Oil and Gas – How the Changing Prices May Affect your Business
Helen Mallovy Hicks
Scott Bolton, a former PwC Advisory Services partner, and John Williamson, a PwC Audit and Assurance Group partner, talk about the oil and gas industry and how it is being affected by the current economy.
Dean: Welcome to Strategy Talks with Dean and Helen, part of the PricewaterhouseCoopers Managing in a Downturn podcast series. I'm Dean Mullett, co-head of our Restructuring and Distress Strategy Group, and a member of our Credit Crisis Task Force.
Helen: And I'm Helen Mallovy Hicks, a Partner in the Advisory Practice of PricewaterhouseCoopers in the Dispute Analysis & Valuations group.
Dean: The current state of the economy is understandably of great concern for most Canadian businesses. This series of audio podcast discussions with a variety of subject matter and industry guests are designed to help your business weather the storm by exploring some of today's hottest issues related to the economic crisis.
Dean: This is Dean Mullet; Helen is away today so I'll be flying solo. Joining us today via telephone from our Calgary office are Scott Bolton, a PwC Advisory services partner and John Williamson, Audit and Assurance Group partner in PwC's Canadian energy leader who will be speaking on how the oil and gas industry is affected by the downturn. Energy prices have dropped dramatically over the past year, from peaks of an excess to 150 down to the low of 35 or so. Everyone is asking what are the expectations for prices in the future?
Scott: You know if you look at it from a high level, what are expectations for prices in the future? If economy grows, commodity prices will follow. We're in for deterioration or continued difficult economic times that are going to impact commodity prices. They do tend to follow together and they might not be instantaneous, pure correlation such as just natural gas, but over time that will hold.
Dean: So we're seeing commodity prices come up a bit so I guess the questions is the economy actually getting stronger?
Scott: I think it's true that global economic factors, oil will respond more, will correlate more directly and more quickly than actual gas will because oil truly is, the lighter grades of oil, they'll trade based on traders perception of general economic conditions. And that I think has largely driven the price increases we've seen from their lows, which were down to 35 dollars in February - March time frame and now it's up over 60 again, it's a far cry from under 50 where it was. It has recovered quite substantially.
Dean: Scott, why would that have, maybe more direct linkage to the economy more than gas?
Scott: Well, first of, oil is a true globally traded commodity. There is a different price of oil that depending on the quality of it; broadly it is a global commodity. Where natural gas can be quite different price wise, it's really a continental commodity so to speak. The way it's priced to a large degree. It will eventually get to where oil is, to be a global commodity, but it's not there yet. So the price of natural gas right now is very much influenced by the significant demand decrease because of the industrial slump in North America. But it was a bit of the perfect storm in that you also had it at the same time some fundamentally material new production of gas that came on-stream related to what we call Shale gas in Texas, North BC and elsewhere, which increased supply at a time almost instant demand destruction and that's fundamentally altered the dynamic and caused natural gas prices to fall.
John: The technology has come a long way in gas in getting gas out of the shale formation. It is a big development, especially in the US and it has added a lot of supply to the market now. Whether it's sustainable or not is anyone's guess but it has created a nice big amount of supply so we need the economy to pick up to start to burn that gas off.
Scott: What will happen, in response to that, because the price is low the drilling for new natural gas supply has been severely curtailed and that took some time to happen but has happened now so that both the US and Canada there's been a sharp fall off in rig activity and that will mean lower gas production which will eventually flow through and should rebalance the supply/demand dynamic so prices will eventually as a result increase over time. But not yet, hasn't happened yet it takes time and there's a lag in time. There are quite a number of factors in play.
Dean: Now we often hear in respects about peak oil, peak oil pricing but I have to say I've never really heard that in connection with gas and John you mentioned about whether that supply can continue going forward, so is there the same risk with gas as there is with oil as far at some point 'the tap runs dry'?
