Canadian Oil Sands has a small team with a long-term view. Late last year, several members of the team met to discuss the outlook for 2007 and beyond, the Trust’s challenges and opportunities and the strategies to ensure continued success. Here is what was discussed.

1.0 what sets canadian oil sands trust apart from other oil sands investment opportunities?

A number of characteristics distinguish Canadian Oil Sands Trust as an oil sands investment. First and foremost is the quality of the Syncrude asset. Our investment in Syncrude represents close to 50 years of oil sands resource at expanded capacity rates of 500,000 barrels per day of light, sweet crude oil. We have tapped into only a fraction of this potential today. Syncrude was one of the first companies to develop Canada’s oil sands deposits, and our leases cover some of the richest resource in the Fort McMurray area. After 28 years of operations, Syncrude also has extensive experience mining and upgrading this resource – a distinct advantage in an industry where there are many new entrants.

We have just finished a major expansion, which provides us with the infrastructure to substantially grow production and improves operational flexibility to mitigate the impact of downtime at the plant. As well, it supports our ability to fund future growth opportunities, thus reducing our financing risk relative to start-up oil sands operators.

Our next growth stage will debottleneck the Stage 3 expansion and is much smaller in scale, which should reduce both our project execution risk and our capital investment. We have already pre-invested and completed the most expensive and complicated work – coking capacity. The coker constructed as part of Stage 3 was built with excess capacity of about 30%.

The other aspect of Canadian Oil Sands that distinguishes us is our singular focus on oil sands. We are a pure oil sands play. And because we remain unhedged, our investors have direct exposure to crude oil prices. While this approach can lead to short-term volatility, we believe it most appropriately matches the long-term nature of our assets.

1.1 how will the federal government’s proposal to impose a new tax on income trusts impact canadian oil sands?

The proposed tax changes would reduce the amount of cash available for us to distribute to Unitholders when the rules begin to apply in 2011 as a result of a new 31.5% tax that would be applied to distributions of income. Distributions to our investors would be considered dividends under the new rules, meaning they would be eligible for the dividend tax credit. As such, the after tax impact is relatively neutral for those Canadians who hold our Units in taxable accounts, while those that hold them in tax-deferred accounts and our non-resident Unitholders would see their after tax amounts substantially reduced.

We believe the new rules, however, do not impact the viability of our business. We continue to be a long-term value investment in the oil sands and we do not need the tax efficiency of a flow-through trust model to sustain our business.

The proposed changes include a restriction on how much trusts are permitted to grow. The guidelines allow an income trust to issue new equity that does not exceed the greater of $50 million and an annual, cumulative “safe harbour” amount. The safe harbour amount is 40% of a trust’s market capitalization (as at October 31, 2006) in 2007 and 20% thereafter to 2010, thus essentially allowing a doubling of market capitalization over the next four years. Canadian Oil Sands’ market capitalization on October 31, 2006 was about $14.2 billion, indicating we have considerable capacity to grow.

In the short-term, our response to the changes was to raise our net debt target to $1.6 billion from our previous target of $1.2 billion. This step should accelerate fuller payout of free cash flow and thereby allow the Trust to maximize distributions until the new tax takes effect in 2011. Beyond that, we have about $2 billion in tax pools available to shelter taxable income.

In the longer–term, we will continue to review our financial plan in light of the final legislation and evaluate our alternatives, including the option of converting to a corporation. The government has indicated this conversion could be made without tax consequences but there are a number of other issues to consider.

1.2 what improvements do you expect as a result of the management services agreement signed between syncrude canada and imperial oil resources?

We think there are significant gains to be realized by improving Syncrude’s operational reliability. As well, Syncrude is currently our only oil sands project so we are very motivated to ensure its growth plans stay on track. The Management Services Agreement is intended to accomplish both objectives.

