Prior to the COVID-19 pandemic, the Western Canadian oil and gas industry faced daunting challenges.
Stalled or cancelled infrastructure projects prevented producers from obtaining fair market value for their products and shook investor confidence. Carbon taxes and new regulations designed to accelerate the transition to green energy increased operational costs. The price war between Saudi Arabia and Russia in early 2020 resulted in plummeting commodity prices, and the combined effect of these, and other challenges, peeled away investment from oil and gas companies.
The COVID-19 pandemic amplified these challenges by almost instantly obliterating 20-30 million barrels per day of oil demand, creating an over-supplied market that ultimately saw commodity prices sink to unprecedented negative numbers (i.e., for some of the May contracts, producers had to pay traders to take their barrels due to storage and demand shortages). Partially aided by OPEC and governmental production cuts, global commodity prices have increased, with WTI trading near $24 on May 5). WCS, the Canadian heavy oil price which traditionally lags behind WTI, was hovering near $22, with the lowest differential between the two in over a decade). Yet these prices remain far below their levels at the beginning of the year and are far below break-even pricing for Canadian producers. There is expected to be continuing volatility in the oil price for the next several months (and further declines are possible) as storage shortages and over-supply continue until demand begins to recover. This economic reality is forcing companies and governments to consider voluntary or mandated curtailments of production.
Needless to say, if prolonged, the cumulative impact of these challenges and their disproportionate impact on Canadian producers present an existential threat to the domestic oil and gas industry.
The ripple effect to the Canadian economy as a whole should not be underestimated. The energy sector contributes about 10% to Canada's GDP and represents over a $100 billion export business to the United States, and federal and provincial governments are going to face the double hit of decreased revenue sources at the same time as skyrocketing costs associated with government support programs and subsidies.
Initial reaction to COVID-19
The dumping of stocks caused by COVID-19 wiped out a significant portion of the market capitalization of virtually all oil and gas participants. While market capitalization has to an extent generally recovered outside of the oil and gas sector, performance of oil and gas stocks has languished behind alternative investment choices, such as those in the technology, financial, pharma and other sectors. The effect of COVID-19 has thus been to compound the precipitous drop in oil and gas stock performance over the last 10 years.
To preserve shareholder value and protect balance sheets, boards have been forced to very quickly make decisions designed to address liquidity and solvency concerns, including storing and shutting-in production (rather than giving it away for nothing or, shockingly, having to pay for it to be taken away), slashing capital budgets and dividends, suspending buybacks, cutting executive compensation, laying off employees and ensuring their companies have access to cash via lines of credit and otherwise.
Measures from the Canadian and Alberta governments supporting the industry, including the $1.7 billion of funding announced by the federal government and a $100 million loan from the provincial government to clean up orphaned and inactive oil and gas wells (resulting in significant job creation), and the $750 million of federal loans for capital investments to reduce methane and GHG emissions, are helpful to the environment and certain segments of the industry.
However, industry executives maintain that these programs do not go far enough to address the effects of the pandemic and the operational issues affecting the industry and have encouraged governments to announce further lines of credit or other support programs in addition to the lending programs currently offered by EDC and BDC
Looking ahead
Acknowledging that crystal ball gazing is difficult in the best circumstances, and that the ultimate outcomes of the pandemic and economic recovery remain uncertain, we expect the Canadian oil and gas industry to experience a combination of the following in the coming months:
1. Increased public support for job-creating oil and gas projects.
Oil and gas stocks were once investors' darling, comprising more than 10% of the S&P 500 Index in 2009. Today, they make up less than 3%. Conventional thinking is that the trend will not reverse itself in a material way, as societal pressures heeded by a Liberal government in Ottawa and other political pressures globally will continue (and potentially expedite) the move away from fossil fuels to sources of renewable energy, such as wind and solar.
However, as the economic effects of the pandemic deepen and drag out, a sea change in societal pressures could be at hand with public opposition to oil and gas infrastructure projects yielding to overwhelming pressure for accelerated job creation and economic stabilization, both of which can be offered by the oil and gas industry with a host of high-value, shovel-ready oil and gas infrastructure projects.
Effectively, the impacts of the pandemic may encourage public support for industry-transforming oil and gas projects on an expedited basis. Environmental and technological improvements over the last decade, as well as concerns regarding foreign supply chains, should position the Canadian sector as a supplier of choice for North American markets and investment, offering a reliable and secure energy source from a jurisdiction with high environmental and social standards.
