Crude Observations

Taking Stock

Well here we are in Alberta, in the middle of the August Long Weekend, a traditional time of deep reflection and soul-searching, where the good people of the province take stock, peer through the haze of forest fire smoke and decide what they are going to do in the fall when they have to go to work.


True to form, our provincial government, in its infinite wisdom, has seen fit to smooth the way back to work by declaring that, as of August 15, the COVID pandemic is officially over and that all extra testing, isolation, mask wearing can go by the wayside. Weird right? Like on August 14 it’s a raging global pandemic with no end in sight and a bevy of Greek-letter named variants hunting us down like a series of Atlantic hurricanes and then the next day, it’s a summer cold.


The government of course says that this is all the idea of the Chief Medical Officer of Health and that they are just following her instructions and the science. And given this government’s history of doing just that, following the science, listening to the evidence, heeding advice from third parties instead of doing just whatever their ideological playbook tells them to do, who am I to doubt them?


Look, no one wants this pandemic to end and life to return to normal more than me. Well maybe some people do, but I’m pretty keen anyway. What I’m saying is, we are all tired. We want to move on.


But here’s an analogy of sorts, a parable if you will.


Once when I was a wee lad, I was walking on some train tracks and I found myself at a tunnel. Needing to get to the other side, I knew I had to proceed. No sooner than taking my first step, I saw a light in the tunnel. Must be the other side. So I took another step. I sure hope it’s not some zombie mutant with a flashlight, I thought to myself. Now more than a little frightened, I took another step into the dark. Suddenly the light came closer to me and there was a loud grinding noise and some air blowing in my face. Oh great, demons and ghosts I thought.  I pressed on.


Then the little Magnum voice in the back of my head said “Dude, I hope you’re not being obtuse and stupid here by walking into a tunnel with a mystery light in the distance making scary noises”.


It was at that moment when I realized the error of my ways – it wasn’t demons, it wasn’t a zombie, it wasn’t the other end of the tunnel. Nope it was, most likely, a dragon, lying in wait for me, as they usually do. So without further ado, I beat a hasty retreat and soon found myself back out of the tunnel, which I still needed to go through, and soon enough, the dragon/zombie/demon thing revealed itself. It was one of those hand pump track repair cart-like things with a lantern and a couple of guys doing maintenance.


“Kid,” they said, “I hope you aren’t planning on walking through a dark tunnel without knowing what’s on the other side, because that’s pretty dumb. If we’d been a train, you’d be a pancake. Why don’t you use the clearly marked trail that goes up and over the tunnel. It’s a little further and a bit more work, but way safer.”


Needless to say, in retrospect, that was pretty good advice. Hope, as they say, is not a strategy.


I think my point here is painfully obvious, but in case I am being too evasive and clever, I’ll clear things up. I wonder if we aren’t abandoning all of those pandemic restrictions this early in the hopes that we can muddle through the delta variant and tail end of the pandemic because we really don’t have a proper strategy for how to deal with it come September. Plus the pandering. There is a lot of pandering here in a move by an embattled government whose popularity is in free fall that seems more targeted at shoring up support from the rural fringe than playing it safe for the crowded cities. But what do I know.


Anyway enough of that. Onto more hope. Because as I alluded, August is the month of hope in Alberta. It starts with a long weekend and boats and it ends with kids back in school, capex budgets being set and drilling programs being ramped up.


And in true Alberta fashion, where hope (and non-conventional liquids rich gas) springs eternal, this is also the time of year to take stock of our industry and see which factors are working in our favour as we approach this most critical time of the year.


Speaking of stock, it is still (and will likely remain so for eternity) puzzling to me why there is such a disconnect between tech companies, the stock market, the economy, the energy sector and, what’s that thing called, reality.


