David Yager - In Closing...........

This will be my last column for MNP. I am moving on to other opportunities in the oilfield
service industry, probably as a player instead of a coach. My 3.5 years at MNP have
been great and the firm has made significant investments in training, processes and
systems to be the best-in-class provider of accounting, tax and consulting services to
this key component of the Canadian economy. Please consider MNP as your trusted
financial services supplier.
Sincerely,
David Yager
For more information contact:
Jeremy Rondeau
Vice President - Oilfield Services
MNP LLP
T: 306.770.3679
Email jeremy.rondeau@mnp.ca

Canada's Oil Industry May Never Be the Same -- Here's Why!

Never is a long time. The dictionary definition is, “at no time in the past or future; on no occasion; not ever.” In the volatile oil and gas industry, those who try to look that far into the future and predict anything with certainty are invariably wrong. Here’s hoping.

But it’s not all bad Oil prices are gradually rising because of market physics and investor sentiment. Federal and provincial politicians are softening their opposition to, and have even publicly declared support for, pipelines to tidewater. The worst is over.

However, it is increasingly certain the future will not be like the past. Previous downturns have been equally devastating but the primary causes eventually reversed themselves; low commodity prices recovered and damaging government policies were rescinded.

This recovery will be different for a variety of reasons which will combine to cap growth, opportunity and profits, even if oil and gas prices spike. The following major changes appear permanent.

Oil Is Destroying the World

“New research shows that the fossil-fuel era could be over in as little as 10 years, if governments commit to the right policy measures… If you think workers are suffering in Alberta now, wait until you see what Canada’s economy looks like if we miss the huge opportunities for jobs and prosperity offered in renewable energy and a truly climate-friendly economy.”

Written by a climate and energy campaigner for the Sierra Club, this appeared on top of page 13 in the April 23 edition of Victoria’s Times Columnist, under the headline, “Pipelines not the pathway to Paris solutions.” B.C.’s views on pipelines are well known.

Whether you or the tens of thousands of laid-off oil workers believe the first paragraph or not, on April 22 at the United Nations in New York, 171 countries signed the Paris climate change agreement negotiated last year. At the event, UN Secretary-General Ban Ki-moon said: “Paris will shape the lives of all future generations in a profound way – it is their future that is at stake.” He said the planet was experiencing record temperatures: “We are in a race against time. I urge all countries to join the agreement at the national level. Today we are signing a new covenant for the future.”

Showing support, in the Globe and Mail April 26, the Minister of Foreign Affairs for the island country of Maldives wrote, “Our ratification (of the Paris agreement) is based on the clear and present danger of losing our country completely to rising tides. How critical this has become can be seen in a report released only this month that questioned the stability of our polar ice sheets. We now know March, 2016 was the hottest month in recorded history.”

This is all caused by burning carbon fuel. True or not, this debate will not die anytime soon.

The anti-carbon movement is already affecting the oil industry in ways nobody would have imagined two years ago. Alberta’s comprehensive carbon tax regime will become law January 1, 2017 apparently to prove the province deserves a social license to stay in the oil business from carbon fuel opponents. The recent Canada / U.S. commitment to reduce methane emissions will come at an enormous cost to the oilpatch if implementation is not preceded by significant study and comprehensive cost / benefit analysis.

These are just part of a growing trend to dismiss and / or deny the essential role hydrocarbon fuel plays in powering the world’s economy. Oil doesn’t matter any longer University endowment funds have been pressured for years to divest shares in oil and gas companies. The Royal Bank of Scotland now refuses to provide funding for oilsands development. Historically, people sought jobs in the oilpatch and were proud of their work.  This is changing fast.

Canada is one of the few major oil and gas-producing jurisdictions determined to push rapidly forward with major and expensive anti-carbon policy changes despite being only a nominal contributor to global emissions. We won’t be followed anytime soon by Russia, Saudi Arabia, Kuwait, Kazakhstan, Iran, Iraq, Mexico, Venezuela, Nigeria and so on. They will be happy to supply Canada with oil, whether Canadian supplies continue or not.

“Quantitative Easing” No Longer Stimulating Economy

Following the 2008 / 2009 recession the world’s central bankers embarked on a program of near-zero interest rates that would be expanded into something called “quantitative easing.” Investopedia’s definition is, “Quantitative easing is an unconventional monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply.” This has now been expanded in some countries to include experimental negative interest rates where banks and, ultimately, savers are penalized for holding cash and not spending their money.

The purpose has been to juice spending to keep the western economic miracle alive while government debt balloons and the economy stagnates. If interest rates ever approached the double digit levels of 30 years ago, the economic devastation would be staggering. Prime lending and mortgage rates peaked at 22.5% in the early 1980s, long before it was believed (then accepted) governments could print money without collapsing the economy or creating runaway inflation.

But it isn’t working anymore. Past recessions were caused by high oil prices and cured when they fell. Not this time. An article in Oilprice.com on April 19 by Gail Tverberg read, “…consumers are the foundation of the economy. If their wages are not rising rapidly, and their buying power (considering both debt and wages) is not rising very much, they are not going to be buying many new houses and cars – the big products that require oil consumption. In fact, in order to bring oil demand back up to a level that commands a price over $100 per barrel, we need consumers who can afford to buy a growing quantity of goods made with oil products.”