2. Continued flight of foreign investment.
Massive oil sands reserves in northern Alberta attracted billions in investment dollars from across the globe, peaking at nearly $34 billion in 2014. The U.S. shale revolution and resultant 2014 oil price crash, combined with exacting price differentials between WTI and WCS, cost overruns, environmental/climate change pressures and transportation bottlenecks impacting oil sands producers, saw investment dollars in the Alberta oil sands dry up (to ~$10.7 billion in 2019) and a number of significant players reduce their oil sands exposure (see Devon Energy, Royal Dutch Shell, ConocoPhillips, Marathon Oil, Equinor, Total and Kinder Morgan). These ongoing challenges and the high-cost environment, exacerbated by the impacts of the pandemic, will ensure a continued trend of decreased foreign investment in the Canadian oil and gas sector and, particularly, the oil sands.
3. Balance sheet recovery transactions.
In the face of decreased revenues associated with depressed commodity prices, demand and production and resultant downward pressure on credit ratings and balance sheets, industry participants can be expected to improve their balance sheets by seeking out (a) partnering arrangements on existing and proposed capital projects, (b) off-balance sheet financing transactions, such as granting royalties over future production in exchange for upfront liquidity, and (c) the continued spin-out of non-core producing properties and midstream assets which has been in vogue since 2014.
The pressures faced by industry executives will surely also lead to seeking out governmental support, though the willingness of the government to provide support, the form that support might take and the strings attached, are all far from certain.
4. Opportunity knocks.
Well-heeled investors and strategics with a long-term, optimistic view of the oil and gas industry driven by rising demand—due to population and economic growth and rising standards of living—may view the current low-price environment as an excellent opportunity to acquire and/or consolidate assets at a once-in-a-lifetime valuation. As was experienced following the 2014 price crash, we should expect that any such investment activity will be concentrated on high-margin assets (following commodity price recovery).
Eventually, the pandemic will pass and demand will return. Fossil fuels are not going away as part of the energy mix, notwithstanding continued pressure for energy transition. Less supply on the market due to OPEC cuts (which continue until 2022) and lack of investment will result in a balancing of oil prices to something approximating fair value. The trick for most Canadian oil and gas companies in the interim will be to weather the storm, while the fortunate few opportunistically seek out growth opportunities at favourable valuations.
Prior to the COVID-19 pandemic, the Western Canadian oil and gas industry faced daunting challenges.
Stalled or cancelled infrastructure projects prevented producers from obtaining fair market value for their products and shook investor confidence. Carbon taxes and new regulations designed to accelerate the transition to green energy increased operational costs. The price war between Saudi Arabia and Russia in early 2020 resulted in plummeting commodity prices, and the combined effect of these, and other challenges, peeled away investment from oil and gas companies.
The COVID-19 pandemic amplified these challenges by almost instantly obliterating 20-30 million barrels per day of oil demand, creating an over-supplied market that ultimately saw commodity prices sink to unprecedented negative numbers (i.e., for some of the May contracts, producers had to pay traders to take their barrels due to storage and demand shortages). Partially aided by OPEC and governmental production cuts, global commodity prices have increased, with WTI trading near $24 on May 5). WCS, the Canadian heavy oil price which traditionally lags behind WTI, was hovering near $22, with the lowest differential between the two in over a decade). Yet these prices remain far below their levels at the beginning of the year and are far below break-even pricing for Canadian producers. There is expected to be continuing volatility in the oil price for the next several months (and further declines are possible) as storage shortages and over-supply continue until demand begins to recover. This economic reality is forcing companies and governments to consider voluntary or mandated curtailments of production.
Needless to say, if prolonged, the cumulative impact of these challenges and their disproportionate impact on Canadian producers present an existential threat to the domestic oil and gas industry.
The ripple effect to the Canadian economy as a whole should not be underestimated. The energy sector contributes about 10% to Canada's GDP and represents over a $100 billion export business to the United States, and federal and provincial governments are going to face the double hit of decreased revenue sources at the same time as skyrocketing costs associated with government support programs and subsidies.
Initial reaction to COVID-19
The dumping of stocks caused by COVID-19 wiped out a significant portion of the market capitalization of virtually all oil and gas participants. While market capitalization has to an extent generally recovered outside of the oil and gas sector, performance of oil and gas stocks has languished behind alternative investment choices, such as those in the technology, financial, pharma and other sectors. The effect of COVID-19 has thus been to compound the precipitous drop in oil and gas stock performance over the last 10 years.
