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By David Yager
Oilfield Services Executive Advisory – Energy Policy Analyst
March 15, 2018
“It’s the economy, stupid”. This became a key slogan during Bill Clinton’s 1992 electoral run to unseat incumbent U.S. President George H. W. Bush. It originated as, “The economy, stupid”, part of an internal campaign team message. But it grew legs. America was in recession and voters were unhappy. Assisted by this simple phrase, the first President Bush, hero of the Kuwait invasion only a year earlier, was replaced after a single term.
A quarter century later orphan wells are back in the news thanks to an outfit nobody has ever heard of called Sequoia Resources Corp. Sequoia recently declared itself insolvent (EnergyNow.ca Article) and unable to continue to operate its significant inventory of wells, facilities and pipelines. As the number of suspended and ownerless assets grows, the blame is consistently placed on everyone and everything except the governments which tax and regulate the industry.
Obviously, Sequoia and others which have suffered the same fate were overwhelmed by some degree of mismanagement compounded by insurmountable negative economic forces. But as everyone has been painfully reminded in the past three years, governments have a huge impact on the economics of the oil and gas industry.
Have The Enemies Of Oil Thought This Through?
A growing belief is the world will be a better place the sooner mankind quits using oil. While there is no evidence consumers will allow this anytime soon, government policy, lobby groups and misinformed voters continuously push this agenda. Carbon taxes. Pipeline opposition. Emission caps. Higher corporate tax rates. Environmental protection regulations. Lawsuits. Municipal property tax increases. Discouraging investment in oil companies. Policies obstructing or prohibiting oil and gas development. Massive taxpayer subsidies for non-carbon energy alternatives.
New supplies of crude oil and natural gas have caused the value of both commodities to collapse. The result? Exactly what you’d think petroleum’s opponents planned, hoped for and successfully engineered: shrinking cash flow.
Cash, the essential ingredient for well abandonment, site reclamation and facility decommissioning.
Tight cash has caused investment in new supplies to shrink significantly. At the recent CERA global oil conference in Houston speakers worried a lack of reinvestment today would cause shortages next decade.
Starving producers of cash is creating unintended consequences for the anti-carbon crowd that cannot rationally be part of a well-conceived master plan. If the oil and gas haters are successful the value of these commodities will decline with demand, further squeezing cash flow. This has been a stated objective of oil sands opponents blocking export pipelines. “Leave it in the ground”.
As a result, existing expensive and marginal assets will be shut-in thus requiring decommissioning. Meanwhile, cash available to fulfill environmental cleanup obligations will decline as remediation obligations rise.
In the morally pure but often irrational world of green logic, producers will have no production and therefore no cash but will have miraculously fulfilled their abandonment obligations prior to insolvency. This is a classic Catch-22, an economic reality nobody talks about or admits.
Collapsed Natural Gas Prices
The Sequoia news coverage speculated receivership is imminent and its assets could end up further swelling the cleanup inventory in Alberta’s Orphan Well Association (AOWA). Sequoia is a recent buyer of some 2,300 wells, 200 facilities and some 700 chunks of pipeline from insolvent Canadian producers like Waldron Energy Corp and Endurance Energy Ltd. or independents seeking cash like Perpetual Energy Inc.
While the buyer was not identified at the time, in September 2016 Perpetual sold 2,200 shallow gas wells, described in one news story as, “high liability mature shallow gas properties in east central and northeast Alberta”. Another news report stated, “According to Perpetual, the buyer is a private company from outside Canada and asked to remain confidential as a condition of the deal”. Perpetual indicated the buyer believed natural gas prices would improve and had the cash to maintain and enhance production from these assets.
In August 2016 Perpetual had publicly offered to exchange producing assets to municipalities to offset rising property taxes based on valuations greatly exceeding their actual value. The company proposed the assessment value be reduced to $1. This view was shared by CNRL which had approached municipalities for a 30% reduction in property taxes to help ensure their producing assets remained economically viable to maintain and operate.
While the actions of Sequoia – and the prior bankruptcy of Lexin Resources Ltd. in 2017 – are controversial, the real problem is the very low price of natural gas and rising costs.
Collapsed gas prices resulted from massive new supplies of shale gas and associated gas from light tight oil in North America. Today’s AECO spot price is 1/3 of 2014 values and 1/5 of a decade ago.
But another problem is the inability of Canada to complete a single LNG export project due to endless government intervention and public opposition. The combination has been devastating.
During the height of the once-promising but ultimately non-existent LNG export boom, the major political issues were increased carbon emissions in B.C. and placement of export infrastructure so it didn’t impact anyone or anything. Although natural gas is cleaner than petroleum and Asian countries need it to displace much-dirtier coal, the opposition to LNG development was vocal and relentless. Some blame the global oil price collapse for Canada’s lack of progress but meanwhile the U.S. has forged ahead with LNG exports in the past three years.
