THE YEAR THAT BROKE OIL
A price plunge hurt Canada’s energy patch. Now the questions are: When will it be fixed and what happens to the sector then?
A price plunge hurt Canada’s energy patch. Now the questions are: When will it be fixed and what happens to the sector then?
Conditions in the oil industry couldn’t have seemed better a year ago. Economies around the world were still rebounding from the 2008/09 recession and West Texas Intermediate oil on June 25, 2014, was cruising along at US$106.50. But that was as high as WTI would get that year since it started sliding the next day, a slide that only picked up steam with the Organization of the Petroleum Exporting Countries’ decision — led by Saudi Arabia — in November to cut prices to defend its market share from those pesky U.S. shaleoil frackers. Oil bottomed at US$43.46 on March 26 this year before beginning a volatile and tepid recovery to above US$55 by the beginning of June. But the damage had already been done.
Energy companies, particularly in Canada, started cutting planned capital expenditures, head counts and existing operations, and revenues and profits plunged. As a result, such companies mostly dropped on the FP500 ranking — for example, last year’s No. 1, Suncor Energy Inc., slid all the way to No. 7 — as did the banks, which depend on a comfy economic environment to soothe investor fears about household debt levels and possible housing crunches. And that’s even though only two quarters of oil’s price slide is included in the FP500 tally. The effect has shown up even more prominently on the stock market. The biggest market cap drop, as of May 4, 2015, from a year ago was $7.6 billion by Husky Energy Inc., with Encana Corp. and Cenovus Energy Inc. rounding out the top three.
Things in the global oil patch got so bad that Harold Hamm, the billionaire founder and CEO of Continental Resources Inc., in December filed an appeal of a US$1-billion divorce settlement for his ex-wife, saying his wallet had been hit hard by oil’s price drop from over US$100 a barrel to less than US$60 at the time. He later
cut a cheque for the full amount, and his wife launched an appeal asking for more, which was denied.
But if history has taught us anything, it’s that it repeats. It’s not a question of if oil prices will recover as much as it is when. But then what? Canadian energy companies have been slashing their head counts, operations and planned capital expenditures to the bone in response to oil’s price slide. Ramping it all back up won’t be easy, especially since it may take a while before they have some degree of confidence that higher prices, when they do return, are back for the foreseeable future. But in the meantime, production levels have barely budged. Indeed, they are actually higher.
Part of the reason is that the Persian Gulf countries haven’t slowed down their activity as they attempt to regain market share from U.S. shale producers and Russia. The Russian part of the equation may take care of itself since sanctions will hurt its access to Western capital and probably prevent multinational oil companies from entering due to fear of reprisals, particularly from the U.S. government. There has also been increased demand as gas prices decline, especially from the U.S., but also the eurozone and parts of Asia and Latin America. Some believe the summer driving season in the U.S. will be the best one in a decade.
But even Canadian heavy oil from the oil sands continues to increase flows to the U.S. The full Keystone XL pipeline may be hung up in U.S. red tape — and may never get built — but the southern leg from Cushing, Okla, to Houston has been expanded, the new Flanagan pipeline is up and running, and rail terminal expansions to carry crude by rail are expected to open in the second half of this year. And the refineries in Houston and along the Gulf Coast are heavily configured to run on heavy crude, so they need to buy Canada. “Heavy crude is our strength in Canada,” says Patricia Mohr, a Scotiabank economist and commodity specialist. “It’s our forte.”
So why all the doom and gloom about Canada’s energy sector? A lot has to do with the huge cuts to drilling and exploration programs. Estimates are in the 40% range, which is hurting all the oil-field service providers that supply equipment, manpower and services to facilitate those programs. As a result, production and exports may level off next year and it may be a while before the sector starts rising again. “It’s going to take at least 18 months, maybe two years, for things to really come back,” Mohr says. “There’s a lot of very negative geopolitical developments in the Middle East, but it doesn’t seem to have done much to oil prices.”
Even the most optimistic don’t believe oil is returning to the US$100 mark anytime soon. Global production is still going strong despite the decrease in price, OPEC doesn’t seem to have any intention of slowing down, and there’s the possibility that Iranian supplies could start coming back this year if sanctions related to its nuclear capability are lifted June 30 or shortly thereafter. The U.S. Energy Information Administration said the re-introduction of more oil from Iran could cut its price projection by up to US$15 a barrel.
Investment banker Goldman Sachs is one of the most pessimistic about oil prices. In May, it cited improved U.S. shale efficiency and unimpeded OPEC productivity while pegging a US$45 price on WTI by October and predicting Brent will only be US$55 in five years. It called the price increase in late spring a “selfdefeating rally.” But even that depressing call was dwarfed by Citigroup’s belief in February that oil would hit US$20 at some point and that the slide had broken OPEC.
Pessimism aside, it’s tempting to look at the last time oil prices precipitously dropped to get a clue about what might happen this time, but the current global environment is quite a bit different than in December 2008, near the bottom of the commodity cycle when oil hit US$32. That was also in the depths of the last recession, but China saved the day that time. China implemented a huge expansion of credit and infrastructure development that lifted its economy well above the global recession and nudged others out of negative territory as well because of its massive need for commodities, including oil.
