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Peter Tertzakian
ARC Financial Corp

Canada’s oil and gas industry is the envy of the world. Thirty four million people are privileged to possess one of the largest hydrocarbon resource endowments of any nation, in the same league as major producers like the United States, Russia and Saudi Arabia. Yet how many oil and gas exporting countries, large or small, can boast all the collective qualities that distinguishes Canada’s from any other? The answer, as you go down the check list, is “none.”

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The Fiscal Pulse of the Upstream Oil and Gas Economy

To gain insight into the Canada's oil and gas industry, it is worthwhile to first model its dynamic functioning. The three simple model diagrams on the opposite pages show how capital flows cyclically into and out of this economy. Owing to the cyclical nature of this capital flow we refer to it as "the fiscal pulse of the upstream oil and gas economy". The first diagram includes both the oilsands and non-oilsands industry sectors, whereas the second and third diagrams show these sectors separately:

The industry is segmented into two broad sectors: Exploration and Production (E&P) and Oilfield Services. Each sector is diagrammatically depicted as a black oval. E&P companies determine where to explore for oil and gas. Oilfield service companies are contracted to do the physical prospecting, drilling and delivery to market. Once additional reserves are found, E&P companies manage the production and sale of their oil and gas from their newly added reserves. Capital flows through both the E&P and the Oilfield Service sectors, which work closely together to create value for stakeholders.

The mechanics of the accompanying capital flow diagrams represent an accounting of the dollars and product volumes flowing through the industry. Production Volumes (1) are multiplied by Commodity Prices (2) to yield gross E&P Revenue (3). Interest and General and Administrative (G&A) expenses are deducted, as are Royalties and Taxes (4). Royalties are mostly dependent on commodity prices, but well depth and production ouput are also major determinants. Taxes are mostly a function of net income, owed both federally and provincially.

Managing and operating the base of production is labour-, capital- and energy- intensive. Operating Expenditures (5) have fixed and variable components that adapt to commodity prices.

A large fraction of Cash Flow (6) is typically allocated to reinvestment; this is the CAPEX pool (7). To leverage capital and gain cycle momentum, the CAPEX pool is supplemented with Debt and Equity. During periods of healthy cash flow, debt may be paid down and equity repurchased through Buybacks. Dividends and Distributions, and changes to working capital account for any remaining cash flow.

A certain amount of capital also ‘leaks’ out of the system as multi-national companies seek to repatriate their Canadian-earned cash flow or reinvest it abroad. This dynamic is difficult to capture and is represented in Foreign Investment and Capital Outflow. Counterbalancing leakage, Foreign Joint Venture (JV) Capital is a new and significant stream of funding that has emerged since 2009, especially from Asia.

Capital in the domestic CAPEX pool can be rationed a number of different ways: oil versus natural gas drilling, exploration versus development, traditional versus oil sands, and so on.

In our chart, we broadly segment capital spending into two: Exploration and Development and Land.

Oilfield Services Revenue (8) is largely dependent on domestic E&P spending, over 50% of which is typically allocated to drilling. Note that not all E&P capital spending goes to the oilfield service sector. There many Other peripheral expenditures for goods and services that percolate into the Canadian economy.

Drilling and Completions (9) yield oil and gas Reserve Additions (10), which are often placed into production as soon as is technically and financially feasible. Productive capacity – the ability of a reservoir to produce hydrocarbons – declines over time, similar to diminishing product inventory. To replenish depleting reserves, the entire cycle of capital flow starts all over again.

How well Canada’s oil and gas capital cycle performs in the face of many internal and external forces determines profitability of the industry. Delivering stable, long-term financial returns has always been challenging amidst a backdrop of uncertain commodity prices, competitive challenges, constrained labour pools, geologic risk, and cost inflation.

Availability of high quality statistics at points around our diagram enable us to model capital flows with a reasonable degree of confidence; enough to determine the magnitude and direction of the most important economic trends and financial measures.

Ten Themes to Follow

Consider that Canada’s oil and gas industry operates in an environment that has: a politically stable democracy; a strong rule-of-law with respect for contracts; strict regulations that are getting stricter; one of the lowest corruption ratings in the world; a highly experienced workforce; trillions of dollars of infrastructure built up over a century; a sophisticated spectrum of capital markets based on free enterprise; and a wide diversity of several thousand companies that produce anywhere from a few barrels a day to several hundred thousand, almost all headquartered in one city — Calgary. With these combined qualities, it’s no wonder that Canada is a prized destination for foreign capital seeking to minimize risk and maximize return.

Yet hubris is uncalled for. None of these ideals can be taken for granted in a capital intense business that relies heavily on foreign investment and doesn’t always generate attractive returns. The health of this industry is never guaranteed, especially in today’s rapidly changing energy markets.

