Impact of the low price environment on Canada’s oil and gas sector
November 2015 | SPECIAL REPORT: ENERGY & NATURAL RESOURCES
Financier Worldwide Magazine
It has been a rough ride for the Canadian oil and gas sector since oil prices started their dramatic decline over a year ago. The oil patch in Canada looks very different today from what it looked like then. And we anticipate that within another six months, the landscape could be unrecognisable.
Reduced activity and cost cutting
Canadian oil and gas producers have reacted to the downturn by cutting their budgets, reducing their drilling programs, laying off thousands of employees and contractors and seeking cost reductions from suppliers. The reaction has been swift and it has been deep – much deeper than we saw during the 2008/2009 downturn. Oilfield service companies have been hit hard, with oil and gas producers looking for cost reductions in the range of 20-30 percent. With drilling and service rigs operating in the 20-30 percent range for much of 2016, the lower rates hit much harder than they otherwise might. While this level and type of cost reduction has significantly aided producers to reduce their costs, and to even maintain or increase their production with less capital, it could have a rebound effect when oil prices improve. If demand for oilfield services increases faster than oilfield services can supply, oilfield service providers could use this as an opportunity to recoup some of their losses during the downturn, resulting in service supply costs that will potentially be higher than they were previously.
In this environment, companies are looking at different and more creative ways of monetising their assets. Two trends we have seen include: (i) the sale of existing and manufactured royalties; and (ii) the sale of midstream assets in consideration for long-term processing and transportation agreements.
The spin-off by Encana Corporation of its freehold lands and royalty interests to PrairieSky Royalty Ltd in 2013 and Cenovus Energy Inc.’s sale of its freehold lands and royalty interests to Ontario Teacher’s Pension Fund earlier in 2015 are two significant royalty deals that have been much talked about. But smaller players have also gotten into the game by creating and selling manufactured royalties (net profits interests, percentage interests in production, or volumetric royalties) on their working interests. While this form of financing held some promise early on, we have noted that it has waned somewhat over the past few months. With development plans being put on hold and production falling or anticipated to fall as a result, the attractiveness of this generally low-risk investment product has likewise fallen.
The lower costs for capital and labour in the current downturn are also providing investment opportunities for companies in the midstream sector. Midstream assets are a profit centre for midstream companies, but they are a cost-centre for producers. Producers that currently own midstream assets are monetising those assets by selling them to midstream companies, many of which are new players, and several of which are backed by private equity, in consideration for long-term, take-or-pay transportation and processing commitments. This type of deal not only provides an attractive relatively low-risk investment opportunity for new players, it allows producers to monetise these assets and free up their cash to meet their resource development objectives.
Private equity – the wave that promises to come
Private equity investment in Canada’s oil and gas sector has waxed and waned over the years, but private equity investment is definitely on the upswing. For several years, companies backed by state-owned entities provided a significant source of funding for Canada’s natural resources development. This type of investment reached its height in 2012 and declined rapidly – for a number of reasons, of course – including the Government of Canada’s decision to restrict the ability of companies influenced by state-owned enterprises to take controlling positions in Canada’s oil and gas industry (and to make it ‘exceptional’ in the oil sands sector). That certainly had a negative impact on some countries’ perception of Canada’s investment climate (and potential). These investment dollars are global and we’ve seen them move elsewhere.
There nonetheless remains a heavy reliance on capital, and we are seeing private equity step in to start filling the void. In this environment, there are no ‘mega deals’ but private equity is active in Canada, although not as active as it is in the United States. That said, we tend to lag behind the United States so we are anticipating a much bigger private equity investment surge in Canada over the next few months and years.
Where is the M&A?
One of the things that we are not seeing right now is an upswing in mergers and acquisitions, whether backed by private equity or otherwise. When the price of oil started dropping precipitously in late 2014, commentators suggested that it was a buyer’s market and that there was likely to be significant consolidation in the industry and an uptick in M&A activity in the first quarter. That didn’t happen, and the time period was extended to the second quarter, and then to the third quarter, and we are now in the fourth quarter of 2015 and it is only just starting to materialise. Although this is one of the longest oil price downturns we have seen in the recent past, there continues to be a disconnect between the price that buyers are willing to pay (especially private equity) and the price that sellers (and/or their lenders) are willing to accept. That said, with each quarterly review and drop in reserve value, and with each drop in reserve value and renegotiation and reduction of a company’s borrowing base for capital, the ‘differential’ is narrowing. There are definite rumblings of activity, shaking the industry from its paralysis.
An opportunity to build much needed infrastructure
There is significant access to market issues and we see that the price of Canadian oil is discounted to the price of oil in the United States because of this. Transportation and processing infrastructure needs to be in place when companies are ready to produce. Midstream companies are prepared to advance the required if oil and gas producers are prepared to backstop those advances by making long-term transportation and processing commitments. Now is certainly the opportune time to make these commitments. Development and production plans have been suspended and/or delayed, as a result, the cost for labour and services are down. Fortunately, we have seen oil and gas producers take advantage of this period. Midstream companies are actually fairly busy responding to producer ‘requests for proposals’ for infrastructure.
The promise of LNG?
The development of Canada’s once ‘promising’ LNG sector is now is question, with several commentators suggesting it has missed the current ‘golden’ window of opportunity – a window that will likely remain closed for at least another 10 years. LNG prices are much softer now than they were when these projects were initially conceived. Australian LNG projects, although they suffer from significant cost overruns, as well as US brownfield projects, will start supplying LNG to global LNG markets before Canadian projects will be in a position to do so. Demand for LNG by the largest Asian buyers, China and Japan, has slowed. Japan has restarted at least one nuclear reactor, and has plans to restart others. The growth of the Chinese economy has declined significantly. Spot-sales of LNG cargoes (and the creation of a spot-market for LNG sales) are on the increase, which has had a significant downward pressure on LNG pricing.
That said, we have at least two large projects that global companies have invested in – the PETRONAS led Pacific Northwest joint venture with JAPEX, Petroleum Brunei, Sinopec and Indian Oil, which has made a conditional final investment decision, and the Shell led LNG Canada joint venture with Mitsubishi, China National Petroleum Corporation (CNPC) and Korea Gas Corporation (KOGAS). These LNG players are large integrated global companies that make investment decisions based on more than simply the economics of one project. The fact that the economics of a Canadian LNG project are not as good as originally conceived will not, a priori, result in the cancellation of the project. It remains to be seen and we continue with ‘cautious optimism’ to think that the two major projects will be in play by 2019.
Alicia K. Quesnel is a partner at Burnet, Duckworth & Palmer LLP. She can be contacted on +1 (403) 260 0233 or by email: firstname.lastname@example.org.
© Financier Worldwide
Alicia K. Quesnel
Burnet, Duckworth & Palmer LLP