First the breaking news – President Obama has rejected the Keystone XL pipeline citing the phantom climate concerns that his own State Department said don’t exist and notwthstanding the fact that since the application was first made, pipelines 10 times the length of the Keystone XL have been built in the U.S. without so much of a climate change “excuse me”.

 

 

This is a sad, but temporary, end to a long drawn-out process and a bit of a kick in the nether regions to a staunch ally, friend and trading partner to the U.S., however special interests will often succeed when a receptive ear is looking for their approval. There is really no point dwelling on this as even the proponent of the pipeline had already moved on to other options. As has been mentioned in this blog previously, relying on another country to act in our economic interests is foolish, so if Canada wants to continue to succeed as a producer and exporter of energy, it needs to be more self-reliant (Energy East, Trans Mountain), stop worrying so much about what other countries think of us if they even do and of course continue to send 1000’s of railcars a year filled with crude along pretty much the same route until the Americans figure out that they actually rely on our oil to the tune of 2.5 million barrels a day.

 

Anyway, back to business!

 

Last week’s mini-rant about corporate handouts is a fitting close to the round of quasi political commentary, so this week I thought it was time to go back to some other favorite subjects as it regards the oilpatch – specifically debt and prices. Oh, but first this – apparently new PM Trudeau has already been approached about federal money for Bombardier – you heard it here first!

 

At any rate, debt, prices, and the title of this post – what do they have to do with each other? Well there are a number of things we know about the current state of the energy industry:

• Prices are low and in many case below the costs of production but stabilizing – “lower for longer”
• Capex for new exploration is being slashed globally
• While production levels remain stubbornly high, there is a decline rate and big declines are coming
• Demand appears to be growing steadily
• There is too much debt and the cost of new debt is increasing

 

In many ways, aside from the debt conundrum, this should all be positive for oil prices, because reduced production, all things being equal should lead to the over-supply situation being resoved and a gradual reinflation of prices.

 

This is the Goldilocks scenario – not too hot, not too cold.

 

By now, everyone knows what the too cold scenario is – it’s the Goldman Sachs $20 call – energy sector armageddon. This is the one that postulates super-resilient tight oil production, a massive influx of Iranian oil and continued market share defence by other OPEC members. It kind of ignores the whole profit and loss side of the market, but is a bold call, nonetheless. Forgive me for thinking that maybe Goldman has some black-box structured derivative product that plays off that $20 bet and generates great trading fees regardless. More power to them if they think they can profit that way, I just don’t think the price call is terribly realistic.

 

Speaking of unrealistic calls, I did see one analyst calling for $130 oil. To call that an outlier is being generous. But that did get me thinking, if a gradual reinflation of energy prices is “just right” in the Goldilocks scenario and the Goldman call is the “too cold”, what does “too hot” look like? What makes energy prices spike and what are the knock-on effects?

 

Hypothetically, I think too hot starts with debt. How much there currently is, how much it costs and how much will be available when it is ultimately needed to get the industry going again.

 

Leverage is a major problem in the oil patch, because cheap debt has been the helium to the energy balloon and as long as that debt was cheap, it masked a lot of problems, particularly with high cost producers such as tight oil – never mind the asset bubbles created in other sectors of the economy by ultra-low interest rates and various forms of quantitative easing. As prices have declined, the cost of debt eats up an increasing amount of per barrel cash flow for these producers and the ratio of the debt outstanding to the value of reserves has increased dramatically as writedowns accelerate causing covenant issues and sending off warning bells across the sector.

 

Consider the following two charts, one is related to Q3 earnings for a cross-section of U.S. producers and the other shows the reserve writedowns/asset impanirments they have taken. The numbers are staggering. Remember this is a sector that has more than $200 billion in just the tight oil space!

