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Musings: Canada, O Canada: What Direction for 2013 O&G Capex?

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Musings: Canada, O Canada: What Direction for 2013 O&G Capex?

A couple of weeks ago, we participated in the annual Petroleum Services Association of Canada (PSAC) drilling forecast outlook meeting in Calgary. I, along with a colleague, spoke about the outlook for the Canadian service industry, while other speakers discussed issues impacting the producing sector up north, but the highlight of the meeting was the presentation of the PSAC Canadian drilling activity forecast for 2013. To help set the stage for that forecast, besides the presentations mentioned, there was a 2013 outlook for the producing sector presented by a representative of the Canadian Association of Petroleum Producers (CAPP). In their respective presentations, both CAPP and PSAC gave estimates for 2013 capital spending by the Canadian petroleum industry.

That morning, and we assume in anticipation of the industry forecasting session, The Globe and Mail's business section had an article about petroleum capital spending for next year that carried the headline: "Austerity Hits Oil Patch's Capital Spending Budgets." The thrust of the article can be summed up in the one-sentence opening paragraph. It stated: "The capital spending drought in the Canadian oil patch looks headed for a second successive year, as weak commodity prices, shrinking cash flows and an uncertain future have oil executives set to tighten again in 2013." The article was reinforced with comments from two financial economists who have concluded Canada's petroleum industry capital spending will fall next year.

As we sat in the audience following our talk and listened to the CAPP and PSAC presentations, we were reminded by our colleague of a phrase one of our early bosses used to repeat frequently. "Hope is not a strategy." With that as a backdrop, what should be expected for Canadian petroleum industry capital spending in 2013?

A couple of weeks ago, we participated in the annual Petroleum Services Association of Canada (PSAC) drilling forecast outlook meeting in Calgary. I, along with a colleague, spoke about the outlook for the Canadian service industry, while other speakers discussed issues impacting the producing sector up north, but the highlight of the meeting was the presentation of the PSAC Canadian drilling activity forecast for 2013. To help set the stage for that forecast, besides the presentations mentioned, there was a 2013 outlook for the producing sector presented by a representative of the Canadian Association of Petroleum Producers (CAPP). In their respective presentations, both CAPP and PSAC gave estimates for 2013 capital spending by the Canadian petroleum industry.

That morning, and we assume in anticipation of the industry forecasting session, The Globe and Mail's business section had an article about petroleum capital spending for next year that carried the headline: "Austerity Hits Oil Patch's Capital Spending Budgets." The thrust of the article can be summed up in the one-sentence opening paragraph. It stated: "The capital spending drought in the Canadian oil patch looks headed for a second successive year, as weak commodity prices, shrinking cash flows and an uncertain future have oil executives set to tighten again in 2013." The article was reinforced with comments from two financial economists who have concluded Canada's petroleum industry capital spending will fall next year.

As we sat in the audience following our talk and listened to the CAPP and PSAC presentations, we were reminded by our colleague of a phrase one of our early bosses used to repeat frequently. "Hope is not a strategy." With that as a backdrop, what should be expected for Canadian petroleum industry capital spending in 2013?

The CAPP speaker presented a slide about industry capital spending showing actual spending by various geographic regions for 2011, an estimate of spending for 2012 and a 2013 spending forecast. According to the CAPP slide, the industry spent C$62 billion in 2011 but trimmed this year's spending to an estimated C$61 billion. Spending is forecasted to rise to C$63 billion next year. PSAC also addressed industry spending plans, but focused on spending to drill and complete wells, which is most appropriate given their focus on drilling activity. According to PSAC, drilling and completion spending fell from C$16.0 billion in 2008 to C$8.8 billion in 2009, but then rebounded to C$13.9 billion in 2010 as the financial crisis with its liquidity challenges and recessionary environment cut energy demand and limited producer spending. In 2011, the Canadian industry spent an estimated C$16.2 billion on drilling and competing wells, which is projected to fall slightly to C$15.6 billion this year but jump in 2013 to C$17.3 billion.

So what we have between these two presentations is either a 3.3 percent or a 10.9 percent spending increase in 2013. This compares with The Globe and Mail's quoting Arc Financial's economist Peter Tertzakian's estimate of a "10 to 15 per cent" decline in industry spending in 2013. His forecast follows his estimated nearly 20 percent decline in industry capital spending for 2012. Is it possible to rationalize these conflicting outlooks? Part of the explanation relates to the definition of capital spending the various forecasters are using. It appears Mr. Tertzakian and CAPP focus on the capital investment undertaken by all sectors of the Canadian petroleum industry – conventional oil and gas and oil sands operations – while PSAC looks exclusively at conventional drilling activities.

