't completely fraudulent.

Deep discounts
But it doesn't work very well when new technologies turn previously unrecoverable oil and natural gas into proved resources. That's what has happened gradually over the last 25 years with the natural gas trapped in oil shale formations like Texas's Barnett Shale. Initial wells, drilled by Mitchell Energy, had to go to what were then extraordinary depths -- 7,500 feet -- and employ expensive fracturing techniques to get the natural gas to the surface. Even then the wells were recovering only 7% of the natural gas in the formation. No way that these resources could be listed as proved.

But beginning in the late 1990s, new fracturing technology improved yields and cut costs. As Mitchell began to actually produce energy from the formation, the natural gas went from estimated resources to proved reserves. Devon Energy (DVN, news, msgs) bought Mitchell Energy for $3.1 billion in cash and stock in a deal that closed in 2002. At the time of purchase, Devon Energy acquired 2.5 trillion cubic feet of proved natural gas reserves. Since then, the company has produced 750 billion feet of natural gas from these properties and booked an additional 1.3 trillion cubic feet of reserves.

Devon Energy bought more Barnett Shale acreage from privately held Chief Holdings this year. "As with Mitchell Energy in 2002, the value of Chief to Devon is not fully reflected in current production or booked reserves," Devon CEO Larry Nichols said. "The true value lies in the trillions of cubic feet of natural gas underlying its acreage in the shale."

I think the same thing will happen to Canada's oil sands -- if oil prices hold up. Technology to mine the sand and turn it into oil isn't the issue: It's being proved and gradually improved as companies such as Canadian Natural Resources (CNQ, news, msgs) ramp up production.

The big SEC accounting issue is economic. Estimates of break-even prices for Canada's oil sands range from $25 to $40 a barrel. If oil demonstrates that it's above $40 to stay, more and more of these oil sands will make the journey from estimated resources to proved reserves. And that will make the stocks of these companies more and more valuable.
Caveat emptor
This logic also assures that these stocks will be even more volatile than the average oil stock. You're doubling your bet on high oil prices. First, because production from oil sands requires oil to stay above $40 a barrel (my preferred estimate) for these companies to be profitable. Second, because the longer oil can stay above $40, the more certain the value of the resources at oil-sands companies become.

On my regular Wednesday morning appearance on CNBC's "Morning Call" I recommended these three oil-sands stocks.

Canadian Natural Resources (CNQ, news, msgs). I like the company's willingness to distinguish between barrels in place -- 16 billion -- on the 115,000 acres of oil sands it leases in Alberta, and recoverable barrels -- 6 billion -- with current technology. The company's big bet on oil sands, the Horizon Phase 1 project, is on time and on budget for producing its first oil in 2008. Production in Phase 1 will ramp up to 110,000 barrels a day. That would be a significant increase to the company's production of 560,000 barrels a day during the first quarter of 2006 from conventional oil and gas wells in Canada, the North Sea and office West Africa. The stock recently pulled back on disappointing first-quarter results as costs rose and natural-gas prices fell. Our StockScouter rates the shares a 5 out of a possible 10.

Imperial Oil (IMO, news, msgs). Owning these shares gives an investor wide exposure to a range of oil-sands projects and technologies. The company's Cold Lake project uses cyclic steam to recover heavy oil in place without mining. It's Kearl and Syncrude projects (it owns 25% of Syncrude) rely on surface mining of the oil-bearing sands. While the Kearl project is hoping for a permit by the end of 2007, the Syncrude project is undergoing an expansion in production to 350,000 barrels a day from 250,000. This one has also pulled back on a first-quarter earnings miss. Our StockScouter rates the shares a 6.

Synenco (SYNEYF, news, msgs). Okay, this is the riskiest of the bunch. The company leases one of the last undeveloped hunks of mine-able oil sands and also has the rights to several other areas that might be suitable for in-situ production using steam injection technology like that used by Imperial Oil. The company went public in 2005 and has cash to take it through engineering and permitting work to be completed in 2007. After that the company will have to raise more capital. (China's Sinopec is a 40% partner, which should assure Synenco of access to sufficient capital. This stock isn't rated by our StockScouter.

As usual I have two other "exclusive" picks for readers of CNBC.com on MSN Money. These two stocks provide ways to profit from the oil sands boom with less risk.

Enbridge Energy Partners (EEP, news, msgs). This is a master limited partnership run by Enbridge (ENB, news, msgs), a crude-oil-pipeline company that transports 60% of the oil from Alberta's oil sands into the United States. The master limited partnership yields 8.4% and Enbridge yields 3.3%. Both are rated 6 by our StockScouter. (Please talk to your accountant about the tax treatment of master limited partnerships.)

Encana (ECA, news, msgs). This natural-gas giant also owns the mineral rights to three potential oil-sands plays, which could, the company believes, produce 500,000 barrels of oil a day on a resource base of 5.3 billion barrels of recoverable oil. So far the company hasn't put much capital into developing the oil-sands projects itself and Encana is believed to be looking for a partner that would handle the refining of the heavy oil produced from these sands. Our StockScouter rates these shares a 9.