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Energy service firms closest to the cash flows of producers will survive. Those counting on capex budgets will not
BY DAVID YAGER
It has been a correction of monumental proportions, and it’s reorganized the entire industry and our expectations of it. That’s the state of the Canadian oil patch just 18 months after the November 27, 2014 OPEC meeting that precipitated this devastating collapse in the price of oil.
Calgary’s ARC Financial publishes a weekly macroeconomic view of the Canadian E&P sector, the industry’s main source of revenue. In 2014, the value of all the oil and gas produced in Canada was a record $149 billion. ARC’s estimate for 2016 is only $75 billion, a 50-percent reduction and the lowest number since 2003.
The next most important number is after-tax cash flow from production, or what remains after all the bills are paid. This is what pays for replacing oil and gas production, which E&P companies require to stay in business. It’s also the lifeblood of the oilfield service (OFS) industry. In 2014, total cash flow was $72 billion. The estimate for 2016 is only $19 billion, or 74 percent less. In the 15 years of data ARC tracks back to 2002, this is the lowest cash flow ever by a wide margin.
Even in 2009, the bottom of what became known as the great recession, production revenue was $89 billion and after-tax cash flow was $37 billion, double ARC’s estimate for this year.
This has had a commensurate impact on capital expenditures. In April, the Canadian Association of Petroleum Producers (CAPP) revised its 2016 capex estimate down to $31 billion, only 38 percent of the $81 billion invested in 2014. This has caused drilling to fall to the lowest level in decades. In late April, the Petroleum Services Association of Canada (PSAC) revised its estimate of wells drilled in 2016 down to only 3,315. This is less than a third of the drilling activity in 2014. According to the CAPP database, if correct, this will be the lowest number of new wells drilled since 1971.
What’s not obvious is that there is a bright spot in the oil sands. Numerous projects that began before oil prices collapsed are being completed with the exception of the mothballed Shell Carmon Creek development. CAPP estimates oil sands capex this year at $17 billion, half of what it was in 2014, but greater than conventional oil and gas capex for the first time ever. But there are no “greenfield” oilsands projects on the books. This will leave a large and possibly permanent hole in investment and employment.
Regardless, oil sands production is expected to continue to grow through to 2018, rising from 2.2 million barrels per day (b/d) in 2014 to as much as 3 million b/d in two years. This will increase operating costs providing steady opportunities for years because oil sands projects have very low-to-zero decline rates. ARC estimates Canada will produce 6.8 million barrels of oil equivalent per day in 2016, the fifth-largest hydrocarbon producing jurisdiction in the world. Keeping this production on stream will provide stable employment and sustainable investment. Even without continued expansion, the oilpatch remains Canada’s largest resource industry by any measure.
However, because of the massive contraction, not everybody is going to make it. For producers, survival is a factor of geology, operating costs and debt. Not all oil and gas reservoirs are the same. Some, like the giant Montney play in northwest Alberta and northeast B.C., are world-class resources, which are competitive and profitable at current prices. Many more are marginal without higher oil and gas prices. The oil sands will likely yield steady production for decades, but have higher operating costs. Fortunately, once the major capital investments are sunk, operating costs are surprisingly competitive and can and will be reduced further. Necessity remains the mother of invention.
The great leveler is debt. How much money any company can borrow is a factor of free cash flow. With cash flow reduced by 74 percent since 2014, the E&P sector as a whole can only afford to carry about 25 percent of the debt in 2016 that it could two years ago. Obviously, paying down debt with reduced cash flow becomes nearly impossible. Out of necessity, lenders have become more patient and flexible in trying to work through troubled loan portfolios than either banks or borrowers would previously have imagined possible.
OFS is much more complicated because of the enormity and diversity of the supply chain—everything from drilling rigs and construction equipment to camps and catering to valves and electronics. The best way to determine which companies have the brightest futures is through looking at the industry sectors they serve. OFS operators that help to keep existing production on stream—those closest to the cash flow—will actually see opportunities grow as oil sands output increases. Conversely, companies that enjoyed years of steady growth because of expanding oil sands capex will see business continue to decline. There will be sustaining capex but it will only be a fraction of previous levels.
As for conventional oil and gas, activity will come back as the price does. However, as the method of well construction and completion has changed in the past few years, technical obsolescence has become a problem. Many conventional oilfield assets that paid the rent for a generation are now obsolete and may never work again.
And for OFS, debt remains a huge problem. As the old saying goes, when E&P gets a cold, OFS gets pneumonia. While producers for the most part have at least some cash flow from production, without increased spending, many OFS outfits have no cash flow whatsoever. The ability to survive until business improves is a matter of balance sheet strength and/or the willingness of the owners to inject working capital to be there when market conditions improve.
There is a growing consensus that the worst is over for oil prices. Since hitting a multi-year low in February, WTI rose nearly 75 percent by the end of April. Natural gas prices at multi-year lows only exacerbate the challenges too. But things can’t get better until they quit getting worse. It will be a slow and painful recovery but the oilpatch will come back; it always does.
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