To try to understand Canada's petroleum capital spending we went to CAPP's statistics and examined the spending history by category for both conventional oil and gas and oil sands. If we exclude spending on land and enhanced oil recovery investments, we arrived at an estimated industry spending total that was approximately equal to the estimate given by CAPP: C$60 billion, our estimate, versus C$62 billion, CAPP's estimate for 2011. Spending on land amounted to about C$4.4 billion that year, which would make our estimated total spending nearly C$2.5 billion more than CAPP's estimate. While we always like to get our numbers as accurate as possible, the important thing is to get close and to have an historical record. Our work allowed us to chart Canadian petroleum capital spending by conventional oil and gas activities and oil sands investments historically. (See Exhibit 1 on the next page.)

What we see in Exhibit 1 is that Canadian spending on oil sands projects has exploded in recent years in concert with the dramatic rise in global oil prices and the increased flow of investment funds, especially from foreign entrants, for new oil sands projects. With weakening oil prices and slowing oil demand growth in North America, coupled with rising operating and investment costs, the economics of new oil sands projects has deteriorated.

Exhibit 1. History Of Canadian Petroleum Spending

We have seen several major Canadian oil and gas companies, including a leading oil sands producer, announce reductions in capital spending plans for the balance of this year and next. Delays in sanctioning new oil sands projects will be a part of the industry investing environment for 2013 that may create a transitory capital spending dip. Cuts in conventional exploration and development spending will also be a factor in 2013 due to low oil and gas prices in Canada.

In The Globe and Mail article, Mr. Tertzakian said he based his forecast for a meaningful capital spending reduction next year on his view of future oil and gas prices. Not only is he projecting lower oil prices for 2013, but the widened price gap between western Canadian oil prices and West Texas Intermediate (WTI) prices in recent months has contributed to a significant loss of cash flow for Canadian producers. A summer article in The Globe and Mail, when the price gap was about $20 per barrel, suggested the discount was costing Canadian producers about C$50 million per day. That represents nearly C$350 million of lost income per week, or about C$1.4 billion per month. To see how this gap has developed, we plotted the average monthly price per barrel posted by three major Canadian producers in Western Canada against the average monthly price for WTI futures prices. As shown in Exhibit 2, there was a modest discount between Canadian and WTI oil prices in 2010 and early 2011. That gap closed during the first half of 2011, but for most of the second half Canadian oil prices actually exceeded WTI. Things changed dramatically in 2012 with Canadian oil prices falling to a wide discount from WTI, but the price gap closed in September and October. With rapid growth in U.S. crude oil production and only a modest demand increase, it is likely the Canadian oil price gap will re-open in 2013. It already appears to be widening here in November.

Exhibit 2. Canadian Oil Prices Are At Discount To WTI

Complicating the exercise in estimating Canadian producer cash flows is the expectation that in 2013 WTI oil prices will be well below the level of 2012 oil prices. Exhibit 3 shows WTI futures prices for 2010 through early November 2012. We have also plotted the WTI futures prices for December 2012 as of a week ago, and for all of 2013. As can be seen by observing the dotted line (purple) for 2013, oil prices will be well below 2012's price trend meaning lower cash flows for the U.S. producing industry and even less for Canadian producers if the price gap remains as wide as it currently is. This lost income from lower prices will not be offset by increased production next year.

Exhibit 3. 2013 Oil Price Reflects Lower Demand

The conclusion we draw from this exercise is that we are more comfortable with the prospect of flat to lower Canadian petroleum industry capital spending in 2013. We don't know whether Canadian producers will announce large capital spending reductions when they outline their plans for next year, but we believe they will be very reluctant to step up spending beyond the winter drilling season. Spring break-up will provide producers an opportunity to reassess their outlook for oil and gas prices and economic demand. A sharply improved outlook some 5-6 months in the future could make the CAPP and PSAC forecasts come true, but at the moment we will take the "under" bet on those forecasts.

G. Allen Brooks works as the Managing Director at PPHB LP. Reprinted with permission of PPHB.

WHAT DO YOU THINK?

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