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?

National Post (Latest Edition) - Financial Post Magazine - - CONTENTS - By Andy Holloway

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

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