John: I think there is a discussion around the world as to how much is out there and most of the technical professionals would say that there is an enormous amount of gas available in the world and as Scott was just say that up until to now and up until recently, gas has been a North American almost landlocked market for gas as supply and demand but now as technology for liquefied natural gas and you hear stories about compressed natural gas being able to be moved around the world will actually enable companies in country send natural gas from stranded gas pools into the big markets Europe or in Asia or North America. So yeah, there's a lot of gas out there it's just a matter of you getting it into the right place at the right time.
Dean: So assuming that with new technology that you can get into the right place at the right time it starts to take on the characteristics of that globally traded commodity which is probably more closely linked to the underlying economic activity.
John: That's the expectation that eventually we'll be able to move gas around the world a lot more easily than we have.
Scott: The bit of difference too though is that there is something fundamental about this, the shale gas, that that it is a new technology, there's technology behind the ability to access those pools of reserves. But to your peak oil question, all of the sudden in North American at least there's a lot more gas reserves than ever imaginable. Eventually it will run out but these are enormous reserves that they're talking about, particularly in Texas, that push out the supply envelope - decades even.
John: We haven't even tapped the Mackenzie Delta in Northern Canada and Alaska and there are enormous amounts of gas with potential to bring it down south as well.
Scott: Staggering amounts of potential reserves of both oil and gas up north. But you know this Shale gas development may have an impact on the timing of the development of the far north because if the supply dynamics change fundamentally the significance of the capital spend required to get northern gas to market is huge and if in more hospitable region there is more gas than we thought, it's going to change the timing potentially as when far north is developed. It's more complicated than that, but it is a fact.
Dean: It is an interesting phenomenon and you look at it across lot commodities, the flows of the business cycles. So when the economy is doing well the underlying commodity prices are strong, lots of drilling and people looking for various commodities and when then economy dries up, their money is not available and so you stop looking for it and all of the sudden you run out of supply. It's almost a pattern that you can look at over the history of civilized man kind and see it repeat in time and time again.
John: I think a lot of that is linked to the fact the industry itself is very capital intensive and it takes an enormous amount of money to access and develop to get the product to market. And it's not without risk and there are a lot of risk dry holes or formation problems that will cause production problems so companies are still having difficulty in finding that kind of capital investment to put in the ground.
Scott: And it's so much more difficult now because you have so much volatility in your pricing environment in a capital intensive industry. It just makes the decision making that much more difficult in a very difficult industry in that regards. It's funny the oil sands development has been significantly reduced over expectations even just six months ago. There was study that suggests the number of announced deferrals of projects if they were fully completed will eventually take out more than two and half millions of barrels of oil a day out of global production which is material, that's the production of Iraq. And that is simply the result of price volatility really in the economy.
Dean: I guess the availability and access to capital whatever shape or form that it comes in, drives a lot of ability to drill for new resource and I guess just when you look at that today and perhaps you can comment on what we're seeing with companies that the reserves are obviously very important in both oil and gas with prices having come down so dramatically over the past year, what's been the impact there? And obviously it's been on drilling I'm sure but there have been other impacts, maybe you can give us some color.
John: Once you actually get to the point where you have met all the regulatory rules to able to book the reserves, the pricing doesn't have a big of an impact as you might expect. At that point in the life cycle you have found the reserve and it's generally producible at a reasonable market price, so you're talking to 60 or 70 dollar oil, most of the oil will get produced at that level and profit will be produced. So you don't loose the reserves. What tends to get chopped off out of the industry is the future of the possible reserve, the ones that you don't really know about yet, you have an idea about it but you don't really have a lot of confidence around the amount. And those are the ones, because of what I said about risks, those are the numbers that are at risk. So you will drop off those barrels when you reduce oil from a peak of 150 dollars down to 30, you're going to loose a lot of those barrels.
Dean: And what you loose in those barrels is the factor of the cost that it's going to take to extract them plus the risk factor because it's not proof in the reserve so it's a combination.