Under the agreement, Imperial Oil Resources will lend its expertise to enhance Syncrude performance on a long-term, comprehensive basis. Imperial Oil Resources has a vested interest through its 25% ownership in the Syncrude Joint Venture. Through their association with ExxonMobil, Imperial Oil Resources has access to proprietary systems and best practices that have been developed and perfected through decades of experience operating more than 50 refineries around the world. A refinery is much like an oil sands upgrader and this expertise will be directly applicable to our Syncrude operations. Key individuals, primarily from Imperial Oil Resources and ExxonMobil and representing among the finest expertise in refinery operations, will be loaned to Syncrude to support in the implementation of these new systems.

The application of these global best practices to Syncrude’s operations is expected to result in:

• better operational reliability, which typically leads to higher production levels and lower per barrel operating costs;
• lower energy consumption, which also contributes to lower operating costs as well as better environmental performance;
• reduced requirements for sustaining capital, which is the capital we spend just to maintain production; and
• improved safety performance, where Syncrude already has a strong record.

In addition to enhancing operational efficiency, the agreement  promotes Syncrude’s growth plans. A new committee is being proposed, with Canadian Oil Sands as the chair, to proceed with the initial design of expansions that should take Syncrude’s productive capacity to over 500,000 barrels per day. With this renewed capability and commitment, we believe Syncrude is better positioned than ever for continued success and growth.

1.3 what is the impact of the Stage 3 expansion on canadian oil sands?

Most importantly, it provides us with a significant uplift in our productive capacity, raising it to 129,000 barrels per day from 92,000 barrels per day (based on our 36.74% Syncrude interest). We now have an expanded revenue base, thus bolstering our capacity to pay distributions and/or fund future growth opportunities.

Secondly, we should have a higher quality blend that we can begin marketing towards the end of the year called Syncrude™ Sweet Premium (“SSP”). The attributes of SSP should help to preserve the value of our product within the context of growing synthetic crude oil supply in the market.

Thirdly, Stage 3 should contribute to better environmental performance by reducing sulphur dioxide (“SO₂”) emissions and improving energy efficiency, thereby helping to reduce our per barrel carbon dioxide (“CO₂”) emissions.

And finally, Stage 3 supports our future growth because it includes investment in excess coking capacity that we can unlock in our next expansion, referred to as the Stage 3 debottleneck.

1.4 what are your plans for the assets you acquired as part of the Canada Southern transaction?

The transaction was an opportunity for us to manage our exposure to natural gas prices. We acquired an estimated 927 billion cubic feet equivalent of natural gas resource at a price of about $0.20 per thousand cubic feet. While this long-life natural gas resource is not in production and there are no plans at this time to develop it, we would expect its value to appreciate if natural gas prices rise significantly. Effectively then, the transaction provides a low-cost hedge against rising natural gas prices.

Natural gas represents about 25% of Syncrude’s operating costs, and as a hydrogen feedstock, is used primarily to improve the quality of oil we produce. We do not expect the Arctic natural gas will be used in our Syncrude operations; not only are there logistical challenges in accessing it, but because of our carried interest position we do not have any influence on its development. Similarly, for the vast majority of these natural gas interests, we are not obligated to fund any field development costs and there are no lease rental payments or interest costs. Thus, the Canada Southern transaction was a unique opportunity to secure a strategic, long-term energy asset for the Trust without increasing our business risk.

We should be clear that this is a unique opportunity for the reasons we just described and that we are not interested in acquiring conventional natural gas production. We have already sold most of the conventional crude oil and natural gas assets we acquired as part of Canada Southern, and renamed the company Canadian Arctic Gas Ltd.

1.5 Will The Increase In Synthetic Crude Oil Supply In The Market Have An Impact On The Price Canadian Oil Sands Receives For Its Oil?

The growth in synthetic crude oil volumes has already begun to impact our price. Historically, we received a price for our Syncrude™ Sweet Blend (“SSB”) that was in a narrow range compared to West Texas Intermediate (“WTI”). In 2006, however, we received an average $2.57 per barrel less than Canadian dollar WTI prices. In 2007, we expect this differential to widen further to average a $4.00 per barrel discount to WTI, although it is difficult to predict and quantify, given the variability in the supply and demand for synthetic oil.