As for B.C., to hell with global carbon emissions. We are reminded daily by the Kinder Morgan dispute that B.C.’s view of the world remains regrettably myopic and introspective.
Low natural gas prices were predicted if governments and regulators didn’t create new markets by encouraging, not obstructing or delaying, LNG exports.
Be assured if the price of natural gas were to increase due to improved market access and/or operating these wells became more economic due to meaningful reductions in taxes and regulations, the number of producer insolvencies resulting in orphaned gas wells would decline.
Challenges For The AER And AOWA
Two organizations intended to be arms-length from the political process – yet somehow stickhandle through this mess – are the Alberta Energy Regulator (AER) and the AOWA.
A series of bankruptcies have saddled the AOWA with a record number of ownerless assets including, for the first time, an oil sands processing facility. As the backlog grows the governments of Canada and Alberta have loaned AOWA $265 million (Alberta $235 million, Ottawa $30 million) to help manage the cleanup.
The AER has tried several methods to mitigate the potential of the public being on the hook for cleanup expenses that by law are the responsibility of the asset owner and mineral licensee.
In 2013 the regulator updated its Licensee Liability Rating (LLR) parameters to attempt to ensure mineral title holders had sufficient financial resources to comply with their current and future cleanup obligations. Due to collapsed prices (and therefore cash flow) the formula required some producers to put up more cash with the regulator to remain compliant. But of course, the same commodity prices that squeezed their LLR also shrank available cash. Starting in 2015 as more producers began to go under, the tightened LLR provisions began to be cited as accelerating solvency problems.
The AER tightened the review process when leases and assets change hands to ensure the new owner was financially sound, had an acceptable LLR, and the principals weren’t on record as having gone broke before, leaving environmental liabilities to other.
Finally, the AER has taken an Alberta court decision under the revised Bankruptcy and Insolvency Act to the Supreme Court of Canada. This involves Redwater Oil & Gas where the receiver, on behalf of the secured lender (ironically Alberta Treasury Branch, a Crown corporation), sold the assets of value to pay down debt and left the other assets requiring abandonment behind. The AER wants decommissioning obligations recognized as legitimate monetary assets in the case of bankruptcy and therefore be considered a ranking creditor, not just a public policy issue.
An Onslaught Of New Environmental Protection Regulations
Many of the industry’s assets are decades old. Although they were legally drilled and constructed under the regulations of the day, the rules have been replaced or strengthened over the years. Today, not only are abandonment and reclamation procedures complex and expensive, the total cost for more problematic assets is too often unknown.
There was a time when cementing the production casing on a new well was only required to isolate the producing formation, not uphole zones. Drill cuttings and drilling mud were dumped into a sump or earthen hole in the ground which was later buried. Salt water produced during drillstem or well tests flowed into the flare pit and later buried.
Abandoning a well involved pulling the casing (most of which wasn’t cemented), depositing an open hole cement plug, leaving the hole full of water and/or drilling mud and covering the surface. The process was cheap and easy. Oil companies did it all the time.
The first major change in the wellbore abandonment process was ERCB Directive 9 in 1990 innocuously titled, Casing Cementing Minimum Requirements. It set new rules for groundwater isolation. Good idea. Sounds harmless.
In 2010 the ERCB introduced Directive 20 titled Well Abandonment to tighten subsurface interzonal isolation requirements and enhanced specifications for bridge plugs, casing recovery and cement tops.
In 2012 directive 50 titled Drilling Waste Management set new guidelines for sumps and surface land recovery. This was strengthened in 2015 to include cuttings and drilling fluid removal. The earthen sump was dead and the buried ones became potential liabilities.
As the old saying goes, the road to hell is paved with good intentions. While nobody will suggest these rules should never have been introduced, according to CAPP statistics there were already 489,745 wells drilled the wrong way by the time Directive 50 came into effect, most of them in Alberta.
Current processes for well abandonment and remediation reference the Alberta Government Contaminated Sites Policy Framework. It assumes all sites could be non-compliant so it falls upon the licensee to prove they are not.
When cash is tight, how does an oil company justify earmarking precious capital to a cleanup operation of unknown total cost? With decades-old assets that may have changed hands several times, you don’t know for sure what you’re dealing with until the process is underway. Regardless of the regulations when the asset was constructed, the new rules apply.
Are unlimited expenses to abandon some assets the right course of action if doing so jeopardizes the health of the company and the ability to finance future commitments?
Is it possible the growing inventory of suspended but not yet decommissioned wells and operators choosing bankruptcy as their only option is in any way related to the foregoing?
Service Sector Doesn’t Understand The Problem
The overbuilt and activity-hungry oilfield services (OFS) sector is, as always, ready to help. The line up to provide goods and services for the AOWA now that it has more money and more work is long and growing.