It is still amazing to me that the stock market has gone so bananas since the big sell off early in 2020 and equally obvious that the market is trading off cheap Fed money as opposed to that inconvenient thing called reality. On the other hand, we’ve been waiting on this day of reckoning for a long time and it hasn’t materialized yet. Unless you own a SPAC, in which case you have experienced a bear’s bear market.


But enough doom and gloom, as always there is a silver lining somewhere, a true value play that is sure to provide Tesla like returns, you know what I’m talking about. That’s right, Canada’s energy companies.


Look, I get it, not a sexy sector right now and with everyone piling on and bailing out, why in the world am I even bringing up this sad-ass, non ESG group of also-rans?


Well because like any energy sector participant, I am a big sucker and do have a few names in my portfolio that are active in the Canadian energy sector. Or put another way, since having a day-job that is 100% leveraged to a volatile and downtrodden energy world just isn’t risky enough, I also have to have my passive investments in there as well.


And let’s just say, they finally seem to be waking up.


Look, it’s hard for a Canadian energy company to catch a break. The sector is under siege, the federal government is indifferent, the media has dug your grave, the pandemic has cratered demand, the capital markets are closed.


But a funny thing happened over the last few quarters. A lot of Canadian energy companies made a shit ton (technical term) of money. What’s that you say? That’s right. Unlike their brethren to the south who have been flaming out in record numbers and have lost a cumulatively staggering $300 billion plus in Free Cash Flow since 2014, Canadian energy companies tend to be very Canadian. Relatively boring, risk averse, conservatively managed and able to eke out cash flow at both the best and worst of times.


Will the market ever notice this historic disconnect and value play or will they continue to chase cheap money fuelled diminishing gains on overvalued macro plays? That remains to be seen, but it’s probably worth taking a look at why they should consider it.


So here goes nothing.


Light at the end of the tunnel or oncoming freight train. An annual look at why Canadian Oil and Gas stocks still rock.


1 – Pipelines and Egress


Yes, I know.  It’s getting pretty boring isn’t it? But it’s one of the most important factors affecting the energy industry and Canadian energy companies. Without new pipelines and the ability to grow access, Canadian energy stocks will always be perceived as a dollar short. Why? Because we have told the market that so they bid accordingly.


In the post- COVID world, pipelines into the US are full and Crude by Rail usage is rising (would be nice if we still had that, wouldn’t it?). With the Trans Mountain expansion another year further along and Line 3 finally past what might be a point of no return, the egress problem is getting solved, notwithstanding the Keystone XL boondoggle or the self-inflicted economic chaos desired by Governor Whitmer’s desire to shut down Line 5. When the market figures out that the egress problem is solved, part of the Canadian discount will disappear. In the meantime, Canadian producers will continue to incrementally increase production, stealthily make obscene amounts of money, strategically invest and do all the things we expect them to do. Light at the End of the Tunnel


2 – Commodity Prices


While this isn’t going to be news to anyone, oil and gas stocks tend to move up and down with the prices of the commodity they produce. This of course is the way it should be. If oil is higher priced, then it stands to reason that a company that produces said oil should be worth more. Makes sense, right? Not anymore. For the last number of years, the performance of Canadian energy stocks has at times found itself completely disconnected from the prices of the underlying commodities. Oil prices collapsed in early 2020 and took stock prices with them. While they have recovered with the price of oil and gas rising, the market still lacks confidence in sustainability due to OPEC+++, lingering COVID demand destruction issues and the “energy transition”. While some companies have seen decent recoveries on price appreciation, not enough have so far been invited to the dance. Tunnel is blocked


3 – Stable, long term production


Canada has the capacity to produce some 4.5 mm boepd of oil. While this capacity had been reduced by government imposed curtailment and voluntary reductions due to COVD related demand declinesall that is gone now – we are now approaching peak production. Unlike the Light Tight Oil market in the United States we also aren’t dealing with literally tens of thousands of wells with super steep decline profiles to accomplish this. More than 80% of Canada’s crude production comes from oil sands projects – both mining and in situ which are extraordinarily long-lived assets with very low decline rates. These projects are also already paid for which means rather than worrying about having to spend billions in new capex, the biggest worry is breaking even on an operating basis, and our costs are generally pretty low. Put another way, put a floor under prices and these projects are more of an annuity than a flyer. Light at End of Tunnel.


