I have been giving some thought to the subject of the “recovery” because at some point, all markets turn around. And it seems that in the context of North America there are going to be some significant challenges once the recovery gets fully in swing.

Never mind the timing, the reality is that in many cycles, the recovery happens a lot faster than most expect and at a time and place that is least expected. Whether it’s a green light on LNG kick-starting North East BC or a sustainable oil price rally over $60 lighting shale fires in the US and Canada, it will come. And when it does, what then?

Unlike what the media and those not in the industry might think, it’s not just a simple matter of sending a bunch of rigs back to work and jacking utilization from 8% to 40% to 60% to 80%. There are logistics involved and a fair amount of the onus is going to fall directly on the backs of the service companies to meet the needs of the suddenly excited exploration and production companies. However, there will be significant challenges.

I have made reference previously to the industry being “hollowed out”, but what exactly does it mean? It’s a nifty term, but when used in this context, it’s always good to go back to basics in what is a capital, people and asset intensive industry and think about the state of each leg of the stool, sitting as we are on the two year anniversary of the start* of the downturn.

*Note that I use roughly the end of June 2014 when prices peaked at $107, while most people use the infamous November OPEC meeting. The reality is that prices started turning down pretty much as the US started to unwind QE-3 and the US dollar started to appreciate in value, accelerated as the easy money started to leave and OPEC was just an unnecessary second layer of icing on an already stale cake.

At any rate…

 
Equipment

Everyone has read stories about the epic auctions of equipment that have been happening continent wide with Ritchie Brothers holding 3 and 4 day auctions in oil producing regions where virtually billions of dollars of equipment is trading hands. And where is this equipment going? For specialized equipment, it is by and large being snapped up by larger industry players and reallocated to different markets or divisions, sometimes overseas, sometimes just being parked in anticipation of a rebound or just being retired. But the services sector also uses a lot of equipment such as yellow iron and transportation equipment that has uses in multiple industries and the firesale has allowed lots of firms in different industries to pick up hundreds of millions of dollars of relatively newer equipment at discounted prices and move it out of industry, permanently.

Companies that haven’t taken their equipment to auction are instead parking it. And for the most part they aren’t prioritizing the ongoing maintenance of that equipment. So it gets older, it dries out, seals crack, lubrication breaks down and idle pieces equipment are cannibalized to provide spare parts for those few items that still are out in the field, saving money in the short term but ultimately and potentially creating a cash crisis when the call on that idle equipment is made and all of a sudden we realize it needs significant investment to get back in the field.

Human Resources

Depending on the source, the estimated job losses in North America as a result of this downturn range anywhere from 250,000 to 350,000. Of that, a significant majority is likely related to the service sector which is the most labour intensive part of the industry. To think that a significant portion of that labour is available to return to work as soon as prices rally is nothing but foolhardy (another reason why it is important to take a healthy pause when people say that “shale oil is going to come roaring back”).

Every oil and gas cycle is different but the one constant is the mobility of the industry’s core labour force – largely young, opportunistic and itinerant. Whether it’s the massive influx of Maritimers flooding Alberta and the oilsands during the boom or carpetbaggers invading North Dakota when the Bakken was rockin’, when the money train stops that labour force disappears and it is hard to lure back.

There is even a name for it – “The Great Crew Change”. This term, coined by Shlumberger, refers to the hollowing out of the industry that occurred in the extended downturn of the late 1980s through the 1990s when job prospects in oil and gas were dim and it was difficult to attract young graduates into the industry. The result is giant generation gap where by the middle of this decade, a large part of the professional class in the industry will have reached or approached reached retirement age (an estimated 70% are aged 50+) and because of the massive shedding of jobs on the 1990s there are few people to replace them except new hires brought on during the boom of the last 10 years who, thanks to the downturn, have been subject to mass layoffs.

The talent drain that follows a downturn is a massively underreported story. Many of these professionals will NEVER COME BACK and the ones that remain are either at the end of their careers or the beginning. In addition, because industry is at the bottom of the cycle, it isn’t presenting the most attractive face to new graduates and young people entering the workforce. The experience gap is huge and the responsibility that will be foisted on these greener professionals will be equally large and, in many respects, unfair.

In the service sector, this lack of talent is going to be especially acute as its labour pool, while specialized, can easily move on to other infrastructure related industries that are currently booming and promise more steady employment. And after experiencing the highs and lows of the patch, many workers will appreciate the consistency of a smaller paycheque that doesn’t bounce over the larger one that is just a promise.

As it regards the older workers in the service sector, the foreman, superintendent and other senior level people, they are a high-priced and largely mercenary commodity and many companies will have been hard-pressed to keep them on. Everyone talks about “keeping their best crews”, but the reality is that if there is no work, there is no cash flow to keep anyone on, so these individuals look further afield. Many will migrate to other jurisdictions (Middle East, Asia, elsewhere) but many more who have already made their money will hang up their coveralls and good luck trying to pry them from their lakeside cabin to go spend 6 months in the bush of Northern Alberta in the dead of winter without some form of serious monetary inducement.

Long story short, it may be possible to staff a nascent recovery, but anything more significant is going to likely create a human resources nightmare.

Capital

It is funny how it often ultimately boils down to money, but capital is going to be critical to rebuilding the industry as activity levels pick up and, quite frankly, I am somewhat apprehensive about how quickly new cash is going to flow into one of the most capital intensive industries there is.

While there is no doubt that there is an enormous amount of “dry powder” on the sidelines waiting to be deployed into the patch (one need only look at the record amounts of capital being raised to recap broken balance sheets), capital is fickle, shallow and impatient.

Most of the capital currently being deployed is going into the producing companies to fix balance sheets or will be allocated to asset acquisitions or corporate buyouts. This means that field activity is going to need to be supported by producer cash flow, which is decidedly challenged.

