Oil and Gas Industry Darren Prins Dylan Watson

Oil and Gas Industry Darren Prins Dylan Watson Jorge Cruz Ian Harcus Lisa Banxachai

Outline § Introduction – Industry overview – Risk analysis § Suncor – Corporate Profile – Risk Management § Canadian Oil Sands – Corporate Profile – Risk Management

Oil and Gas Industry Structure § The oil and gas industry is a branch of the Energy Industry § Oil and Gas Industry components: – – – Upstream operations (Exploration) Midstream operations (Refining) Downstream operations (Distribution and sales) § The industry is pro-cyclical (it is positively correlated with the business cycle) – Pro-cyclical demand – There have been negative supply shocks (1970’s OPEC and current OPEC quotas) § Barriers to entry due to high capital requirements

Oil Industry Structure § Global Industry: § Top 10 Oil Producers and Consumers

Oil Industry Structure § Global Industry: § Largest Oil Companies by production (Oil and Gas Journal, 1999) – State-owned companies are marked with a star * Oil & Gas Journal, 1999 http: //www. gravmag. com/oil 2. html

Oil Industry Structure § Global Industry: – Technically Recoverable Reserves: the amount of oil that experts are certain of being able to extract without regard to cost from Earth – Only a small fraction of the World’s Technically Recoverable Reserves can be extracted at current prices. – Of the known oil reserves that can be profitably extracted at current prices, more than half are in the Middle East; only a small fraction are in North America.

Oil Industry Structure § Global Industry: – World Oil Demand is projected to grow by over 2 percent in 2004 and 2005. – On the supply side, oil inventories have been low for the last year and are expected to remain the same for 2004 and 2005

Oil Industry Structure (North America) § US: General aspects – The United States is the world's largest energy producer, consumer, and net importer. It also ranks twelfth worldwide in reserves of oil – During 2002, the United States produced around 8. 1 million barrels per day Energy Information Administration: http: //www. eia. doe. gov

Oil Industry Structure (North America) § US: Imports – US oil demand has been increasing by 3% on average – Imports from: § § Persian Gulf Mexico Canada Venezuela Energy Information Administration: http: //www. eia. doe. gov

Oil Industry Structure (North America) § US: Sector Organization – Merger activity in the oil business accelerated sharply during 2000 and 2001 (before slowing considerably in 2002 and early 2003). – The largest merger/acquisition announcements came from BP and Amoco, Exxon and Mobil, BP Amoco and ARCO, and, most recently, Chevron and Texaco

Oil Industry Structure (North America) § US: Production – Top producing areas as of 2002: § Gulf of Mexico (1. 6 million bbl/d) § Texas onshore (1. 1 million bbl/d) § Alaska's North Slope (954, 000 bbl/d) § California (707, 000 bbl/d) § Louisiana onshore (274, 000 bbl/d) § Oklahoma (181, 000 bbl/d) § Wyoming (150, 000 bbl/d).

Oil Industry Structure (North America) § Canada: General aspects: – Canada was the fifth-largest energy producer in the world in 2001: § § § 39% natural gas 25% oil 20% hydropower 11% coal 5% nuclear power – 3 rd largest producer of natural gas – 9 th largest producer of crude oil § Oil sands account for approximately 30% of Canada’s total oil production – According to Oil & Gas Journal, Canada's total crude oil reserves stood at 180 billion barrels as of January 2003 – Annual Production Average: 2. 9 MM bbl/d – Annual Consumption Average 2. 0 MM bbl/d – Exports 2002: 1. 5 MM bbl/d crude (to US)

Oil Industry Structure (North America) § Canada: General aspects: Energy Information Administration: http: //www. eia. doe. gov

Oil Industry Structure (North America) § Canada: Exports – Canada is a major source of U. S. oil imports. In 2002, the United States imported 1. 97 million bbl/d of oil from Canada. – This makes Canada the top petroleum supplier to the United States and the thirdlargest supplier of crude oil imports (behind Saudi Arabia and Mexico, and ahead of Venezuela). – Canada has been the top supplier to the United States of refined petroleum products, including gasoline, jet fuel, distillate, etc. , since 1996. Energy Information Administration: http: //www. eia. doe. gov

Oil Industry Structure (North America) § Canada: Exports CAPP: www. capp. ca

Oil Industry Structure (North America) § Canada: Sector Organization – Significant mergers and acquisitions in recent years. – In 2001, U. S. firms purchased over $35 billion in Canadian oil and gas assets including the purchase of Gulf Canada. – En. Cana Corp. was the result of the merger between the 2 largest Canadian oil companies. It is now the world's largest independent oil and natural gas producer (by market value).

