By David Yager
May 25, 2021
The last major excuse for Canada’s rejuvenated exploration and production companies to continue to protect their cash disappeared on May 12, 2021 when Enbridge did not stop shipping 540,000 b/d of oil and natural gas liquids through Line 5 to the US, Ontario and Quebec.
The 2018 election campaign fantasy of Michigan governor Gretchen Whitmer – that she had the legal and moral authority to halt the flow of oil in a safe, functioning and essential energy conduit from one end of another country to the other – is now where it belongs: in the courts.
As I have written before, the Line 5 shutdown was hopefully the last “Black Swan” event for our industry. Avoiding this mess follows five years of bad news culminating in the COVID-19 pandemic and the second American cancellation of Keystone XL.
Now we can focus our attention on how and when Canadian producers will spend their money. Because despite what you see, hear and read about a struggling industry with a questionable future, the cash flow recovery of producers in 2021 is nothing short of spectacular.
In defending themselves from punitive public opinion and policies, E&P companies have been telling Canadians for years how important the oil and gas business is to the economy – a valuable and unreplaceable source of investment, employment and prosperity.
At the same time, they have been telling current and prospective shareholders about their new-found respect for their cash after years of negative returns and value destruction. The new buzzword is “capital discipline”.
Can you still be the nation’s economic engine and not invest in your own business?
Is this really a genius long-term strategy? Or has the time come to relax and crack open the vault?
That producers would be cautious is hardly surprising. Having oil prices fall below zero last spring is impossible to forget. Any company with serious debt is alive today only because of patience and covenant waivers from lenders. Many never made it. Others saw their shareholders’ equity annihilated as they converted unmanageable debt to equity to keep the doors open.
Fixing balance sheets and servicing capital is essential. But to what degree depends on the future outlook and confidence in the forecasts. And, of course, how much you owe.
That shareholders are unhappy with their returns is hardly surprising. So are the tens of thousands of former oil workers and an extensive supporting cast who have lost their jobs, houses and companies. The misery of the past six years was not restricted to lenders and capital markets.
Oil prices began to recover last year but when the 2021 budgets were created, the outlook was hardly as strong as it looks now. World crude prices were supported by OPEC+ production restraint agreements, a marriage of convenience between Saudi Arabia and Russia. The contribution of materially higher natural gas prices to the industry’s remarkable recovery doesn’t get enough attention.
Announced capital spending for 2021 is only marginally higher than 2020 and still well below 2019 when 5,500 wells were drilled. Drilling fell below 3,000 new wells in 2020. Current forecasts for 2021 don’t exceed 3,500. While there are suggestions that there will be more money spent in the second half of 2021, hard numbers are lacking.
Government funding for well abandonments and site reclamation has put service rigs and associated equipment to work. But this is an operating expense, not capital. Asset retirement obligations are already on producer balance sheets. And much of it isn’t the operators’ money.
The ESG investor phenomenon is also a factor. As more institutional investors with activist agendas take larger position in E&P companies, they are pushing for reduced capital spending and seeking a larger share of cash flow through higher dividends to shareholders. They want the cash in their pockets, not put back into the ground.
It is noteworthy how seemingly altruistic money managers have managed to package climate salvation and self interest into the same trade. This isn’t divestment. They don’t want to avoid oil stocks. They want the ones they own to be more lucrative.
Add to these factors the Line 5 fiasco. While most producers didn’t believe that Whitmer would be successful, the May 12 deadline had to pass. Now that common sense has prevailed – at least for now – there’s lots of time left to spend more money in 2021.
Oil and gas producers have proven to be extremely nimble adjusting spending as market conditions change. A year ago, they slashed everything possible in record time after pandemic lockdowns collapsed oil prices and demand.
Should they be so inclined, they can easily change plans and increase spending this year. The uncompleted 2020 capital programs – the rest of the work that never got done because of COVID-19 – are still in the files.
What is not mentioned frequently enough is how much money the E&P sector has to spend. There has never been more cash flow publicly committed to less capital spending in the history of the Canadian oil and gas industry.