4 – Bad Public Relations


I think I wrote a whole blog about this some time ago, but we do a really lousy job of self-promotion. Aside from all the market and business issues, there are very few uninterested parties extolling the virtues of the Canadian energy sector. Instead we have a whole ecosystem of aggression and doom and gloom that serves to push investment in different directions. Who is going to invest money in a sector that needs to be defended by a “War Room” that talks about a giant cabal of US oil companies and charitable foundations lined up to protest us out of existence? The reality is far different. Canadian companies make money, have conservative balance sheets and offer high quality in demand product to a voracious consumer. Plus we have a pretty enviable regulatory system. But we aren’t getting the message out to the right people in the right way. This is why companies write down their investments in the sector and ESG focused financial institutions find reasons to not invest or to not insure our oil sands and related infrastructure. I’m not singling out the government here – if industry did a better job, do you think Jason Kenney would feel the need to try and do their job for them? As a whole, the industry needs to do a much better job figuring out its audience and its message. When producing companies are leaving your advocacy association, it’s time to take a second look. Oncoming Freight Train


5 –Climate Change and Peak Demand Fears


It is unavoidable that climate change factors play a part in the publicly traded energy sector. In a world where fossil fuels are seen as a pariah and renewables ascendant, it is easy to see where replacement fears, stranded assets and inevitable peak demand are catalysts for investment decisions. Canada is squarely in the crosshairs on this and the more air the misguided belief that fossil fuels are on their way out in the very near future gets, the more the prices of publicly traded companies find themselves held down. This is misguided on several levels but I would point out the following – the likelihood of fossil fuel demand being substantively reduced in the next generation is pretty much nil, peak demand assumes no growth in Africa and the Indian subcontinent, a perfect storm of affordable renewable energy implementations and an electric vehicle in every suburban garage. The next point I would make is that energy companies are run by very smart people. There is no chance that these management teams won’t be able to adapt to changing circumstances given and reinvent their companies in a changing world. Oncoming Freight Train


6 – Capex collapse


In the wake of the Saudi-Russia price war, the demand collapse caused by the pandemic and the production rollbacks by OPEC++++ and other producers, capex programs around the world were slashed, in some cases by 50% or more. In the short term the implications of this were pretty negligible unless you were a contractor who suddenly doesn’t have any work. But in the medium term, as demand recovers and inventories get drawn down and spare capacity gets used up the implications of all these projects being shelved will become apparent. Holding steady at previous consumption levels, the world needs to replace between 5 and 10 mm boepd of production per year. OPEC +++ spare capacity is currently down to about 5. With consumption recovered to 95% of pre-COVID levels and rising, spare capacity covers a year, two at best. That’s it. But many of these projects that have been shelved are long term developments that can take up to five years to bring online. This will result in higher prices and greater profitability for producers who have ready access to long term production. Like Canada. Light at the End of the Tunnel


7 – Permian Permania


Up until early 2020, the United States continued to grow production like their hair was on fire. Never mind whether that was a good or a bad thing (it’s a bad thing BTW) or whether US companies actually made money (they don’t). The key takeaway is that the growth of production at all costs attitude of the average US producer contributed to the worst market for energy stocks since the 1980s and has dragged Canada down with it, regardless of whether our production profile is different or whether our companies are actually returning real cash to shareholders. It was a contagion afflicting North American producers as a whole. But now, the average Permian producer has re-invented themselves.