While synthetic crude oil supply is growing, we also expect demand to grow for a number of reasons. First, conventional crude oil supply is falling and synthetic volumes are becoming an important supplement to the overall supply base. Secondly, due to a number of pipeline reconfiguration projects completed in 2006 in the U.S. mid-continent, the number of markets we can send our oil to has increased, allowing more refineries to include SSB as part of their supply mix. Finally, with more volumes of heavy oil being produced in Western Canada, there is demand for synthetic crude as a diluent whereby light synthetic crude is blended with heavy oil to create a less viscous and more “flowable” product. The growth in this market may be limited, however, by the condensate import pipelines being planned for Western Canada.

The critical issue for crude oil producers in the short-term is not demand but transportation. Export pipeline capacity is currently very tight and, while a number of expansions and new pipelines are in the planning stages, it is uncertain how many of them will materialize. Furthermore, most new pipeline projects take years to be approved and constructed, thus access to transportation likely will continue to be tight for the next few years.

In anticipation of increased competition for pipeline space, we have been actively pursuing a number of transportation alternatives. Our experience is that pipeline traffic tends to fluctuate throughout the year with demand being higher in some months than others. Bearing this in mind, we have begun to investigate the option of acquiring mid-stream infrastructure such as storage tanks. This would allow us to store our product during peak traffic times and then transport it in months when space is more readily available. We also are exploring opportunities to support pipeline projects, a move that would allow us to secure rights to pipeline capacity, and we continue to work with pipeline companies to develop pipeline extensions and expansions.

Our most important initiative in anticipation of higher synthetic volumes was undertaken about six years ago when we decided to upgrade our entire production to the higher quality SSP crude oil as part of our Stage 3 expansion. SSP should enable our existing refining customers to increase their intake of our production as well as potentially attract new customers.

1.6 What Challenges Do You See For The Oil Sands Industry?

We see four main areas that present both challenges and opportunities for our industry, and will most certainly shape its future; they are: the tight supply of skilled labour, the pressures on regional infrastructure to support oil sands growth, the impact of oil sands operations on the environment, and the Alberta government’s review of Crown royalties.

Tight supply of skilled labour

There has been a tremendous rise in demand for skilled labour to construct and operate the growing number of oil sands projects. Many operators are experiencing difficulties sourcing skilled labour to construct their projects, leading to rising capital costs and completion delays. Fortunately, the pressure on Syncrude is less, given we have just completed the Stage 3 project and the next expansion is anticipated to be much smaller in scale. Nonetheless, we plan to continue to grow, and as such, attracting and retaining skilled workers is critical to our success.

Syncrude’s permanent workforce has remained fairly stable with an attrition rate among the lowest in the industry. We aim to keep it that way and, in 2006, introduced an employee retention program designed to ensure our people, which are some of the best and most experienced in the industry, remain with Syncrude.

With the increased competition for skilled labour we must remain an employer of choice. We plan to do this by maintaining our reputation as a leading operator in Canada’s oil sands industry with one of the best records for safety performance. Syncrude also strives to attract new people to the industry by promoting apprenticeships and partnering with post-secondary institutions.

The joint venture arrangement under which Syncrude operates provides the unique benefit of accessing the expertise and human resources of the owner companies. This advantage was recently elevated with the signing of the Management Services Agreement, which expands access to the global refinery talent within Imperial Oil Resources and ExxonMobil. The agreement also enhances the career development opportunities for Syncrude Canada’s employees.

Pressures on regional infrastructure

We recognize the growth of the oil sands industry has created pressure in the regional municipality of Wood Buffalo, which includes the city of Fort McMurray, to meet the needs of an expanding population. Appropriate support of infrastructure, housing availability and provision of quality services, including schools and hospitals, is critical for a good quality of life and to attract and retain people in the region.

