Petro-Canada (PCA.TO) is rethinking the design for an expansion of its MacKay River, Alberta, oil sands project due to surging costs for the steam-driven development, an executive said on Monday.

Petro-Canada, the country's No. 4 oil producer and refiner, had aimed to spend about C$1.2 billion ($1.2 billion) on the project, slated to start up in late 2011.

It would have been maybe 20 percent higher than that based on the work done on the previous design, vice-president Andrew Stephens told reporters after speaking to an investment conference.

Since we've done that, we've seen real cost pressures, not only in terms of capital equipment but also in terms of operating costs as natural gas gets higher, he said.

In addition, Alberta's decision to increase royalty rates starting in 2009 contributed to making the economics of the project marginal, he said.

Petro-Canada has pushed its go-ahead decision for the 40,000 barrel a day expansion to the first quarter of 2009 from the last quarter of this year.

The company is now considering integrating parts of the expansion with the much larger Fort Hills oil sands mining project, in which Petro-Canada has a 60 percent interest, Stephens said.

There are some elements of equipment that we might be able to eliminate, and we might be able to produce some product that can be blended with the Fort Hills, he said.

He said Petro-Canada will not have a new cost estimate until it finishes the rescoping of the design.

The first phase of MacKay is expected to produce 25,000 barrels a day this year. It is an in situ oil sands project, in which the company injects steam into the ground to loosen up the tar-like bitumen, allowing it to be pumped to the surface in wells.

Petro-Canada shares rose 6 Canadian cents to C$58.69 on the Toronto Stock Exchange on Monday. ($1=$1.02 Canadian)

(Reporting by Jeffrey Jones; Editing by Peter Galloway)

© Thomson Reuters 2008. All rights reserved.