Rig count in the US have rallied slower than the count in Canada. In a market where capital was once available on demand, restraint and living off cash flow are the orders of the day. The debt wall that faces the US producer sector just doesn’t exist in the same scale in Canada. Our production profile doesn’t depend on a drill bit focused treadmill – our best producers are generating cash from an installed production base that doesn’t need a tsunami of cash to keep afloat, instead it generates a tsunami of free cash. If you were allocating energy capital to your portfolio, explain again why you would pick a Permian producer over CNRL or Tourmaline? Light at End of Tunnel


8 – Biden


Biden has made his position clear for the energy sector. Even if drives a beautiful, classic Corvette, he is not a fan of fossil fuels. He killed KXL. He banned ban fracking on federal lands, he’s reintroducing strict new methane emissions rules and limit flaring. He’s going to shut down more coal-fired electrical generation. This is all bearish – for the US energy sector. For Canada? Not so much. Remember, the argument we make all the time to anti-fossil fuel advocates here is that the production will just come from somewhere else so, if it ain’t coming from the United States, why can’t it come from Canada, what with all that pre-installed infrastructure and all. Light at End of Tunnel


9 – Competition


No, not renewables. I’m talking about producers and producing countries that produce the type of oil we do. I read a lot of commentary that Canada produces a substandard dirty product that no one wants and that there is no export market for our heavy oil and that the United States buys our dregs at pennies on the dollar because they pity us. Never mind that these comments are insulting to our industry, they are also poorly informed. Oil comes in many different ranges of quality, but for now, let’s separate it into light, medium and heavy. Light oil is used primarily for transportation fuel because it requires relatively little refining the lighter it is. Medium grades are used for transportation and other uses, with many products being made. Heavy oil has the most complex molecular structure which means it can be refined into the largest portfolio of products. A significant portion of the Gulf Coast is set up to refine and process heavy oil. Heavy oil demand is growing. Pre-pandemic this was very obvious to anyone in industry and as the dust settles here, it will be the case again. And who produces heavy oil? Saudi Arabia, Iran, Iraq, Mexico and Venezuela. Oh, and Canada. Iran is embargoed. Iraq doesn’t produce in sufficient quantities. Mexican production is falling and Venezuela, with the (on paper) 1st or 2nd largest reserves in the world has collapsed and doesn’t even have a rig working. Saudi imports into the United States have been on the decline for years. Why is that? Because little old Canada is a critically important and reliable supplier of much needed heavy oil into the US market. This is a good thing, is it not? Light at End of Tunnel


10 – The Emotional often overrides the fundamental


This is the last point I will make and this is why it seems Canadian companies can never win. Our fundamentals are good. At US$60 heavy oil and a $0.80 dollar, Canadian producers are generating an ungodly amount of cash. CNRL made $3 billion in funds flow in Q1, on weaker pricing! That’s the same as Exxon.


Our rocks are better. Our decline rates are lower. Our balance sheets are stronger. Our capex and spending discipline is higher. Our environmental standards and ESG scores are higher. Our regulatory regime is (for now) stronger. Our management teams are smarter. Our carbon footprint is shrinking. Our egress is happening. All that but “Trudeau”, “no pipelines”, “single customer”, “end of world pandemic”, “peak demand”, “energy transition”. It’s emotion and it overrides the fundamental. This is the world we are in. Until that changes, Canada’s energy stock prices are going to lag. Woof. But it is hard not to think that the winds of change are here and that at this point in time, sentiment is slowly turning back to Canadian names. Light at End of Tunnel


So what’s the answer?


Well you can either sit around and wait for the market to let you know or take advantage of this historic undervaluation of so many quality Canadian companies because it can’t last.


If I had a pile of money sitting around and I was allowed to by my broker, then I’m going long Canadian energy. A hard long. Even if only for the ridiculous dividend yields. I’m picking the highest quality companies in oilsands, conventional and gas-weighted production and letting it rip, trusting battle-hardened management teams to deliver.


Of course, the other alternative is shove it all into a SPAC or an EV company and hope for the best. Given how stretched the current market feels, Canadian energy may actually be the less risky play and should have the longer legs return wise.




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