John: That's right, so you think about whether you're willing to invest hundreds of millions of dollars of unproved resource and it takes a lot of confidence to invest that kind of money with risked returns.
Scott: One interesting dynamic that you should be aware of is the fact that the oil sands play is a little different because you know the reserves are there it's not the exploration risk, the geology risk isn't there but then again the 3D question of the enormity of capital spend required and then the complexity to be able to deliver the project on time and on budget, in that scale in a difficult climate and geographic location presents a different set of risks but the lack of price certainty we have now has the same ultimate impact in those projects too.
Dean: We've seen a lot in the press recently the profitability potential of various projects in the tar sands and people have a tendency to take a generalization of when things are profitable at a certain price and when they're not. But it would seem to me, I guess listening to what you're saying around cost extraction and not really having the geological risk, it really is a case by case in understanding the type of underlying project to determine what is the price point of barrel oil.
Scott: What's difficult is that there has been severe price escalation in these projects that we've heard about in the past three or four years and that have become a variable in itself and the real question is are we going to with this economic slow down and this deferral of projects and the cooling of the industry result in costs come down? It's logical but it's just a question of just how much? And so with the price of oil at 60 dollars a barrel will that price point work for new projects? It's uncertain as to whether it will and then there's the issue of whether it will stay at 60 dollars and you have to have some certainty it will if that's your price point and be convinced that that's long term sustainable.
John: Dean you're absolutely right though, each of the oil sands projects have its unique operational characteristics and you need to understand how that plays into the project overall. You'll have different depths of tar sand available and you'll have different qualities throughout the project and that all plays into the economics f the project and some of the newer ones or the ones that are being planned don't have the same depth and quality as some of the established oil sand projects.
Dean: Perhaps we can shift more towards the environment and environmental legislation. You know we hear a lot of the environment and not just in respect to energy but in general. There are some pressures being targeted directly to the energy sector. President Obama has gone on record making comments about the tar sands. What is our perspective on the impact of environmental legislation pending or future?
John: The environmental legislation is not just one piece of legislation; there are multi levels of legislation that companies have to deal with. In Canada we have the federal as well as the various provincial rules that you need to abide by. So if you are exporting your product into the US or elsewhere overseas you also have to consider what the requirements are in those jurisdictions. It's very complex to make sure you have all the right data and are reporting and accessing the data in a timely as well as accurate fashion.
So a lot of companies have spent a lot of time and hired a lot of folks to deal with those regulations. The question as to whether people like President Obama or Arnold Schwarzenegger who is also quite vocal on oil sands, whether or not the companies have to change their operating practices is up for debate. However, I think most companies are aware that in order to get their product to these large markets you need to play by the rules. What we're seeing is that most companies are investing a lot of time and money to deal with carbon emissions and sulfur emissions.
I think the strides taken by companies are very good, I think people have achieved great reductions in those emissions over the past five or ten years with the realization that more can be done. This is not easy, it's difficult, it's very expensive but I think most companies are willing to take up the challenge and apply technology as well as apply some very good market relations and to educate people as to what is going on in the oil sands.
Scott: And I think too the government is stepping up as well. The provincial government is set aside up funds, considerable funds to help facilitate, initiative, investments, carbon capture storage techniques or any other technological aspects or innovations that will help bridge this issue. Also too, it's important to reflect that the oil sands are fundamentally are important to our North American oil supply base, global supply base going forward. It's an enormous deposit of reserve in a political stable environment and we have to recognize that it's a fundamentally important resource for all of us. So I think in everyone's interest that we look at this issue head on seeing how the industry is doing and seek to solve those problems because we need the resource.