According to ARC Energy Research Institute, forecast after-tax cash flow from existing production in 2021 will be the second highest in history. In its May 17 weekly report, ARC estimated that after fixed costs, taxes and royalties, this year producers will generate a whopping $70.5 billion in after-tax cash flow. This is over three times the cash generated in 2019, and greater than the last high-water mark of $67 billion in 2014 when WTI averaged US$93.17/bbl.
The most startling number is ARC’s estimated “reinvestment ratio”; how much cash is committed to capital expenditures. When the industry was rocking from 2010 to 2014, this ratio averaged 1.24, or 124% of cash generated. The additional funds came from equity or bank debt. Canada was seen as great place to invest, and the dough poured in from domestic and international capital providers.
After oil prices and cash flow started falling in late 2014, in 2015 and 2016 investment ratio averaged 1.72 largely because of capital committed to completing large projects, primarily oil sands. By 2017 it was down to 0.94. Thereafter it continued to slide. Market access was a big issue, as was crumbling investor confidence.
ARC’s estimated reinvestment ratio for 2021 is only 0.35, meaning producers have only announced capital plans for just over one-third of their after-tax cash flow. Be assured this is the lowest reinvestment ratio in history. I have been studying these numbers since 1980 when I began receiving the old Petroleum Monitoring Agency reports. Using ARC data back to 1998, the 24-year average reinvestment ratio from 1998 to 2021 is 1.01.
The only year even close to 2021 in terms of big cash and low spending was 2008, an embarrassment of riches because of rising production, crude peaking at US$147/bbl, and gas averaging $7.75/GJ. That year ARC reported after-tax cash flow from production of $83.3 billion and capital expenditures of only $54.4 billion resulting in a calculated reinvestment ratio of only 0.65. Producers couldn’t figure out how to spend all the money.
We’ve been told repeatedly that debt and equity markets are closed for new funding for oil and gas development. But what the foregoing proves is that for the industry as a whole – and depending upon the company – producers don’t need either. And for the right operators with decent balance sheets and sound business strategies, external capital is available. Deals are getting done.
ARC’s pricing assumptions are not aggressive, even with the strong Canadian dollar. The average AECO spot price in ARC’s model is $2.54/GJ. The closing price on May 20 was $3.09 and the 12-month average futures price was $3.02. ARC’s Edmonton annualized par price for conventional oil is $74.91, or US$62 at the current Canada/US exchange rate of $0.83. According to the EIA, the average price for WTI for the last 90 trading days is US$62.50.
WCS closed on May 20 at US$47.43. The average price for WCS for all of 2019 was US$44.27. It was only US$26.80 in 2020.
World oil inventories are declining. OPEC+ compliance is holding. Of the 10 mmb/d OPEC+ shut in a year ago to support oil prices, all but 4 mmb/d is back on production. Demand is recovering as more economies open up with the assistance of COVID-19 vaccinations. Iran is a wild card, but so are Libya, Venezuela and several other countries. Nothing new here. US shale oil production remains flat and two million b/d below last year’s peak. Six years of underinvestment in new reserves has more analysts and commentators figuring oil prices are likely to go way up before they go way down.
The ultra-enthusiastic are calling petroleum part of a commodity “super cycle”, and that crude consumption will continue to grow driven by global population and economic growth. Repeated stern lectures on how the future of mankind depends on using much less oil as soon as possible don’t appear to be having a material impact on the behavior of planet’s 7.8 million fossil fuel consumers.
But being extra cautious in the short-term following the pandemic price collapse is not confined to Canadian producers. In a May 21 article, the Financial Post interviewed global oil analytics firm Rystad Energy about its 2021 investment outlook. The firm predicted only a modest increase in investment worldwide, from US$382 billion in 2020 to only US$390 billion in 2021. The top spenders will be the US, Russia and China.