“The minute that oil traders saw China buying commodities at bargain basement prices in early ’09, all the traders jumped back into their positions and drove the prices up,” Mohr says. “Things recovered very quickly, and not only oil, but commodity prices generally.” She adds that although China is once again ramping up stimulus efforts to achieve its 7% growth target, its economy doesn’t have quite the same wherewithal to boost both its own growth and that of everyone else.
Mohr, who correctly called the recent mini-recovery in oil prices, believes oil will be back up to US$65 by late this year, though there will be some volatility, but that level isn’t expected to increase much next year and she has oil only hitting US$70 in 2017.
But at US$65, some of the U.S. shale producers will likely
“HEAVY CRUDE IS OUR STRENGTH IN CANADA,” SAYS SCOTIABANK ECONOMIST PATRICIA MOHR. “IT’S OUR FORTE”
increase production. U.S. shale is a new wildcard that wasn’t really around in 2009. Perry Sadorsky, associate professor of economics at the Schulich School of Business in Toronto, says the behavior of frackers as swing producers now has a strong effect on the fortunes, or lack thereof, of Canadian oil producers. At US$57, he says some frackers are making good money, while others may be mothballing some operations. But if prices go higher, all the offline frackers are going to start producing, flood the North American market with more oil, and put further pressure on oil prices to drop. The Gulf states are covered since they can make money at US$20 a barrel. “Some people are concerned about what we call a W-shaped pattern for oil prices,” he says. “They fell a lot last year, rebounded a bit now and if it bounces back a little higher, then all the frackers are going to go back online and prices will plummet again.”
Many investors are afraid of that very thing since the oil futures market was trading oil in May for delivery a year later at US$60. Go out 18 months, and oil was still about the same level. “The big overriding factor is that you have this huge supply relative to weak demand globally,” Sadorsky says. “If you see more fracking around the world, you could see $50 a barrel for oil for probably the next five to 10 years and that’s pretty scary if you’re hoping for a quick rebound in Alberta.”
Sadorsky believes anything over US$80 a barrel would be unjustified given the amount of oil being produced, not to mention the amount of oil sitting in tankers, tank cars and storage facilities, as well as the technology that is making it possible to produce more in a cost-effective manner.
“If you think fracking has a long future, you’re certainly going to delay any huge capital expenditures. The one thing about fracking is that frack wells only last about five to seven years. They run out real quick, which is why there is so much activity in that drilling sector,” he says. “On the other hand, there’s so much fracked oil available in the U.S. that they are going to be permanently self-sufficient in a few years and that could last for 30 or 40 years.”
Peter Tertzakian, chief energy economist and managing director at ARC Financial
“IF YOU THINK FRACKING HAS A LONG FUTURE, YOU’RE GOING TO DELAY ANY HUGE CAPITAL EXPENDITURES”
Corp., an energy-focused private equity firm in Calgary, agrees that it won’t be good enough for prices to rise, it will have to be sustained before energy company executives will be inclined to move ahead and start rehiring. “I would say the price of oil has to rise above $70 and sustain for a couple of quarters, without fear of retreat,” he says.
Martin Pelletier, a portfolio manager at TriVest Wealth Counsel Ltd, a Calgary-based private client and institutional investment management firm, is a bit more optimistic. He says it would probably take about eight months for energy companies to feel comfortable that a higher price was here to stay, or about the same time it took for them start cutting jobs and projects. They will, of course, be initially gun shy, but it won’t take long to become optimistic when oil is rising. “It depends on how much capital they can raise and how quickly,” Pelletier says. “In today’s low interest rate environment, perhaps quicker than in the past.”
Tertzakian, though, says the decision to ramp spending back up depends on what segment of the industry a company is in. Big oil-sands projects (those that require more than a few billion dollars in capital spending) will be a long time coming, he says, while unconventional oil projects will ramp up much faster, probably within a quarter.
As Mohr says, the Canadian sector has turned cautious. But she also points out that there are still some projects on the go. A company such as Cenovus Energy Inc. has quite economic SAGD (steam assisted gravity drainage) bitumen projects that they’re proceeding with at Foster Lake and Christina Lake. Mohr says these projects can be economic at US$40-$50 WTI. Canadian Natural Resources Ltd. will probably keep moving ahead with its Horizons Lake field, while the Fort Hills oil-sands project will likely keep Suncor Energy Inc. and its partners busy. But, she adds, “companies with weaker balance sheets will be challenged and probably will dial down their activity.”
But a lot depends on what OPEC plans to do. At its June 5 meeting, the bloc reaffirmed its production commitments, but it may not be able to keep the taps open indefinitely. Indeed, Jasper Lawler, a market analyst at CMC Markets UK, said in a report that OPEC may have to revisit its decision as early as this fall because low oil prices are taking a “huge bite out of the national revenues of oil-producing countries” even while forcing the competition to take a haircut as well. “Even if U.S. oil production does come down, until there are widespread defaults amongst U.S. firms, it is likely to be a gradual reduction,” he said. “U.S. dollar strength and a global growth slowdown especially in China both have the potential to weigh on the price of oil.” And that will hurt OPEC, but not as badly as it will Canadian energy producers.
Fort McMurray, Alberta