To preserve shareholder value and protect balance sheets, boards have been forced to very quickly make decisions designed to address liquidity and solvency concerns, including storing and shutting-in production (rather than giving it away for nothing or, shockingly, having to pay for it to be taken away), slashing capital budgets and dividends, suspending buybacks, cutting executive compensation, laying off employees and ensuring their companies have access to cash via lines of credit and otherwise.
Measures from the Canadian and Alberta governments supporting the industry, including the $1.7 billion of funding announced by the federal government and a $100 million loan from the provincial government to clean up orphaned and inactive oil and gas wells (resulting in significant job creation), and the $750 million of federal loans for capital investments to reduce methane and GHG emissions, are helpful to the environment and certain segments of the industry.
However, industry executives maintain that these programs do not go far enough to address the effects of the pandemic and the operational issues affecting the industry and have encouraged governments to announce further lines of credit or other support programs in addition to the lending programs currently offered by EDC and BDC
Looking ahead
Acknowledging that crystal ball gazing is difficult in the best circumstances, and that the ultimate outcomes of the pandemic and economic recovery remain uncertain, we expect the Canadian oil and gas industry to experience a combination of the following in the coming months:
1. Increased public support for job-creating oil and gas projects.
Oil and gas stocks were once investors' darling, comprising more than 10% of the S&P 500 Index in 2009. Today, they make up less than 3%. Conventional thinking is that the trend will not reverse itself in a material way, as societal pressures heeded by a Liberal government in Ottawa and other political pressures globally will continue (and potentially expedite) the move away from fossil fuels to sources of renewable energy, such as wind and solar.
However, as the economic effects of the pandemic deepen and drag out, a sea change in societal pressures could be at hand with public opposition to oil and gas infrastructure projects yielding to overwhelming pressure for accelerated job creation and economic stabilization, both of which can be offered by the oil and gas industry with a host of high-value, shovel-ready oil and gas infrastructure projects.
Effectively, the impacts of the pandemic may encourage public support for industry-transforming oil and gas projects on an expedited basis. Environmental and technological improvements over the last decade, as well as concerns regarding foreign supply chains, should position the Canadian sector as a supplier of choice for North American markets and investment, offering a reliable and secure energy source from a jurisdiction with high environmental and social standards.
2. Continued flight of foreign investment.
Massive oil sands reserves in northern Alberta attracted billions in investment dollars from across the globe, peaking at nearly $34 billion in 2014. The U.S. shale revolution and resultant 2014 oil price crash, combined with exacting price differentials between WTI and WCS, cost overruns, environmental/climate change pressures and transportation bottlenecks impacting oil sands producers, saw investment dollars in the Alberta oil sands dry up (to ~$10.7 billion in 2019) and a number of significant players reduce their oil sands exposure (see Devon Energy, Royal Dutch Shell, ConocoPhillips, Marathon Oil, Equinor, Total and Kinder Morgan). These ongoing challenges and the high-cost environment, exacerbated by the impacts of the pandemic, will ensure a continued trend of decreased foreign investment in the Canadian oil and gas sector and, particularly, the oil sands.
3. Balance sheet recovery transactions.
In the face of decreased revenues associated with depressed commodity prices, demand and production and resultant downward pressure on credit ratings and balance sheets, industry participants can be expected to improve their balance sheets by seeking out (a) partnering arrangements on existing and proposed capital projects, (b) off-balance sheet financing transactions, such as granting royalties over future production in exchange for upfront liquidity, and (c) the continued spin-out of non-core producing properties and midstream assets which has been in vogue since 2014.
The pressures faced by industry executives will surely also lead to seeking out governmental support, though the willingness of the government to provide support, the form that support might take and the strings attached, are all far from certain.
4. Opportunity knocks.
Well-heeled investors and strategics with a long-term, optimistic view of the oil and gas industry driven by rising demand—due to population and economic growth and rising standards of living—may view the current low-price environment as an excellent opportunity to acquire and/or consolidate assets at a once-in-a-lifetime valuation. As was experienced following the 2014 price crash, we should expect that any such investment activity will be concentrated on high-margin assets (following commodity price recovery).
Eventually, the pandemic will pass and demand will return. Fossil fuels are not going away as part of the energy mix, notwithstanding continued pressure for energy transition. Less supply on the market due to OPEC cuts (which continue until 2022) and lack of investment will result in a balancing of oil prices to something approximating fair value. The trick for most Canadian oil and gas companies in the interim will be to weather the storm, while the fortunate few opportunistically seek out growth opportunities at favourable valuations.
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