Oil Industry Structure (North America) § Canada: Sector Organization CAPP: www. capp. ca

Oil Industry Structure (North America) § Canada: Exploration and Production – The industry is based primarily in Alberta § The Athabasca Oil Sands deposit, in northern Alberta, is one of the two largest oil sands deposits in the world (Oil Sands) – Atlantic Coast: Mainly in Newfoundland – Pacific Coast: The British Columbia government is pushing to lift a 30 -year-old ban on exploration in the Pacific Ocean in order to begin production by 2010.

Oil Industry Structure (North America) § Canada: Main Producers – En. Cana – Syncrude (a joint venture of eight companies with Canadian Oil Sands Investments Inc. having the largest stake) is Canada's largest producer of crude from oil sands. – Suncor, the first company to begin processing Alberta oil sands in 1967, completed in 2001 its Project Millennium, which increased production capacity to 225, 000 bbl/d – Shell Canada Limited – Chevron Canada Limited (a wholly owned subsidiary of Chevron. Texaco Corp. ) – Western Oil Sands Inc – Canadian Oil Sands

Oil and Gas Industry Structure (North America) § Canada: Natural Gas – Canada is the third largest natural gas producer (after the United States and Russia) – Second largest natural gas exporter (after Russia). Energy Information Administration: http: //www. eia. doe. gov

Products § Products Being Produced: – Oil: § § Gasoline Kerosene Jet Fuel Lubricants – Natural Gas § Major Substitutes § § § Nuclear Power Hydrogen Hydropower Coal Methane Solar energy

Regulations § Global: – The United States maintains energy sanctions against several countries, including Iran and Libya – OPEC regulate its members oil production

Regulations § Canada: – Government: § Efficiency and market regulations (National Energy Board and Office of Energy Efficiency of Natural Resources Canada) § Environmental Regulations (Environment Canada) § Property Regulations (Provincial Government and Federal Government) – Self-regulation: § Canadian Association of Petroleum Producers (CAPP)

Major Risks § General Business risk (production and sales uncertainty) § Financial and commodity market risk: (interest rate risk, FX risk and in the form of volatile oil and natural gas prices) § Excessive Cash Flow fluctuations § Credit risk and liquidity risk: (Counterparty failures (airlines, etc. )) § Operational Risk: (Pricing) § Legal risk: (contract enforcement, i. e. OPEC) § Environmental Regulations: Kyoto Protocol and growing environmental concerns (Canada ratified the Protocol in December 2002) § Other: – Accidents: Plant, equipment and frontline employees – Lack of diversification (assets and current and future investments) – Exploration and Development

Risk Measurement § Sensitivity analysis: – On cash flows sensitive to: § Oil and gas prices § Interest rates § FX changes – Further developed with: § Probability calculations for movements in prices, interest rates and FX.

Available products and techniques for risk management § Derivatives are at the center of the risk management for these companies: § Major Products for risk management: – – – Energy Futures traded in COMEX FX Futures traded in CME OTC Forward contracts (oil, gas, etc) Interest rate and FX SWAPS Options: Costless Collar § Other products used for corporate purposes: – – – Managerial Stock options Warrants Puts (used in stock repurchase programs)

Available products and techniques for risk management § Costless Collar:

Available products and techniques for risk management § Costless Collar: – A collar (or fence) is a spread comprising a long (short) call and a short (long) put, both out-of-the-money and for the same expiration. The strikes can be chosen so that the purchase (sale) price of the call exactly offsets the sale (purchase) price of the put so the spread is a costless collar.

Hazards from risk management activities § § § Decreased earnings Liquidity pressure Potential loses from hedging

Corporate Profile • Integrated energy company (Canada/US) • Core business is Oil Sands – Fort Mc. Murray, Alberta • Market capitalization: US$11. 790 Billion • 3400 employees • Oil Sands, Natural Gas, EM&R

Growth Strategy • Developing and Expanding Oil Sands – facilities to increase the production of crude oil • Controlling costs • Reducing natural gas price risk – producing volumes exceeding internal demand • Developing new marketing – further integrate Suncor’s upstream and downstream business • Managing environmental and social performance

Financial Statement Analysis • Income Statement • Balance Sheet • Statement of Cash Flow