Canada’s oil is increasingly subject to cost inflation, environmental pressure and social scrutiny. Our natural gas is overwhelmed by depressed prices caused by continental oversupply. Both energy commodities are increasingly suffering from discounted prices due to lack of access to global markets. Yes, Canada is a global leader with an enviable position, but further work must be done to reinforce all the positive attributes.

What’s at Stake?

For a sense of scale, one should bear in mind that the upstream oil and gas industry will continue to generate more than $100 billion per year of top-line sales for at least the next five years, notwithstanding a major commodity price collapse. Contrasted against other businesses, hydrocarbons are by far the largest product-selling industry in Canada, larger than manufacturing automobiles. Importantly, domestic oil and gas companies typically reinvest every dollar of their cash flow plus more back into the ground. The multiplicative effect of these dollars circulating in Canada’s economy means that the stakes for ensuring a healthy oil and gas industry are high for all Canadians.

10 Themes to Follow

No doubt the next five years will be full of surprises, and any attempted forecast will end up appearing too stable when subjected to hindsight in 2015. Nevertheless, from what we’ve seen in the past, what we see today, and what our analysis portends for the next five years, here are 10 important themes to follow.

1. Commodity price volatility – Price is always the most important theme in this business. Though forward market indications for oil and gas are pretty flat when measured against "base case" commodity prices (i.e. these prices have been selected from the futures market for the five-year period 2011-2015), volatility is guaranteed.

2. Policies and regulation – Beside price, government policies are the most influential force in energy. Changes to federal and provincial legislation had much impact over the past half decade. Fiscal, labour, environmental and export policies will be themes to follow closely.

3. Cost inflation – Rising costs challenged profitability and competitiveness last decade. Too much capital deployed too quickly bred inflation, a dynamic that will be an ongoing thematic challenge. Disciplined companies that innovate, migrate to high-quality resources and achieve economies of scale can be insulated.

4. Oilier and oilier – Rising oil sands production in the face of flat natural gas output means Canada’s hydrocarbon mix is getting oilier and oiler. The increasing concentration to oil is favourable as long as prices stay buoyant and costs are contained.

5. Natural gas themes – Surplus gas from shale formations has led to depressed prices during the past six years. Exploring for this “fuel of the future” has become unviable for many Canadian producers. Looking ahead, supply declines, domestic demand growth and access to high-value Pacific markets will be active themes.

6. Traditional investment – "Traditional" refers to that segment of the oil and gas industry exclusive of the oilsands. Uncharacteristically, this segment did not spend all its cash flow most of the last decade. New technologies, vast resource plays and competitive fiscal regimes may now give companies incentive to invest more than their cash flow.

7. Oil sands cash flow – The oil sands segment is expected to generate cash flow in excess of its currently planned project spending. However, the surplus may not persist. Developing new projects is a capital intense business vulnerable to inflation; how oil sands companies spend their cash flow will affect the entire industry.

8. Globalization – Since 2009, foreign interests have committed close to $18.5 billion into the industry, mostly into the oilsands.The shift from western capital providers to foreign sources is one of the biggest trends in the industry. More inflow is expected over the next five years, subject to predictable government policies. Paired against this large influx of offshore capital is reciprocal momentum to open up exports of oil and gas beyond North America.

9. More change and innovation in the field – Progressive oilfield service companies have led innovations that yield more productive, profitable wells. The rapid pace of advancement and innovation in oil and gas fields will continue. From service companies, to producers, to capital providers, only those companies that are flexible to the changes will prosper.

10. Profits will increase, but not always profitability – It would be prudent to focus on the latter. The dollar volume of the capital flow will continue to grow, driving the impression that the industry is making more money. But how well the industry copes with internal and external challenges will determine whether value is being created year-over-year, and whether more capital will be attracted to the business in the coming years and beyond 2015. One thing is certain: the industry’s fiscal pulse going forward will be volatile.

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The objective of this short paper is to "feel the pulse" of the Canadian oil and gas industry in order to forecast its health over the next few years. The fact that views of health vary with perspective added to the challenging nature of this objective. Forced to provide such an universally applicable description of health, however, we might formulate it as follows: "Canada's oil and gas industry operates best when there is a sustained flow of growth capital — not too much and not too little; not too fast, not too slow — that each successive pulse delivers increasingly rewarding levels of prosperity to all stakeholders, within the bounds of world-class regulatory standards." There are, of course, a multitude of factors mitigating against this ideal condition — such as competitive threats, capital flow constrictions, the nagging push of costs, tightening environmental standards, market constraints — but the resilience of the industry in the face of these unpredictable factors is, in a sense, the true mark of its healthiness. Stakeholders must be ever on the lookout for these factors and, in counteracting them, hubris is uncalled for.

Peter Tertzakian is chief energy economist at ARC Financial Corporation, Calgary.

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This article is an adapted extract from the publicly available report Turmoil and Renewal: The Fiscal Pulse of the Canadian Upstream Oil & Gas Industry.