With close to 30 years of operations and being one of the largest employers in the region, Syncrude has a strong relationship with the local communities. In 2006, Syncrude announced a major donation of $2.5 million to help meet the need for greater recreational facilities in Fort McMurray. As well in 2006, Syncrude reached the $1 billion milestone for business activity with Aboriginal companies. Syncrude is the only business in Canada to have achieved Gold Level accreditation for the third time with the Canadian Council for Aboriginal Business – a national program that recognizes companies committed to increasing Aboriginal employment, assisting in business development, building individual capacity, and enhancing community relations.

Recognizing that it takes more than the efforts of a single organization, Syncrude is a founding member of the Regional Issues Working Group. This industry association is working with government to build an understanding of the needs of the region and to encourage action on a variety of infrastructure needs. In 2006, the government made important progress on transferring more Crown land for new housing, improving road infrastructure and providing bridge financing to the municipality for a wastewater treatment plant. We believe cooperative efforts such as this can help ensure the region can adequately support the growth of an industry that is providing significant economic benefits across the country and generating revenue for all levels of government.

The environment

Syncrude is committed to sustainable development and that includes continuous improvement in our environmental performance. We have delivered on that commitment through strong performance in the areas of protecting air quality, becoming more energy efficient, providing leading-edge land reclamation and increasing efficiency in water use.

Air quality:

Syncrude is reducing SO₂ emissions on both a per barrel and absolute basis at the same time we grow our operation. In 2006, Syncrude added roughly 100,000 barrels per day in productive capacity and total SO₂ emissions went down. This is due to the Stage 3 expansion including a new flue gas desulphurization unit, which virtually eliminates SO₂ emissions from Syncrude’s sulphur recovery plants and new coker. Syncrude plans to reduce SO₂ emissions even further – about 60% from the current approved levels of 245 tonnes per day – by 2011. Extensive air monitoring and studies have shown that the region of Wood Buffalo has as good or better air quality as anywhere in Alberta, and our investments will help protect the region's air shed as well as neighbouring areas.

Land reclamation:

Syncrude is also committed to ensuring land disturbed by our operation is returned to a stable, safe condition. Reclamation efforts began in the 1970s and to date, Syncrude has reclaimed about 22% of its disturbed land, establishing us as an industry leader in this area. Over the next 10 years, land reclamation should keep pace with land disturbance.

Water:

Syncrude recognizes the importance of water as a precious resource by using it responsibly. In fact, Syncrude is the oil sands industry’s most efficient user of water. We recycle about 80% of the total water we use, and the water we do draw from the Athabasca River represents 0.2% of the river’s average annual flow. Expansion of our operation is expected to increase that draw to 0.3%, or about 1% during the lowest flow period in the winter. Syncrude remains focused on finding further efficiencies in water use and maintaining its leadership role in this key area of sustainability.

Greenhouse gas emissions:

Syncrude continues to explore new ways to reduce its CO₂ emissions intensity by developing new technologies and improving our energy efficiency performance. We are an industry leader in research and development with $40 million devoted annually towards the development of new technology and the enhancement of current processes. In fact, many of the energy-efficient technologies used across the oil sands industry today were pioneered by Syncrude.

The application of new technology and equipment, combined with gains in reliability, led to a 14% reduction in per barrel greenhouse gas emissions between 1990 and 2004. A key breakthrough was Syncrude’s invention of a low energy extraction technique, which reduced process water temperatures to extract bitumen from the original 80°C to between 35°C and 40°C.

Another technology under development that holds promise for reducing greenhouse gas emissions is a new mining and extraction process called at-the-face mobile crushing and slurrying. This process should also help to reduce costs by minimizing the transportation of waste sand.

Regional initiatives:

In addition to Syncrude’s efforts to improve our environmental performance, Syncrude is a leading member of a number of multi-stakeholder organizations committed to addressing environmental issues in the region. These organizations include the Regional Aquatics Monitoring Program, the Cumulative Environmental Management Association, and the Wood Buffalo Environmental Association.