Financial Highlights

Project Millennium

Financial Highlights

Cost Structure

Pipeline Network – Oil Sands Production

Sensitivity Analysis

Risk Exposure • Fluctuations in prices of: – crude oil – natural gas • Currencies exchange rates – Canadian $ earnings to US $ • Interest rates – cross-currency • Counterparty Credit Risk – High credit rating counter-parties • Environment legislation – KYOTO

Risk Management Philosophy • Suncor cannot predict or control prices • Reduce exposure to market volatility and support the company’s ability to finance growth (artificial spot price range) • To manage interest or currency-sensitive assets and liabilities (ex. Bonds) • Has Audit committee that works with BOD – Assess hedging thresholds in light of price forecast and cash

Hedging Instruments Used • Swaps – Crude Oil – Hedging Program – Interest Rate • Swapping floating rate and fixed rate interest payments – Foreign Currency • Options – Costless Collar

Crude Oil Hedges

Crude Oil Hedges

Crude Oil Hedges • Hedged 3 -4 years out; convenience yield

Interest Rate/Foreign Exchange Swaps Hedged 9 years out; term structure of prices of currency constant

Adverse Hedging Effects • Decreased earnings by: – $160 million (2002) – $148 million (2001) • Reduce potential benefits of favorable changes in commodity prices and exchange rates • Artificial spot price range created by the hedging program

Executive Compensation • Executive Stock Plan – Granted 1. 8 million options to executives – 10 year life, exercisable immediately – Exercise price=market value at expiration • Old Plan (1997 -2002) • Cash payments of $34 million to employees

Executive Compensation • New Stock Option plan (Sun. Share) – Granted 9 million options to all eligible staff • 10 year life, 10 year vesting period • Accelerated vesting by meeting performance targets • Issued at-the-money (zero expense) – Possible adverse affects due to lack contingency

Executive Compensation

• Monitor expected future price fluctuations in the oil spot –Adjust hedge position accordingly • Maintain natural price hedge in NG • Re-evaluate hedging ratios and hedging instruments used –FX risk, Interest Rate

Pure Investment Intensive Progress

Corporate Profile Canadian Oil Sands Unit Trust – An open-ended investment trust – Sole income producing asset is its percentage ownership share in Syncrude – Syncrude is the world's largest producer of crude oil from oil sands – Produces 13% of Canada’s petroleum requirements Source: www. cos-trust. com; Poitras, Case Studies in Fundamental Analysis, 2004

Corporate Profile • Oil Sands Project: Syncrude – Syncrude is a joint venture partnership – The largest 3 share ownership: • Canadian Oil Sands • Imperial Oil Ltd. • Petro-Canada 35. 49% 25. 00 12. 00 – Syncrude: averages 230, 000 barrels/day – Canadian Oil Sands: 66, 793 b/d in 2003 Source: www. cos-trust. com

Corporate Profile • Other Oil Sands Project (Competitors) – The Athabasca Oil Sands Project • Shell Canada and Chevron Canada • Produces 155, 000 barrels/day – Suncor Energy Inc. (original oil sands project) Source: www. cos-trust. com

Corporate Objectives • 3 main objectives – Investment grade credit rating • but also sustaining stable distribution, and • minimize discretionary equity financing – Acquisition of oil sands assets – Lowest overhead cost structures Source: 2002 Annual Report

Growth Strategy • Expansion internally and externally through acquisition • Remain in oil sands business Source: 2002 Annual Report

Financial Structure • A unit trust • Has characteristics of a common stock – Marketable and transferable – Variable cash flow dependant on return of a real asset (% share in Syncrude) • Features of an unincorporated mutual fund – Income passes to unit holders (fully taxable) – Distribution not taxable at trust level

Financial Statement Analysis • Income Statement • Balance Sheet • Statement of Cash Flow Source: 2002 Annual Report

Cost Structure • Debt-to-equity – Debt structure stands at approx. 35% - 40% • Revenue – One product: crude oil • Operating costs – Approx. 50% of revenues Source: 2002 Annual Report

Sensitivity Analysis

Executive Compensation As of December 31, 2003: Source: SEDAR - Interim Financial Statements, Jan 29, 2004

Executive Compensation • On October 2, 2003: – Options no longer issued – Purchase of units in the secondary market • October 23, 2003: – The directors surrendered all options in exchange for Trust units (value of approx. $1 million) • Cash compensation Source: 2002 Annual Report

Risk Management Philosophy • The Trust hedges to protect the cash flow needed to fund its capital programs, while maintaining some exposure to the upside in the price of crude oil • No formal committee dedicated to risk management or a risk management officer Source: MD&A, 2002 Annual Report

