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It’s Time For Canadian Oil To Re-Shuffle, Re-shape And Rebound

It’s Time For Canadian Oil To Re-Shuffle, Re-shape And Rebound

The numbers are sobering. Make that alarming. According to the folks at ARC Financial Corp. in their March 1 weekly macro-economic overview of Canada’s upstream oil and gas industry, revenue from the sale of produced oil and gas this year will be only $78.2 billion, the lowest since 2003. This is despite production hitting a record 6.97 million barrels of oil equivalent (boe) per day, the highest in Canadian history. Noteworthy is this figure is $10 billion lower than the previous report issued February 23 as ARC redid the math based on lower average commodity prices for the year.

After-tax cash flow – the free cash exploration and production (E&P) companies have for reinvestment after paying all their bills – is estimated to be only $17.0 billion – the lowest number in the 15 years ARC covers, back to 2002. This is $12 billion lower than $29.4 billion in 2002. The figures for the past five years are summarized below.

(Click to enlarge)

Source: ARC Financial Corp. ARC Energy Charts March 1, 2016

*Estimate

1) 2016 based on an average price of C$30.73 per boe on average production of 6.968 million boe/day

2) After-tax cash flow from production

It is early in the year and much could change. But in the simplest terms, total revenue from production this year is currently estimated to be $71 billion lower than in 2014, the all-time high water mark for the value of Canadian hydrocarbon production. Cashflow will be down nearly 76 percent, or $55 billion, from 2014, over three-quarters of the revenue reduction. That is because, despite valiant efforts to cut costs, there is a point at which operating costs can no longer be reduced. Shut in production and close the doors or produce oil and gas for practice, not profits. The missing cash flow is what is used to service capital and replace and / or grow reserves. Replacing reserves is the lifeblood of oilfield service (OFS) companies.

Most OFS managers now understand their clients are being mercenary with costs because they must. That’s why there are the fewest number of rigs drilling this winter anyone can remember. Oil sands projects are being cancelled or postponed. More production is being shut-in. Capital budgets are slashed. Compared to historical levels of activity, there is nothing going on because there is no money to pay for it. Related: In Risky Move Wall St. Backs Shale With Nearly $10 Billion In Equity

The $70 billion puts a lot of other numbers into perspective. It was recently announced that the federal government had found $251 million in emergency financial aid for Alberta. While every bit helps, this is under 4/10 of one percent of the missing $70 billion (assuming most of the pain is in Alberta, which it is). Apparently there are two other federal aid programs for Alberta totaling $950 million. Add them and federal assistance rises to only 1.7 percent of the absent revenue. Saskatchewan’s ask for $156 million to abandon wells works out to 2/10 of one percent of the reduced upstream cash flow. Again, great work for a few but the amount of money governments can and will inject to make the pain hurt less are not meaningful in big picture.

The devastation of the combined collapse of crude oil and natural gas prices has negative impacts beyond day-to-day operations. Below is a summary of the stock market values of 10 of the larger publicly-traded Canadian E&P and OFS companies. This, too, is extremely ugly.

 

(Click to enlarge)

Source: Toronto Stock Exchange

1) Closing data (price and shares) February 26, 2016

2) Closing price February 28, 2014

3) Two-year change in share price

4) Shares outstanding (millions) TSX Feb 26, 2016

5) Change in market capitalization (billions) assuming same numbers of shares outstanding at February 28, 2014 except as noted below

6) Calfrac 2014 share price corrected for 2:1 stock split in 2014

7) Canadian Energy Services 2014 share price corrected for 3:1 stock split in 2014

Using this methodology, 10 of the top Canadian-headquartered E&P companies lost a combined $96.5 billion in market value in the two years, from the end of February 2014 to the end of February 2016. Ten of the largest Canadian-headquartered OFS companies dropped $12.6 billion in market value, bringing the total to $109.1 billion, about double the revenue drop for the producers.

Since companies trade on a multiple of cash flow, these numbers are not out of line. At a valuation of five times after-tax cash flow, the companies producing all of Canada’s oil and gas had a theoretical market value of $350 billion in 2014 and only $85 billion today. That is $265 billion in disappeared wealth.

This is also somebody’s money. It is remarkable investors in these 20 companies could lose $109.1 billion in two years and many people figure the downturn in oil and gas is a regional problem. Some even believe former high flyers like Alberta and Saskatchewan deserve such punishment for being excessively successful in recent years. Others block pipelines which would provide tidewater access to western crude because they see their region taking all the risk and receiving none of the benefits. Related: Canadian Oil Slammed By Low Prices, Pipeline Woes

Today most mutual funds and pension plans hold Canadian E&P and OFS equities as core holdings. Because overall stock markets aren’t doing well, perhaps the damage the oilpatch is causing is disguised. But a look at the Canadian equity holdings of the Canada Pension Plan at March 31, 2015 (last date available) indicates the federal government owned on behalf of all Canadians shares of 16 of the above 20 companies. The governments of Quebec, Ontario and B.C. do not disclose the equity investments of their various public sector pension plans with similar granularity.

