Even with oil barely over half of what it fetched in June of 2014 and the active drilling rig count doing better than (December 20, 2016 – 257, December 16, 2014 – 420; source JWN Rig Locator) compared to two years ago, it is obviously reckless to declare next year a success while it hasn’t even started yet.
However, it appears 2017 will provide significantly better times than the two previous years perhaps not by design but by exception. It won’t be as bad as 2016 because oil and gas prices are higher and it looks to be headed in an opposite direction from 2015 which was characterized by continuous contraction. Historically, most times this industry looks forward with even modest optimism it has been incorrect. The herd always seems to be going in the wrong direction. Super.
However, the recent OPEC and non-OPEC cooperation meetings have placed a floor under oil prices. Bloomberg News ran a headline December 18 declaring, “OPEC Deal Makes Oil Investors Most Bullish Since Slump Began”. It reported about the weekly data from the U.S. Commodity Futures Trading Commission where speculators report trading positions. The last time this many traders were going “long” on crude was July of 2014. Meanwhile, the shorts continue to retreat. One New York hedge fund manager said, “There’s been a full embrace of the OPEC, non-OPEC deal. They are being given the benefit of the doubt. The consensus is supplies will tighten quickly and as a result investors are positioning for higher prices in the near term.”
Since oil prices began their freefall in late November of 2014 there has been mountains written about what crude will or won’t do. Every modest gyration in the U.S. rig count or storage levels has caused prices to move one way or another. In the end what causes prices to rise is when more commodity traders think it should go up than down. This is why the CFTC data is comforting, at least for this week. After all this has happened before.
The easiest explanation of why 2017 looks materially different than the past two years comes from the December mid-month report from the International Energy Agency (IEA). Analyzing the news from the two supply management meetings, the IEA redrew its main chart through to mid-2017 which is reproduced below.
Although global oil production reached an all-time record 98.2 million b/d in November, this was not hugely above estimated demand of 96.95 million b/d in the fourth quarter of 2016. The excess of supply over demand was still just over 1 million b/d making a 1.2 million b/d OPEC cut plus another potential 0.5 million b/d from non-OPEC producers very meaningful. Demand growth for 2016 is now estimated at 1.4 million b/d which is above all prior IEA estimates for the year. This is an area where the IEA has often been criticized as being excessively pessimistic.
The result is a major change in global oil markets. The key data above is storage or stock change (blue bar), supply (green line) and demand (yellow line). For the past two years supply has materially exceeded demand resulting in continuous builds in global storage. This has included offshore tankers when the tanks on land reach capacity. For the first two quarters of 2017 – based on the assumption the announced production cuts will hold – demand will finally exceed supply and inventory levels will fall. The chart shows these three key data points have not been aligned this favorably since the first half of 2014, three years ago.
If this information is materially correct you can see why future traders have changed their positions. Commodity traders are often considered mercenary but never stupid. The more courageous oil price prognosticators are predicting WTI is more likely to see US$60 a barrel next year than US$40. Your writer falls into that camp.
Which in the WCSB changes everything. According to the PSAC/GMP First Energy daily commodity price report, Synthetic Crude closed December 21 at C$69.34, nearly C$19 a barrel above the price a year ago. Edmonton Mixed Sweet fetched C$65.25, almost C$22 above the last year’s price. Even the perpetually discounted Western Canada Select (bitumen plus synthetic plus condensate) was posted at $C48.83, close to $C18 above the December 21, 2015 value.
These are big numbers if current prices hold for 2017. On December 13 ARC Financial’s weekly upstream oil and gas macro-economic synopsis reported Canada produces nearly 4.2 million b/d of synthetic crude, bitumen, conventional crude and natural gas liquids. At an average of C$20 a barrel more that’s nearly $31 billion in additional revenue from existing production.
This could be augmented by a meaningful increase in the price of natural gas if current prices hold. On December 21 AECO spot gas closed at C$3.27 per mcf, C$0.95 higher than the YTD average of only C$2.15. If that price was sustained for all of 2017 this would add several billion more to the pie.To put these numbers into perspective, for 2014 ARC reports total revenue from all the oil and gas produced in Canada reached a record C$150 billion. Two years later in 2016 this had fallen to only C$76 billion despite an increase in oil sands production volume. The current prices for oil and gas, if maintained through next year, could return something like half the missing revenue from 2014 back into the system in 2017.