 

Putting on a banker’s hat, when you see that type of asset covenant destruction, capital availability has to become severely constrained (less funds made available) or needs to cost significantly more to compensate for risk – either way, less funds means less capex means less production in the long run. In the short run, as hedges run out and the impact of low prices are felt and companies can’t refinance or can’t pay their banker, it means accelerating defaults, a scenario that is being replicated across the energy sector globally.

 

A deleveraging of the energy sector has the potential to make 2008 look like a dress-rehearsal.

 

So the scene is set – capital is rapidly drying up.

 

Now let’s roll in decline rates and capex. The next chart shows new oil and liquids supply additions by year starting in 2006 and how each addition declines and needs to be replaced by growth in the subsequent year just to keep pace with declines in exsiting production.

Decline rates as we have discussed previously have averaged 3% to 5% a year, however these decline rates tend to accelerate when capex is cut (as is currently the case). As an aside to this it is worth noting that the new additions to global supply in the last few years have been largely from high cost areas (tight oil, off-shore, oil sands) and with new carbon policies we are making these high cost areas even more expensive.

 

These are the first to go when capex is cut, putting more pressure on legacy production (i.e. OPEC) where the excess supply is currently tight given their over-producing market share battle. As the chart suggests, to even stay level with global demand, 2 to 3 million barrels of oil needs to be added a year, but no one is spending.

 

So what happens when these factors collide, as they eventually will? Specifically, realized prices below the cost of production leading to massive losses, defaults among high cost producers, accelerating decline rates and higher capital costs that further dampen free-falling capex?

 

In an ideal world, it should mean significantly higher prices and a rescue for the energy industry – yay, right?

 

But our ideal world also operates in the real world.

 

And in the real world, the air is coming out of global economic growth as the low interest policies and quantitative easing of the past 5-10 years fail to deliver the economic boost needed and the monetary and fiscal stimulus cupboard is bare.

 

The U.S. Fed is looking to raise rates which will increase the costs of doing business, buying capital assets, cars and homes – all things that use energy. Wage growth is stalling. The consumer will have less money to go around. As rates increase, the asset bubble deflates further which affects public and private equity markets, profits and growth plans. Numerous sovereign nations that are heavy oil producers (Russia, Venezuela, the Middle East) are starting to see their credit ratings cut, some may even default. Those that have sovereign wealth funds will use those petrodollars to plug holes in their budgets and the selling pressure of this repatriation of capital will have its knock-on effects. China’s transition from a constructtion-based economy to a consumer driven one continues to depress the commodity market.

 

Then finally, as a result of all the cutbacks in capex, the supply glut is gone and energy prices respond – aggressively. But as we discussed above, asset values have been written down so severely that banks are reluctant to lend new money to high cost producers until the prices show sustained levels for a period of time (the decline needs time to reinflate), so new investment is stymied, exacerbating the supply situation, pushing prices up further.

 

This increase in energy prices results in rapidly accelerating inflation at just the wrong time for a slowing global economy. The policy response for rising inflation is to increase borrowing rates which would further dampen economic activity. Lower economic activity compresses government revenues requiring them to utilize other fiscal measures such as raising taxes and cutting spending, further depressing economic activity.

 

At the same time, the marginal barrel of oil is still the most expensive to produce, only now the break even price is no longer $40, $60 or $100. It’s $130. No one will fund it. No one can afford to use it and there are no alternatives to replace it. Ouch.

 

Globally, we have benefitted for a long time from cheap energy prices which has powered economic growth, leading to low inflation, declining interest rates and a rising standard of living around the world. The last time this didn’t hold is shown in the middle of the final chart. Ask your parents how fun that was.

 

 

I’m not suggesting this is what will happen, it is just one of a variety of possibilities – a low-likelihood, maybe lower than the $20 forecast, but anything is possible.

 

So, not too hot, not too cold. Maybe $60 oil in 2016 isn’t going to be so bad after all.

