Commentary – First Quarter Fiscal Pulse

Photo: Peter Tertzakian
Photo: Peter Tertzakian

It’s federal budget time. Debits and credits won’t quite balance this year, in part because of the poor health of the country’s largest resource industry. The mettle of the Canadian oil and gas industry has been stressed on numerous occasions over its 155-year history. Yet when we look back years from now, the oil price war of 2015 will rank among the most challenging for industry and for governments.

Canada’s oil and gas industry as a whole is forecast to see its first accounting loss position since 1998, an indication of the severity of the current situation. If history is a guide to 2016, we can expect gradual commodity price recovery going forward, though the present circumstances suggest see-saw volatility on the path back to viable economics.

Yet not all companies are performing poorly. In fact, those with strong balance sheets, superior low-cost assets, hedged production, and an innovative mindset are finding opportunity in the turmoil. As we’ve seen before, this 155-year-old industry has always come out stronger after every downturn.

In a report that we will be publishing later this week, we will be examining the effects of low oil and gas prices on the “fiscal pulse” of Canada’s oil and gas industry. With the first quarter behind us, the highlights of our 2015 diagnosis are summarized below:

Cash flow is at a 15-year low – At $90 billion, the expected upstream revenue for this year will mimic the depths of the Financial Crisis in 2009. But it’s the industry’s cash flow – how much money is left over after expenses – that will take the award for drama. Down a projected 68% from last year, only $22 billion of cash flow is expected in 2015, less than it was in 2000.

Weak revenue, weak royalties – Royalties are mostly a function of production volume and price. Blended oil and natural gas prices have been hammered down 40% in 2015, so royalties should be off proportionally. Production growth of 3%, mostly from oil sands, will provide some offset. Nevertheless, the net numbers point to a big hole in provincial pockets this year: an expected drop of $7 billion in total royalties relative to 2014.

No earnings, no taxes – Collectively, companies in the industry are on track to report a profit puncture through the bottom line. An overall net loss means that federal and provincial tax collectors, in theory, should not expect big cheques from oil and gas companies in 2015. Profitability in peripheral businesses will also be impaired. The public purse could be short a few billion dollars.

Belt tightening, by two notches – On a four-notch belt, the industry’s capital investment will be down by two, almost 50%, or $36 billion relative to 2014. That’s why field activity is quiet and layoffs are a weekly occurrence. Cash flow impairment suggests there should be even more tightening in spending, up another notch. However some big oil sands projects are near completion. Money is still being spent on finishing up near-term projects like Imperial Oil’s Kearl Oil Sands Project.

A falling axe on future oil sands projects – Board of directors have been quick to slash budgets for 2015 by 25%-30%, but it’s the delay and cancellation of long-term oil sands projects that’s more significant. Since oil prices started falling in the latter half of 2014, at least a dozen early-stage oil sands projects have been delayed or cancelled. Soon we’ll see analysts paring back long-term Canadian growth estimates. The price war is taking big prisoners.

Parking lots full of oilfield equipment – The classic barometers of traditional (non-oil-sands) oilfield activity are the rig and well counts. Although process innovations are diminishing the relevance of these measures, sudden changes still reflect economic conditions. Drilling activity is down 44% in the first quarter of 2015 – that’s sudden. As in 2009, the 2014/15 winter drilling season was forfeited. This summer will be eerily quiet. Compared to over 11,000 wells last year, as few as 5,300 wells may be drilled in all of 2015.

Narrower oil price discounts – Oil price discounts relative to global prices have been afflicting the US and Canadian industries since 2010, ever since rising production in North America began clogging up pipelines. Today, equivalent discounts have retreated to $15/B, however the fiscal pain is still there: $15/B on $50/B is more painful than $30/B on $100/B.

Lower costs – There is a pewter lining in this downturn. Declining activity is freeing up labour and services. Producing companies are focusing hard on improving logistics and innovating for operational efficiencies. Existing production is now costing approximately 10% less than before. Some wages are reportedly down 20% and in some instances services for finding and developing new reserves are being offered for 25% less than last year.

Investment defies gravity – Here is some more good news. Despite the malaise in the oil patch, investors are still pouring money into the business. Already in 2015, investors have put $5 billion of mostly equity into the space. Part of the buy-low-sell-high investor psyche is the recognition that such dire, bottom-of-the-market industry conditions can’t last. Another factor is the safe, politically-stable investment opportunity that Canada offers.

Forward markets for oil and gas are indicating prices that are about 10% to 15% higher in 2016. If such prices materialize, the industry’s “fiscal pulse” will beat stronger, though not quite with full recovery. Yet imagine the rush to invest when oil prices firm up more.