Risk Management Philosophy • Comprehensive Insurance program – Mitigates risk of Trust’s share of Syncrude assets from physical damage • Oil and natural gas price hedging – Reduce exposure to price volatility • Hedging to protect cash flow • Hedging of US denominated crude oil prices and Cnd-US FX rates Source: MD&A, 2002 Annual Report

Risk Exposures • Commodity Price risk – Crude oil prices: • Highly leveraged by price of crude oil (sole product) • SSB product is sold for floating prices calculated with reference to the WTI futures contract – Natural gas price: • As a consumer, input to production • Syncrude has long-term purchase commitment; COS share is 21. 74% or $39 M

Risk Exposures • FX risk – Fluctuations in US-Cdn currency exchange • Revenue from oil sales based on price benchmarked in US dollars • Pay interest in US dollars on US denominated debt • Interest Rate risk – Impact on period when they draw on credit facilities

Risk Exposures • Operational Risk – Exposure to value of Syncrude Project – Lack of diversification – Syncrude expansion project – Unscheduled maintenance/outages – Business and physical loss insurance – Technology

Risk Exposures • Regulatory environment – Kyoto: COS estimates it will cost $0. 20 - $0. 30 per barrel for the first commitment period between 2008 -2012 (worse case) – They have steadily reduced emission levels over the past 10 years

Risk Exposure • Credit risk – Limit exposure to any one customer – Sale revenue receivables settled in the month following the sale – Select counterparties of high credit rating for swaps and contracts Source: 2002 Annual Report; Q 4 2003 Report

Hedging Position Derivative Instruments Source: 2002 Annual Report; Q 4 2003 Report

Hedging Position • Crude Oil Hedging Program – Hedges both US$ denominated crude oil prices and US-Cnd FX rates – To reduce revenue and cash flow volatility – 2 methods: • US$ WTI forward contracts + foreign currency • C$ WTI forward contracts Source: 2002 Annual Report

Hedging Position • Crude Oil Hedging Program – In 2002, loss of $10. 7 M due to increase in WTI price – Increasing position in Q 4 2002 using • Combination collars and swaps • Entire incremental production from Stage 3 expansion – 61% in 2003; 21% in 2004 (up to 50%) Source: 2002 Annual Report; Q 4 2003 Report

Hedging Position Crude Oil Hedging Program Source: 2002 Annual Report

Hedging Position • Natural Gas Hedging – Forward contracts on natural gas – 60% of forecast consumption in 2002 – Resulted in hedging gains for 2002 of $5. 2 M – As of Jan. 2004, no natural gas hedges in place Source: 2002 Annual Report; Q 4 2003 Report

Hedging Position • Natural Gas Purchase Commitments – Syncrude has long-term natural gas purchase contracts (subject to an annual price redetermination) – Based on NYMEX natural gas futures – Syncrude to pay min. $180 M annually – COS 21. 74% share is approx. $39 M – The contracts expire at varying dates until 2004 Source: 2002 Annual Report; Q 4 2003 Report

Hedging Position • Foreign Currency Hedging – Contracts to fix exchange rate in future – Unwinding current positions – In conjunction with crude oil price hedging – Realized gains recog. when forward expires – Deferred gains of $16. 5 M (22 M as of 2003) to 2006 and beyond Source: 2002 Annual Report; Q 4 2003 Report

Hedging Position Foreign Currency Hedging Source: 2002 Annual Report; Q 4 2003 Report

Hedging Position • Interest Rate Hedging – 7. 625% fixed Senior Notes to a 5. 95% fixed rate US dollar payment – Reduction of $1. 8 M interest payments in 2002 and 2001 – Gains/losses recognized in period the swaps are settled Source: 2002 Annual Report; Q 4 2003 Report

Hedging Position • Interest Rate Hedging Source: 2002 Annual Report; Q 4 2003 Report

Hedging Position • http: //www. cos-trust. com/files/investor/pdf/COS_Q 4_2003_FINAL. pdf • Unrecognized gains/losses As at Dec 31, 2003, unrecognized – loss of $69 M on crude oil hedges – gain of $50 M on FX hedges – gain $5 M on interest rate swaps Source: 2002 Annual Report; Q 4 2003 Report

Recommendation • To maintain hedging strategy on crude oil, natural gas and interest rate • Re-evaluate optimal hedge-ratio on crude oil – Production increasing but prices increasing • Re-evaluate position and FX hedging strategy – Unwinding of position – Speculation or hedging?