The unconventional technologies that have unlocked the oil and gas within the Western Canadian Sedimentary Basin (WCSB) will bring profits to companies operating there as long as West Texas Intermediate (WTI) oil prices stay above US$85 per barrel and natural gas prices remain above US$4 per million cubic feet (Mcf). We see the best of these companies having a great run for at least the next 12 months.

Here’s why.

The WCSB encompasses some 1.4 million km² from British Columbia and the Northwest Territories in the north to Manitoba in the south of Canada.

Reason 1: The Weak Canadian Dollar

The Canadian dollar continues to weaken against the US dollar; we predict this trend will continue throughout 2014 and 2015. The Bank of Canada is in no rush to increase interest rates. Its latest Monetary Policy Report declared a “lower Canadian dollar should provide additional support” to the economy, which is certainly true for the WCSB. In fact, for every 10 cents the CAD weakens relative to the USD, the cash flows of exploration and production (E&P) companies increase by 15%.

Reason 2: Drop in Oil Price Differential

The heavy oil in western Canada is priced as Western Canadian Select (WCS), comprised of heavy conventional and bitumen crude oils that are blended with diluents. WCS is exported from Alberta south to the United States for refining.

Currently this oil trades for around 15% less than the lighter, sweeter WTI: US$83 per barrel (WCS) versus US$99 (WTI) on May 5, for example. But this differential will narrow if refining capacity of WCS opens up.

There are two ways this can happen: increasing the amount of WCS that can get to refiners; and increasing the amount of product refiners can generate.

Both of these developments are happening. We’re pretty convinced that the Keystone XL pipeline will be approved; but even if it’s not, rail capacity is ramping up rapidly to get WCS to transport heavy crude to refiners. Rail’s current capacity of 150,000 barrels of oil per day (bopd) is expected to reach 800,000 bopd by 2015; companies that can take advantage of this spike could increase netbacks by more than C$10 per barrel.

The sixth new coke drum is lowered into place at the BP Whiting refinery (courtesy nwibq.com).

Second, in the next year, 330,000 bopd of heavy oil refining capacity is expected to come online from the coker expansion underway at BP’s Whiting Refinery on the southern shore of Lake Michigan (see above). There’s also excess refining capacity along the US Gulf Coast due to the decrease of heavy oil production in Mexico and Venezuela.

All these factors mean the price differential between WCS and WTI will narrow, increasing the profit of many Canadian players.

Reason 3: Canada Will Find New Customers for Its Oil

The United States has traditionally depended on Canada for much of its energy needs, and Canada depended on the United States as a friendly export market. However, this relationship is changing. With newfound oil sources in the US and the continued controversy and delays over Keystone XL, Canada is looking to hedge some of its risk by shopping its oil elsewhere.

Suncor (SU.TO) is currently building an offloading terminal on the St. Lawrence River, for instance, looking to follow the lead of Husky Energy (HSE.TO), which now exports to India from offshore eastern Canada. Crescent Point Energy (CPG.TO) is following Husky’s and Suncor’s diversification efforts.

On the West Coast, Imperial Oil (IMO.TO) is selling oil from its Kearl oil sands project to Malaysia. IMO transports it from Alberta southwest to the Vancouver port via the Trans Mountain pipeline. Builder and operator Kinder Morgan (KMP) is looking to increase capacity of the 60-year-old pipeline as much as 12 times, to 600,000 bopd.

Then there’s the proposed Northern Gateway pipeline to also transport heavy oil from Alberta to British Columbia coast, this time more due west to Kitimat for shipping to Asian markets. Like Keystone XL, construction of Northern Gateway is meeting a lot of opposition—and like Keystone XL, we think it will get built anyway.

In short, Canada is finding eager customers for its oil with or without the United States.

Reason 4: Technology Is Bringing Faster Profits

Geologists consider the WCSB mature as far as conventional drilling is concerned—meaning most of the easy oil has already been pumped from the ground. What’s the game-changer now is unconventional technology—everything from horizontal (versus vertical) drilling to multiple wells branching out from a single well pad.

Thanks to drilling achievements like longer horizontal bores, it’s taking less than nine months for many projects in the WCSB to recoup their costs. That’s good for two reasons: production brings in profit sooner, of course; and it also means the typically dramatic decline rate in production is less of an issue.

Newer technologies such as zipper fracs—working two wells alternately from the same pad—are proving to increase initial production as well as speed up the payback period even more.

The net result is lower-cost penetration in the WCSB. That’s bullish for the oil producers with the right acreage in the oil patch. Those are the ones more likely to pass on their profits to shareholders in the form of dividends.

In a global market where investors are chasing yield, the WCSB is turning out to pay respectable yields at current natural gas and oil prices. But buyer beware: not all companies are the same, and many companies we’ve researched will have a difficult time maintaining their high yields.

(If you’re interested in higher-risk/higher-reward mid-tier producers as well as large-cap companies, you may want to consider subscribing to our more in-depth newsletter, the Casey Energy Report. Two of the WCSB recommendations in our CER portfolio have done very well the past six months.)

Reason 5: Natural Gas—WCSB’s Add-On Value

The US bonanza in natural gas supply that resulted from the shale revolution hasn’t stopped the recent rally in North America’s natural gas prices.

A cold winter and late-season snowstorms in the United States has depleted inventories. At 822 bcf (billion cubic feet) at the end of winter, total US inventory was 878 bcf less than last year and 992 bcf (about 55%) less than the five-year average. It’s recovered somewhat—981 bcf as of April 25—but still has a lot of catching up to do.

Obviously, less supply means an increase in price. Canada’s gas benchmark AECO is expected to increase in price as well for the same reason. Storage levels in Canada are 60% below its five-year average.

Putting It All Together

For these reasons, we believe Canadian E&P companies have plenty of room to deliver exceptional shareholder value. As long as oil stays above US$85 and US$4 per Mcf, many companies in the WCSB will remain quite profitable, and their dividends will keep coming.

So here’s the obvious question: What companies will give us the best potential to profit from the upswing in the WCSB?  Can we find US-listed companies that operates there?

In several of the preceding points, we’ve noted that existing infrastructure is key.  Investors often steer clear of investing in WCSB companies because of past infrastructure restraints— that is, until now. What a pipeline can’t accomplish, rail can; refinery capacity is on the rise, and Canada is expanding its customer base. Put together, it means infrastructure is no longer a bottleneck for the WCSB.

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