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A Focus on Energy

This article will focus on Canada’s role as a significant energy producer and the impact of recent sharp oil price declines.

Oil price declines had an immediate negative economic impact in Alberta and Saskatchewan. Canada’s GNP as a whole declined in the first and second quarters of 2015 - technically a recession. However, lower energy costs, plus a lower Canadian dollar, had a positive impact outside the oil producing provinces. Canadian manufacturers became more competitive and Canadian trade balances with the U.S. improved.

Investors are seeing a wide range of forecasts for future energy prices. What does the future hold for this essential Canadian industry? The immediate cause a year ago of the oil price decline was the move by Saudi Arabia and its OPEC partners to increase production and sharply reduce oil prices. They did this to protect their declining world share of oil production. Their particular target was new rapidly growing oil production in the U.S. After years of dependency on Saudi oil imports, the U.S. with imports from Canada and domestic production from the Bakken fields in North Dakota and oil shales in Texas, has sharply reduced imports from Saudi Arabia. This story however has an important technological background.

Fossil fuels are found concentrated underground in particular geological formations with some formations allowing for relatively easy extraction of both oil and gas. Other formations were called tight with extraction difficult or impossible. For decades the easy formations provided the basis for world oil and gas production but a decade ago technology developed to produce from tight formations. First it was the natural gas sector, with horizontal drilling plus fracking rapidly growing natural gas production. Horizontal drilling increases the exposure of a particular well bore to a product producing section. Fracking shatters the tight rock to allow hydro-carbons to escape. In North America increased gas production caused prices to drop from $6.00 to under $3.00 per million cubic feet. Recently Texas tight shales provided an excellent source of oil using the same technology.

Oil prices under $50.00 U.S. make most world oil production uneconomical. The drilling of new oil wells has already declined sharply and where wells are drilled it is into high production locations. Saudi Arabia has already lost billions of dollars at these price levels but is showing no signs of changing its strategy. Given falling production world wide and rising consumption, the present oversupply of approximately 2.0 million barrels daily will likely disappear within the next year. Where will prices settle as demand and supply come into balance? With oil industry cost cutting and efficiencies we see $60.00 US oil prices as the point at which drilling and then production rise again particularly in the Texas shales. We also have the prospect of Iranian oil entering the market in 2016, which will not be price sensitive – they need the foreign exchange. So $60.00 could well be the new norm.

All the foregoing is not good news for Canada and its oil and gas industry. Recent reports from the industry indicate significant cost cutting has been achieved. Gas producers have had longer to adjust to lower prices and can live with present price levels. The large oil sands projects face particularly difficult problems. At prices in the $60.00 U.S. range profit margins are slim if non-existent for any new projects. Unfortunately a number of large scale oil sands projects are still coming on stream with production increases in excess of 200,000 barrels daily occurring over the next several years. Once a multi billion dollar oil sands project is in place and producing then operating costs become the hurdle to overcome for production to continue. Since operating costs can be under $30.00 per barrel production will continue. In this environment oil sands projects not already underway will likely be shelved and existing projects will continue to be under pressure to reduce costs.

The Canadian energy industry is not going to disappear. It is however going through a difficult period that will see some companies disappear, lower profits, job losses and much slower growth. The industry has already shown the ability to cut costs and improve technology to further increase efficiency. With significant infrastructure in place, experienced operators and the best technologies, the Canadian industry is world class and will survive and grow in the future. With a major source of national growth neutralized, Canada as a whole will struggle to achieve GNP growth in the 2% range in the near term. Longer term U.S. growth and a low Canadian dollar will bring better times.

Equity markets continue to be volatile because of investor concerns about a potential slowdown in China and the direction of future Federal Reserve policy. Investors should continue to focus on equities that pay safe dividends and display lower than average volatility, combined where appropriate, with alternative investments such as private real estate, private equity and debt along with carefully chosen hedge funds in order to better diversify a portfolio. With the Greece problem put to bed for the present and the prospect for quantitative easing in Europe, it makes that area worth considering for investment.

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