So it’s awful. Everybody knows that. Now what?

The number one thing everyone in upstream oil and gas must get their head around is the severity of the revenue collapse and its implications. By now people realize it is extremely serious. The purpose of these figures is to demonstrate just how serious. How many managers and owners have truly streamlined their operations to market realities is unknown because the thousands of smaller and private businesses across the Western Canadian Sedimentary Basin (WCSB) must make thousands of independent decisions, based on their unique circumstances.

But media reports of continued layoffs by the larger publicly-traded operators indicate many managers have delayed this element of fixed cost reduction as long as possible. In an industry so dependent on human capital for success, this is not delinquent but strategic.

One could consider the “glass is half full” approach. Even with revenues of only $78 billion this year, Canada remains the fifth largest hydrocarbon producing jurisdiction in the world, so oil and gas is hardly a sunset industry. At this reduced level, the oilpatch is still equivalent to the Canadian vehicle manufacturing industry was in 2013 when the government of Canada reported total revenues of $84.7 billion. There is work to be done, albeit at a lower level, with squeezed margins and fewer jobs. Keeping almost 7 million boe/day on stream will remain good business for many, even if production growth is not in the cards at current prices. And production will grow by another several hundred thousand barrels per day in the next few years unless the current oilsands and offshore expansion projects are cancelled because of continued low prices.

Waiting for an upturn as a strategy only works if your company has the financial resources to do so. Many don’t. But as I’ve written many times, the current low price of oil is unsustainable. Even the futures markets agree. On futures markets, the price of WTI crude is about US$8 a barrel higher for April 2017 delivery than today’s price. Based on 4.5 million b/d of crude and liquids production this alone would add $18 billion a year to production revenue, a meaningful and measurable improvement.

But the reality is, for this industry to survive in any meaningful form it is time to regroup, retool, rethink, restructure and rebound. The industry is rife with stories about excessive compensation, egregious waste, poor procurement policies, engineering and design blunders and operational incompetence, all symptoms of an industry that has had it too easy for too long. Combined with seemingly unlimited supplies of cheap capital, too many E&P companies decided they had to spend the money now, regardless of labor and equipment availability, efficiency and productivity. In doing so, they ignored what the macro-economic impact of everyone trying to do too much with too few resources would have on costs. While the adjustment from 2014 is extraordinarily painful, the case can be made the industry was overheated two years ago and that business conditions were not normal nor sustainable. Perhaps 2013 was in the same category.

At the IHS CERA investment conference in Houston on February 23, Saudi Arabia’s oil minister Ali Al-Naimi told attendees the future of competing in the global market was to, “Let everybody compete. Follow the marginal cost curve.” He said it was not for the Saudis to make high-cost operators competitive by shutting in oil. In brutal words that received global attention, Al-Naimi said higher cost producers must, “lower costs, borrow cash or liquidate.” Simply put, Canada needs a better plan than OPEC saving our bacon by restricting supply. Ouch. Related: The U.S. Still Dominates World Oil Prices

That said, the price of oil is gradually strengthening. At the Mar 1, 2016 close of US$34.40 WTI is 31 percent higher than the recent record low price of US$26.68 on January 20. This is caused by declining U.S. oil output and media reports of continued discussions among producing giants Saudi Arabia and Russia about capping output. As importantly, more people are realizing that having the world’s most important energy source trading at half of replacement cost is unsustainable in the long term. The ARC numbers for Canada in 2016 are likely to end up higher than the most recent report meaning at least part of the $70 billion hole will fill itself.

Nevertheless, reality has hit home with numbers no one could even imagine two years ago. No entrepreneur would ever start an E&P or OFS company and sell shares to investors while anticipating they could or would one day lose more than 90 percent of their value due to commodity price fluctuations. No entrepreneur starts an oil or service company and “stress tests” their income statement and balance sheet to survive a 50 percent to 70 percent reduction in revenue. If anybody thought business was going to get that bad, they wouldn’t bother. In some cases, current markets look more like a force majeure (French term for an unpredictable or unforeseen event often used in insurance contracts, sometimes compared to an act of God) than a vicious commodity price cycle.

But the $70 billion hole is real and will be the challenge of a generation. Filling in this massive hole with something is not a matter of if but how. This industry has reinvented itself before and in 2016 it is time to start doing it again.

By David Yager for Oilprice.com

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  • R.Biese on March 04 2016 said:
    A brutally frank article and quite true. A root cause is the huge discount of WCS to WTI. Producing crude for sale at

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