Despite the extra cash, Rystad VP Thomas Lyles said, “Canadian upstream spending is projected to come in sixth place in 2021 at US$16.8 billion, representing a 4.5 per cent increase over 2020 levels.” But next year, things get better. “From 2022, however, we expect year-over-year investment growth to exceed 10 per cent as oilsands players increased capex to levels required to sustain base production. Similarly, shale oil and gas players will help drive growth post-2021 given an overall more robust oil demand environment.”
Peculiar times. Historically, producers have spent well over 100% of the internally generated cashflow. In 2021, they apparently want to spend as little as possible. Or maybe not tell anybody.
Has the industry really changed that much? Is there nothing to do? Are all the E&P company balance sheets really that levered? Is the influence of the ESG investing crowd so powerful that our industry sees no future beyond producing what we have and giving all the money to debt and equity capital providers?
Or did Canadian producers somehow anticipate the May 18 report from the International Energy Agency that the world needed no more oil and gas development on the path to net zero by 2050? Or the G7 announcement a few days later about the future of fossil fuels that warned yet again about stranded assets?
A Calgary Herald article by Geoffrey Morgan on May 19 carried a title that explains a lot. “After ‘near death experience’, Cenovus Energy pauses on growth until new pipelines come online”. Which is really only a continuation of a trend that started years ago. Morgan reported the four large oil sands producers – Suncor, Cenovus, CNRL and Imperial – will collectively generate over $16 billion in free cash after dividends this year if oil prices hold.
And equity investors want cash, not growth, and aren’t reserved with their criticism. Eight Capital analyst Phil Skolnick told Morgan that the history of the industry that keeps investing more money in growth has resulted in a “horrible, horrible track record when it comes to (capital) discipline”.
One might have thought pipeline obstruction, collapsed oil and gas prices, challenging federal and provincial policies and project delays might have had something to do with that.
The ability to look back at the oil industry’s performance after six years of challenges is a remarkable skill. But today’s definition of capital discipline is giving more money to investors than drilling contractors. Don’t increase reserves. Increase dividends.
Institutional investor aspirations notwithstanding, the cash generated from the industry’s recovery will find its way back into the economy. It has already started.
Producers are behind on routine maintenance of their producing assets and infrastructure. To conserve cash, all but essential maintenance and repairs have been put off for some time. Producers don’t always telegraph when they are delaying maintenance, nor when they resume.
Part of it was to preserve cash. The other part is the pandemic which remains an obstacle to putting together the larger repair, shutdown, turnaround and maintenance crews, particularly for operations without camps that normally depend on local hotels and restaurants. There’s more work to be done basin-wide and operators have the cash flow to pay for it.
Emissions reduction will attract more spending than in the past. Producers can no longer recite “net zero by 2050” without doing something about it. At minimum, the process of measuring and documenting what is being emitted from where will get underway. This is an interesting opportunity for a lot of new companies, technologies and processes.
There will have to be a lot of money spent on reducing emissions and ARO commitments, and it can’t all come from government programs. This is a good time to get started.
As for capital programs, some E&P companies are already telegraphing to shareholders, vendors and analysts that they intend to ramp up spending in the second half of the year. Selected service providers are being told to get their equipment and personnel in order and to get ready to go back to work.
Despite all the advice they get from a multitude of sources, the default behavior of oil company executives is still to grow their business as long as somebody wants the products. Repeated warnings about the climate emergency notwithstanding, there is no indication that demand for oil or gas is going to materially decline anytime soon. In all operations except bitumen mining, reservoir depletion never takes a day off so long as the wells are producing. Using production equipment every day still wears it out.
The cash in coming in, the outlook looks stable, and there’s work to be done. Look for a lot more of these funds to find their way into the economy in the weeks and months ahead.
Since the pandemic began, Canada’s upstream oil and gas industry has been claiming it can be an important driver of Canada’s post-pandemic economic recovery.
Feel free to get on with it.
David Yager is an oil service executive, energy policy analyst, oil writer and author of From Miracle to Menace – Alberta, A Carbon Story. More at www.miracletomenace.ca