Oops. This time oil prices collapsed and so did demand. The International Energy Agency is forecasting, despite low prices, demand growth of only 1.2 million barrels (b/d) per day this year compared to 1.6 million b/d or higher in 2015 and prior years. Middle class incomes, the main driver of growing oil consumption in the past, are no longer rising in the western world. Quantitative easing has run its course. What growth in oil demand may occur will be in Asia and other foreign markets. Should governments reverse policies on near-zero or sub-zero interest rates or people lose confidence in the long-term stability of central banks printing money as required, oil consumption and prices are doomed.

The U.S. Shale Boom Was Financed By Low Interest Rates

The hunt for yield in the era of lower to zero interest rates leads to peculiar investment decisions. In 2008 the collapse of the housing bubble – driven by an endless investor appetite for high-yield mortgage bonds of questionable quality – was said to cause the global recession. This precipitated the collapse of major financial institutions like Lehman Brothers and the bailout of many more. Regulators frowned and tried to bring in policies to ensure it would not happen again.

The great light tight oil (LTO) or shale boom in the U.S. since 2010 has all the hallmarks of a similar asset bubble. Exploration and production (E&P) companies were able to finance significant drilling through the sale of subordinated bonds with an attractive yield of 6% or more. They were for the most part interest-only and due in several years. The problem with drilling high decline LTO wells with high yield debt is by the time the bonds mature, the production from the wells the debt paid for has declined to the point the assets are only worth a fraction of the leverage outstanding. Many companies in the U.S. are already broke and more will follow. Much analysis has been done to show some of the top LTO drillers in the U.S. spent $2 on drilling for every $1 of cash flow prior investments had generated. The difference was made up by seemingly limitless capital inflows.

This has created two problems for Canada’s oil future. The first is even if commodity prices rise and transportation issues are solved, the ability of companies to raise cheap debt will be impaired for some time, perhaps forever, depending on what happens to interest rates. Historical E&P spending has almost always exceeded cash flow providing investment, jobs and opportunity that would not exist otherwise. External capital inflows are essential to feed the machine.

The other is the impact debt-financing has had on oilfield services (OFS) sector balance sheets. As has been written on these pages before, in 2014 and 2015 alone 21 diversified Canadian OFS operators invested $37 billion adding new rigs, frack spreads, camps, processing plants, midstream facilities and pipelines for a growing North American oilpatch. Three large Canadian pressure pumpers alone carried a combined $2.6 billion in debt and one has gone broke. A lot of E&P demand was financed by debt, which is no longer available. Now OFS is overbuilt and many operators over-levered. It will take some recovery to clean this up.

Middle East Production About Volume, Not Price

Why Middle East producers do what they do remains a mystery. But whatever the plan or strategy, the cash cost of finding and producing the next barrel in this region remains the lowest in the world. In the past it seemed Middle East oil strategy was about price with oil sales assured. Now it looks like volume and market share.

The Middle East may soon be the world’s most active market for drilling rigs. According to the Baker Hughes worldwide rig count, the only area of the world (Latin America, Europe, Africa, Middle East, Asia Pacific, U.S., Canada) still operating about the same number of rigs in 2016 as it was in 2014 is the Middle East. The only region that has increased its active rig count from 2013 and 2012 and its share of the global active drilling rigs is the Middle East.

Source: Baker Hughes Worldwide Rig Count April 22, 2016, average rigs operating for the period

Why? Because they can and to sustain output they must. Whatever the financial situation may be for the governments in charge, there is clearly sufficient cash flow from existing production to fund more drilling. With the Baker Hughes U.S. total active rig count for April 22 down to 471, the average 403 rigs drilling in the Middle East in the first three months of 2016 make it the second-busiest region in the world. Unless prices recover soon, it could become number one.Source: Baker Hughes Worldwide Rig Count April 22, 2016, average rigs operating for the period

This is not a price war Canada can win. One of the attractions of Canada in recent years is foreign capital was welcome to develop massive, if expensive, oil reserves. Now Iran is said to be open for business. As is Mexico. Saudi Arabia wants to diversify its economy away from oil and sell its refining operations to global investors. The Saudis are talking bravely about an economy no longer dependent upon oil profits as soon as 2030.

Western Canada is not the only oil-producing jurisdiction wondering about its future. It is, however, the highest cost oil-producing jurisdiction wondering about its future.

Canada Down But Not Out

Canada produces 7 million barrels of oil equivalent per day of bitumen, crude oil, natural gas liquids and natural gas, making it the fifth largest hydrocarbon-producing jurisdiction in the world. The country won’t be going out of the oil and gas business anytime soon, so keeping it going will remain good business and the largest resource industry in Canada.

But the current mantra of “lower for longer” is wrong. This is only the price of oil. In terms of the Canadian oil and gas industry there are multiple reasons it could be “lower for a long time, possibly forever.” As a country that performs all elements of producing still-essential hydrocarbons as well or better than anyone else in the world – everything from broad economic participation to worker safety to environmental protection – that is a tragedy.

This will be my last column for MNP. I am moving on to other opportunities in the oilfield service industry at the end of April, probably more as a player than a coach. My 3.5 years at MNP have been great and the firm has made significant investments in training, processes and systems to be the best-in-class provider of accounting, tax and consulting services to this key component of the Canadian economy. Please consider MNP as your trusted financial services supplier.

Sincerely,

David Yager