 

Oh, and in the interests of coming full-circle, it is worth noting that when energy prices do spike and there is no capital available to fund high cost production at home or it is in terminal decline and you are the largest consumer of oil in the world, it would sure be nice to have a stable supply of oil coming to your massive network of refineries from a friendly neighbour – ideally by pipeline.

 

Prices as at November 6, 2015 (October 30, 2015)

• The price of oil ended the week down, after a choppy week of mixed indicators.
  • Storage posted a less than expected increase
  • Production was up marginally
  • Markets are by and large drifting
  • The rig count decreased again
• Natural gas gained slightly during the week as production declines were offset by a persistently warm fall

• WTI Crude: $44.39 ($46.37)
• Nymex Gas: $2.366 ($2.326)
• US/Canadian Dollar: $0.7517 ($ 0.7649)

 

Highlights

• As at October 30, 2015, US crude oil supplies were at 482.8 million barrels, an increase of 2.8 million barrels from the previous week and 102.6 million barrels ahead of last year.
• The number of days oil supply in storage was 31.2, ahead of last year’s 24.9.
• Production was up to 9.160 million barrels per day. Production last year at the same time was 8.957 million barrels per day. Based on the numbers, it is likely that by December year over year production growth in the U.S. will be negative. The increase in production this week came from the lower 48.
• As at October 30, 2015, US natural gas in storage was 3,929 billion cubic feet (Bcf), which is 4% above the 5-year average and about 10% higher than last year’s level, following an implied net injection of 52 Bcf during the report week. This matches the previous recod high storage amount set in 2012 and with the warmer fall, it is possible that storage may exceed 4,000 Bcf in the next week or so.
• Overall U.S. natural gas consumption increased by 1.4% this week with a power consumption decrease of 3.1% being offset by a residential and commercial increase of 7.6%
• Oil rig count at November 6 was down to 572 from 578 the week prior.
• Natural gas rigs drilling in the United States are up to 199 from 197.
• As of November 2, the Canadian rig count was at 174 (23% utilization), 115 Alberta (21%), 32 BC (38%), 26 Saskatchewan (21%), 2 Manitoba (11%)). Utilization for the same week last year was 47%.
• US split of Oil vs Gas rigs is 74%/26%, in Canada the split is 43%/57%

 

Drillbits

• Earnings Watch – Q3-15 (Q3-14)
  • Enerplus – loss of US$293 billion ($67 million profit). The company recognized $321 million in impairments. On the plus side, production was up.
  • Bonavista Petroleum – net loss of $216 million ($24 million profit).
  • Penn West – net loss of $764 mm ($15 mm). Funds from operations $45 ($232).
  • Crescent Point Energy – net loss of $201 mm (income of $258mm) Funds from operations $484 mm ($618mm)
  • Canadian Natural Resources Ltd – net loss of $111 (income of $1,039 mm). Funds fromm operations of $1,533mm ($2,440mm).
  • Paramount – net loss of $172 mm ($9.4). Funds from operations of $36.9 mm ($36.4 mm)
  • Arc Resources Ltd. – new loss of $235 mm ($90.3 income). Funds from operations of $174.9mm ($284.2mm)
  • Tourmaline – net income of $28.5 mm ($67.4) . Funds from operations of $197.1 mm ($211.6 mm)
  • Pembina Pipeline – $113 net income ($75)
  • Enbridge Pipelines – Loss of $609 million (loss of $80 mm). Adjusted earnings were positive at $399 million compared to $354 the same time last year. Adjustments relate to mark to market hedging and some writeoffs related to its Canadian restructuring plan.
• A massive strike at Petrobras in Brazil is keeping some 270,000 bbls/day off the market
• Prime Minister Justin Trudeau was sworn into office surfing a rainbow wave of sunshine on a boat named “hope and change”, which should be familiar to American readers.
• Drumpf Watch – Live from New York – it’s Drumpf Night! Yes, the Donald is hosting Saturday Night Live this weekend (with musical guest Sia, if anyone cares)