In its December 20 report ARC made its first estimates for 2017 and forecasts total revenue next year to be C$32 billion higher than 2016. After tax cash flow is expected to jump from only C$20.4 billion in 2016 to over C$45 billion next year. Big money. Note to oilfield services (OFS); pay attention!
Considering many producers have already hedged their 2017 production at these prices or higher, it is okay for Canada’s battered OFS industry to remain at least somewhat optimistic. The light at the end of the tunnel is not only not an oncoming train but the sector may actually be emerging from the tunnel entirely.
Because the greatest source of capital for anything in this business is cash flow from existing production. Debt markets are likely closed for all but the most successful. Net debt will most likely decline as increased cash flow enables the overextended to repair their balance sheets. Equity markets are returning because investors are able to buy shares in solid companies at a fraction of what they sold for in 2014. There has been a lot of capital on the sidelines waiting for opportunity. This money is moving now because investors understand if they wait much longer they could miss the best deals in the recovery. For most companies they are already too late.
The vastly improved macro-economic outlook for 2017 is reflected in the capital programs for producers. You can’t make it in the exploration and production business by only doing the “P” in E&P. Reserves must be replaced. While land sales are at multi-year lows there is a significant inventory of drillable prospects. Most major operators have a significant backlog of opportunities. It just has to be economic to invest and that is vastly improved.
But at this stage the recovery is hardly evenly distributed. OFS is still for the most part working for food. Equipment overcapacity is rife. What the industry is short of is personnel. But as more operators become determined they must proceed with their capital programs they will accept higher service prices not because they are feeling magnanimous but because they must. Alberta’s carbon tax comes into effect January 1, 2017. Higher fuel prices loom. Higher labor prices are underway as skeptical former employees wonder why they should go back into the business from which they were recently dismissed. Unfortunately, too much of the extra revenue coming in the front door from price increases is going to immediately go out the back door to cover the big expenses that matter most; fuel, wages and direct cost of goods sold.
Nevertheless, having the phone ring from a client who wants to buy something – no matter how awful the terms – sure beats laying off your receptionist because the phone never rang at all.
Significant macro-economic problems remain. New Alberta Premier Rachel Notley and her NDP government and Prime Minister Justin Trudeau’s Liberals appear to exist in a parallel universe. Representing only 4/10 of 1% of the world’s population, they believe Canadian carbon taxes and one-off arbitrary decisions such as an oilsands emissions cap or the cancellation of Northern Gateway will somehow change the world’s climate.
What makes these policies unsettling is Canada is going in opposite direction of that of U.S. president-elect Donald Trump. With the appointment of pro-oil, pro-industry people to key positions such as Secretary of State, department of energy and department of environment, Canada is looking completely out of step with its major customer for oil and gas and its major trading partner. Canadian politicians usually figure out when they are going in the wrong direction but it always takes longer and causes more damage than it should.
Federal approval of the expansions of Kinder Morgan’s Trans Mountain pipeline to the Pacific and Enbridge Line 3 to the Midwest U.S. appear promising, assuming you can stay in business until 2019. In politics pipeline approvals are big news. Lots of handshakes and photographs. But in the real world oilpatch, like the one described herein, what is required is pipe carrying oil and gas leading to higher volumes and netbacks creating increased cash flow for reinvestment. Today. Not only are the benefits from these pipelines not happening now but at least for Kinder Morgan they may never happen at all.
Worse, major capital projects like the North West Refinery and Suncor Fort Hills are winding down. There’s not much of an order book behind them. There has been some interest in recent downstream/petrochemical incentives offered by the Alberta government leading to a couple of new projects. This will help. But even with the recovery in conventional oil and gas looking positive in 2017, the lack of major capital investment in oil sands that has become the norm in the past decade will be painful with no relief in sight.
Regardless, things look better for 2017 than they have in some time. Best wishes to you, your friends, colleagues and families over the Holiday Season. May my optimistic prognostications for a much improved oilpatch in the New Year actually come true.