This picture does very little to help the service companies who are going to have to supply the labour and equipment to either drill new wells or tie in all those DUCs we discussed a couple of weeks ago. When it comes to the industry capital cycle, the service companies are always third or fourth in the pecking order.

But as we have discussed above, the amount of working capital likely required to get the fleets going again in any significant upturn of activity and as well to hire and train workers is going to be mind-boggling. But with lending restrictions and covenants extra-tight as we come out of a downturn, many service companies may in fact find themselves encountering more solvency and working capital issues on the way up than they had on the way down. It is a strange phenomenon indeed that sees companies being staggered by being too busy, but that is the cyclical reality.

Industry can address this by being cooperative with their service providers and allowing more favourable turnover times for billings but this is an industry that has never learned that lesson well enough. So unless those same banks and lenders step up with working capital for the service companies, what we are going to see instead is aggressive price increases on the part of the service companies, which of course does no one any favours when it comes to managing the cost structure and retaining the “productivity gains” achieved during the downturn.

So, prospective equipment issues, a lack of human capital to execute the turnaround and reluctant capital flowing into long term assets instead of working capital all suggest that as nasty as the fall was, the upswing may yet prove to be choppier than many anticipate – to put it mildly.

Prices as at July 15, 2016 (July 8, 2016)

• The price of oil ended the week up marginally after a pretty rough ride
  • Storage posted a smaller than desired decrease
  • Production was up as an Alaska anomaly was corrected
  • The rig count was up marginally
  • The market reacted to an OPEC production report (up, but added another producer to the calculation) as well as prospects of long term Libyan and Iranian production increases
• Natural gas gave ground during the week, essentially on a “no news” week..

• WTI Crude: $45.94 ($45.18)
• Nymex Gas: $2.756 ($2.801)
• US/Canadian Dollar: $0.7728 ($ 0.7666)

Highlights

• As at July 8, 2016, US crude oil supplies were at 521.8 million barrels, a decrease of 2.6 million barrels from the previous week and 60.4 million barrels ahead of last year.
  • The number of days oil supply in storage was 31.4, ahead of last year’s 27.8.
  • Production was up for the week at 8.485 million barrels per day. Production last year at the same time was 9.562 million barrels per day. The change in production this week came from a recovery in Alaska deliveries and a drop in lower 48 production.
  • Imports fell during the week to 7.841 million barrels a day, compared to 7.354 million barrels per day last year. Imports are distorting the storage story.
  • Refinery inputs were flat during the week at 16.544 million barrels a day
• As at July 8, 2016, US natural gas in storage was 3,243 billion cubic feet (Bcf), which is 22% above the 5-year average and about 19% higher than last year’s level, following an implied net injection of 64 Bcf during the report week.
  • Overall U.S. natural gas consumption was up 5% during the week with increases across all major sectors
  • A heat wave in California is driving consumption
  • Production for the week was flat and imports from Canada declined
• Oil rig count at July 15 was at 357, up 6 from the week prior.
  • Rig count at January 1, 2015 was 1,482
• Natural gas rigs drilling in the United States was up1 at 89.
  • Rig count at January 1, 2015 was 328
• As of July 11, the Canadian rig count was at 95 (14% utilization), 65 Alberta (14%), 8 BC (10.5%), 22 Saskatchewan (19%), 0 Manitoba (0%)). Utilization for the same period last year was about 20%.
• US split of Oil vs Gas rigs is 80%/20%, in Canada the split is 20%/80%
• Offshore rig count was up 3 at 22
  • Offshore rig count at January 1, 2015 was 55

Drillbits

• The amount of junk bond defaults by US oil and gas producers has reached $28.8 billion, a recard accourding to Fitch Ratings. The already high 29% default rate is ecpected to rise to 35%
• Strad Energy Services acquired Redneck Oilfield Rentals in a bid to offer a consoilidated suite of rental products once the market recovers
• Alberta Treausry Branches (ATB) and Business Development Corp (BDC) announced a $1 billion co-lending program targetted at mid-market Alberta businesses. The capital will be welcome.
• Exxon declared force majeure in Nigeria after it’s pipelines were bombed.
• The Alberta Government announced two incentive programs targetted at increasing production from older wells and to incentivize development of high cost, high potential basins. These programs, which replace expiring incentives put in place in 2008, are expected to provide modest stimulation to the market
• The Alberta Government also announced that companies would be allowed an “early opt-in” to its new royalty program which is expected to be moderately stimulative in the next quater and half.
• China oil production is down more than 10% year over year as cheaper imports shutter expensive fields
• LNG Canada announced that it was delaying (not cancelling!) its LNG project. This delay by the only approved LNG project puts all the LNG eggs in the Pacific Northwest LNG basket, which as we all know is currently in the hands of the Federal Government for approval with an annoucement expected in September. God help the BC energy industry.
• Drumpf Watch – We have a VP pick, although I am saddened that no one named CARD was available, as I was really looking forward to the Drumpf-Card ticket. Instead we get the Drumpf-Pence ticket which right out of the gate is a loser phonetically. But who is this Pence character anyway? Clearly not Hunter Pence, the scrappy outfielder who led the San Francisco Giants to a World Series a few years ago. No, Mike Pence is a socially and fiscally conservative Tea Party type who is anti-abortion, anti-LGBTQ and, presumably, anti-immigration, particulalrly of the Muslim, radical Islamic Terrorist variety – but also Mexicans, and Canadian singers and comedians… and French… maybe Italians… but not so much British, unless they are East Indian… not Indiana. What propels someone to want to be on the tail end of the most corrosive ticket in US history is beyond me. He must have lots of time on his hands.