OFS, no fan of its clients after three years of predatory procurement practices, regularly complains customers don’t spend enough on abandonment and reclamation…and provide vendors with much-needed work.
The problem is non-revenue generating expenses with a potentially unknown total cost. Once the abandonment file with the regulator is open the job must be completed. Problem wells with known mechanical or compliance issues, classified as higher priority assets under AER rules, come first.
OFS is historically a time and materials business. If drilling a 10-day well takes 20 days, few rig contractors care if the additional cost impairs the economics of the investment. Same goes for abandonments. As vendors complain about low prices they too often don’t understand the asset decommissioning market is elastic – cut the price in half the clients will do twice as much work. Help control and fix the cost and more activity will materialize.
Having oil and gas companies and OFS behave like partners, not competitors, would accelerate cleanup activity.
“Competitiveness”, The Heart Of The Issue
The Canadian Association of Petroleum Producers (CAPP) is a lobby group with a clear purpose. “CAPP’s mission, on behalf of the Canadian upstream oil and natural gas industry, is to advocate for and enable economic competitiveness and safe, environmentally and socially responsible performance.”
Organizations like CAPP typically discuss their issues directly with governments behind closed doors. This is because politicians dislike being criticized in pubic and have, over the years, punished oil industry trade associations that don’t play the game by their rules.
But finally, enough was enough. On February 26, just before the federal budget, CAPP released a competitiveness report which was a scathing indictment of the current direction of Canadian political and fiscal policy.
CAPP wrote, “Rising government costs, the burden of inefficient regulations, and the lack of infrastructure to move Canadian energy to growing markets are all undermining investor confidence in Canada and negatively affecting the country’s ability to attract the capital needed to create jobs and national prosperity…Around the world capital investment in the oil and natural gas sector increased globally in 2017, but was down in Canada. Total capital spending on Canadian oil and natural gas was $45 billion in 2017, down 19 per cent from 2016 and 46 per cent from 2014. In comparison, capital spending on oil and natural gas in the United States last year increased by 38 per cent to $120 billion. It’s taken Canada 150 years to grow its oil and natural gas production to current levels and only eight years for the U.S. to accomplish the same.”
CAPP also stated that if other oil and gas producing jurisdictions don’t charge carbon taxes, Canadian producers shouldn’t have to pay them either. This is ironic after executives of four of CAPP’s largest members appeared on TV with Premier Notley in November 2015 for the unveiling of Alberta’s Climate Leadership Plan.
When investing equity capital or loaning money, the financial attractiveness of any company is ultimately based upon free cash flow generated from operations. Lots of free cash? Share values are high and debt is cheap. Little to no free cash? Share values tumble and the cost of borrowing escalates.
If you wonder how much the key variables – commodity prices, production volumes, taxes, royalties, regulations and the cost of doing business – are affecting the cash generating capability of oil and gas producers or the service sector, look no further the share prices of public companies. Then remember what they once were. The shareholder value wiped out in the past five years is breathtaking. Tens if not hundreds of billions in Canada, trillions globally.
Data from a Forbes article in February 2016 when crude tagged bottom highlights the immensity of the problem. Crude had fallen from US$100 to below US$30. The world had 1.7 billion barrels of proven reserves. The “value decline” was US$119 trillion.
In Edmonton and Ottawa governments were so moved by the economic devastation thrust upon one of Canada’s major industries they raised taxes.
Capital markets and corporations understand the value of cash. As this article began, “It’s the economy, stupid”.
Time For Governments To Acknowledge Their Actions
World commodity prices, the most significant driver of producer cash flow, are not controlled by governments. But because Canadian oil and gas is largely land-locked, market access is a growing factor impacting domestic prices. The politicians are in complete control of how and if production gets to market.
Increasing operating costs through taxes and regulations when prices are depressed was, as CAPP President Tim McMillan opined a few years ago, “piling on”.
As the suspended and orphan well problem continues to grow, surely governments at all levels – federal, provincial and municipal – will at some point acknowledge their actions are making it increasingly difficult for industry to meet its legal and societal obligations to return the places it operates to as close to the same condition they found it as is economically feasible.
For politicians to point fingers and recite the mantra of “polluter must pay” without admitting or even understanding the relationship between regulation and taxation and the ability of industry to properly do its job serves no one.
Looking around the world it is obvious the wealthier the country, the cleaner the air, water and land.
Corporations will react favorably and appropriately to similarly attractive economic conditions.
About David Yager – Yager Management Ltd.
Based in Calgary, Alberta, Canada, David Yager is a former oilfield services executive and the principal of Yager Management Ltd. Yager Management provides management consultancy services to the oilfield services industry in a number of areas including M&A, Strategic Planning, Restructuring and Marketing. He has been writing about the upstream oil and gas industry and energy policy and issues since 1979.
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David Yager can be reached at Ph: 403.850.6088 Email: yager@telus.net
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