Dean: So Scott that actually leads to our next question that people ask all the time. So you talk about the price volatility that's out there and the price makes it difficult to plan ahead. You hear about the environmental pressures from Governor Schwarzenegger from President Obama and the question is will the Canadian industry survive? And I think maybe you're hitting on that and talking to the strategic importance of it. Maybe that's what drives the survival of the industry over the longer term as opposed some of these direct drive dynamics that people focused on.
Scott: Yeah I mean will the industry survive? Absolutely it will. It has an amazing track record of adapting to circumstance because it's been forced to because volatility isn't something new to this industry. It's been with us since the first oil was ever discovered and I think it's driven a particular perspective and ability in the industry and the government supporting it for that matter to adapt. The fact of the matter is that we need energy in the future; there will be different alternatives, forms of energy as we move forward. But for the foreseeable future at least, oil and natural gas and other traditional forms of energy are fundamentally important and that's not going to change and the world is demanding more of it. So no, the future is bright in long term for this industry. We're in a tough market right now and companies are hurting but looking past that now absolutely this industry will survive.
Dean: If I was to ask you if an oil or gas exec today, what is a top of mind issue that keeps them awake at night. Apart from pricing because that gets a lot of airplay, apart from that what would those one or two issues be?
Scott: Existing situation at hand, it is cash flow and traditional blocking and tackling of any business that every executive is worried about. Cash is king right now and conserving what you have and spending prudently. Managing your balance sheet, watching debt levels closely, the fundamentals are back in vogue in this industry just like any other one.
John: I think I would add to that that uncertainty is probably top of mine. And that's that the government levels are we going to have to deal with more regulations around emissions or are we going to have changes to government royalty regimes in there various jurisdiction that you're working in. And that kind of uncertainty makes it hard to plan so without being able to have your crystal ball and gaze into the future to understand what the rules are going to be it causes doubt as to whether or not you're going to make the next million dollar investment or billion dollar investment for that matter.
Dean: I guess we're talking about lots of zero's in this sector.
Scott: We are, it's a capital intensive as John mentioned, like no other probably.
Dean: Just before we wrap it up here, just one last question for you. Obviously there's been a big announcement recently about M&A the oil patch with Suncor and Petro Canada. There's a lot of speculation that's the first transaction of many to happen in incoming months or perhaps years. What's your take on that?
Scott: I guess I would just say it's just part of the industry and from time to time companies will find that they can add value on Bay Street as they say; they can buy reserve from someone else easier than finding it themselves from the ground. It's nothing new and it always happens in the industry from day one companies are being bought and sold so nothing new. It will go through phases as always, it's all about value and creation for share holders.
John: May I just add that there are some signs of life looking today there are good management teams that are able to raise money again. There are some IPO's potentially, there are some M&A buzz on the street and certainly and expectation there will be more going forward because it will come back.
Dean: If we can summarize the message that we're getting from you Scott and John today, is clearly companies need to focus on the here and now today cash flow management a little bit of blocking and tackling as Scott said, but definitely keeping one eye on the future and on the opportunities that are going to be out there. Not just getting mired in the mud that perhaps we see in front of us today.
Scott: Absolutely, I think like any downturn creates enormous opportunity and if you've got the financial wealth and management vision then this is a great opportunity for many organizations and companies to look back on this as a great time to make investments and take initiative.
Dean: Well Scott and John thank you very much for your time today. I think it's been quite informative and hopefully our listenership will take some solid messages away. For more information on the oil and gas industry please see the energy and utilities industry pages on PwC's website at http://www.PwC.com/ca/energy. For more information regarding business issues for this industry in Alberta visit http://pwc.com/ca/doingbusinessinalberta.
Dean: This concludes this episode of Strategy Talks, part of the PricewaterhouseCoopers Managing in a Downturn podcast series. I'm Dean Mullett, thank you for listening.
Helen: And I'm Helen Mallovy Hicks. We hope you'll join us again soon for another episode. To download or to subscribe to this podcast series or to find more information on this topic, please visit our Managing in a Downturn website at pwc.com/ca/managinginadownturn.
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