More information on Syncrude Canada’s commitment to sustainable development practices can be found in Syncrude’s sustainability report, available on their website at www.syncrude.ca.

Crown royalties

The Alberta government has announced it plans to review Alberta’s current oil sands royalty regime to determine if it applies the most appropriate royalty rate to oil sands’ production.

The current regime was instituted in 1997 and calculates royalties as 1% of gross revenue until a project reaches payout, after which point the rate rises to 25% of revenue less operating and capital costs. As a percentage, the rate is designed to increase the government’s take as crude oil prices rise – higher prices accelerate recovery of costs and once payout has been reached, the royalty is a cash sharing formula.

We believe the current regime strikes the right balance between the owners of the resource – the people of Alberta – and those risking capital to develop it. The success of Alberta’s oil sands is largely due to the historically stable and predictable fiscal regime that has been in place since 1997, which has encouraged investment by recognizing the unique challenges of the oil sands business. Oil sands projects are capital intensive and risky, requiring billions of dollars of upfront investment and very long lead times before they are capable of generating revenue and eventually a profit. Once these projects have recovered their costs, however, the regime provides Albertans with the opportunity to participate with a 25% share in the industry’s profits.

The Syncrude project is already providing this higher return to Albertans. Robust crude oil prices have increased revenues from the base plant and accelerated payout of the new Stage 3 expansion. As a result, the Syncrude project began paying the higher royalty rate at roughly the same time as the expansion was completed. Based on Canadian Oil Sands’ assumptions for 2007 contained in this annual report, Syncrude is expected to pay Crown royalties of $675 million, or $6.14 per barrel, this year.

As the oil sands industry expands, overall royalties should continue to increase. In fact, the Regional Issues Working Group forecasts annual royalty payments to the Alberta government will exceed $4.5 billion annually in less than 10 years, assuming a crude oil price of US$50 per barrel.

1.7 Is Canadian Oil Sands Considering Switching To A Bitumen Based Royalty?

Until 2010, the Syncrude Joint Venture has the option to switch from calculating the Crown royalty on upgraded SSB revenues, as it currently does, to a royalty based on bitumen production. The province of Alberta has indicated that this option cannot be exercised until a Bitumen Valuation Methodology is established for the industry, which would define the process for determining a market price for Syncrude bitumen. In addition, an arrangement needs to be reached on recapture of upgrader growth capital previously claimed and a methodology for allocating common operating and capital costs. Until these and the associated economic issues are resolved, the Syncrude Joint Venture owners cannot exercise the option or properly assess its long-term impact on the project’s royalty expense.

1.8 What Opportunities Does The Oil Sands Industry Provide?

The oil sands have proven to be a tremendous resource that benefits all Canadians. Next to Saudi Arabia, Canada has the second largest recoverable reserves of crude oil in the world with an estimated 179 billion barrels, 98% of which is attributable to the oil sands. This resource enables Canada to be self-sufficient in a world dependent on energy, as well as providing significant economic benefits.

Development of the oil sands provides enormous opportunities across the country. By next year, it is expected that the oil sands will have created about 240,000 jobs across Canada – 27% of which are outside Alberta – and by 2020 will have generated $885 billion in GDP activity. Syncrude itself is a major engine of growth for the Albertan and Canadian economies with over $3.3 billion in total spending during 2006. The oil sands industry greatly contributes to the prosperity and high quality of life enjoyed by all Canadians.

1.9 What’s Next For Canadian Oil Sands?

We plan to continue to grow responsibly. We have an excellent resource base through our Syncrude interest that can support further increases in productive capacity. Current plans call for productive capacity to grow to about 184,000 barrels per day, based on our 36.74% interest, late in the next decade.

We also will continue to evaluate opportunities to acquire additional oil sands interests. We believe our Syncrude asset has exceptional value, so anything we evaluate is benchmarked against Syncrude. Our preference would be to increase our Syncrude ownership; however, we would also consider other opportunities along the oil sands business chain, from reserves to downstream refining assets.