Canada Oil and Gas Industry Primer

Energy is one of the most important industries in Canada, as Canada has one of the largest energy resources in the world after Saudi Arabia and Venezuela (Venezuelan reserves are widely accepted by energy professionals to be overstated).

Energy companies are some of Canada’s largest by market cap and revenue, with prominent names including Suncor, Imperial Oil, Cenovus, Encana, Crescent Point, MEG Energy and Canadian Natural Resources, and have been responsible for some of the largest mergers and corporate finance activity in Canada.

The “oil patch” and industries whose revenues are indirectly driven by oil sales constitute a significant part of the Western Canadian economy and Canadian exports in general, so much to the point that there is a strong correlation between the price of oil and the USDCAD exchange rate.

Canada exports a large amount of oil as it produces millions of barrels more than it consumes. Due to a lack of energy infrastructure getting the oil to tidewater (where it can realize global pricing), Canadian oil is usually sold to the USA, moved via pipeline, rail, barge and trucks. Accordingly, the higher the global price of oil and the higher the volume of Canadian oil moved, the greater the amount of exports and the more the Canadian dollar will appreciate against the US dollar.

However, general movement in the US dollar independent of oil will boost prices in Canada (as the realized Canadian dollar amount realized will rise), which will in turn boost production. As it follows, the oil industry has somewhat of a natural hedge where the exchange rate will become less favorable as things are good and more favorable when things are bad.

Given that energy is so important to the Canadian economy, it supports robust capital markets activity as resource companies require equity, public debt (US dollar denominated to match the revenue stream) and loans. So far this year (2017), oil and gas deals have made up the majority of investment banking revenue via major mergers and acquisitions in Canadian Natural Resources’ purchase of Shell’s oil sands assets as well as Cenovus’s purchase of ConocoPhillips’ ownership of Christina Lake and Foster Creek oil sands assets as well as assets in the Deep Basin.

Characteristics Unique to the Canadian Energy Economy

Canada has both conventional and unconventional oil production. The growth of unconventional extraction from the oil sands and shale and tight oil fields is responsible for the incremental growth in production, as measured by barrels of oil per day equivalent. Canada has an immense energy resource (barrels of oil in the ground), but the oil tends to be in reservoirs that require more technological know-how to get it out of the ground.

Extraction from the oil sands is very different from shale plays (we can compare the geology to popular US shale basins such as the Permian, Eagle Ford and Bakken). In the oil sands, thick viscous bitumen is either on the ground or under mild overburden where it is mined by giant shovels or in large reservoirs (in-situ) where engineering techniques such as steam-assisted gravity drainage or SAGD are used to stimulate the oil and get it to surface. We are increasingly seeing improved economics for SAGD methods and recovery is improving as technology gets better.

These major oil sands projects take tremendous amounts of initial capital expenditures to get production started and have very high fixed costs but can achieve very low variable costs (good examples include MEG/ConocoPhillips/Cenovus’s Christina Lake and Suncor Firebag). However, if economics change, oil companies are reluctant to turn off the taps and cut production even at a loss as for many of these projects stopping and restarting may have economics inferior to running them at a loss. This heavy oil extraction is fairly unique to Canada.

Conversely, shale basin extraction is similar to various global projects and the geology for many Canadian basins (Montney, Duvernay) yield very good economics. There is precision in estimates of recovery and production can begin and cease much more pragmatically than large oil sands projects.

Heavy oil focus: Suncor (and previously Canadian Oil Sands via Syncrude), Canadian Natural Resources, Cenovus, Imperial Oil, MEG Energy, Baytex

Light oil focus: EnCana, Crescent Point, Penn West, Enerplus

Due to the relative difficulty in getting bitumen and heavy oil out of the ground in Canada, as well as an expensive labour environment, the average cost of extraction is high on the global cost curve. As such, if a barrel of oil sells for $50 globally but the all-inclusive cost is $40, the realized netback or profit is substantially lower than in a place such as Saudi Arabia where the incremental cost of extraction may be dollars for a barrel.

In addition to this, Canada has energy infrastructure constraints. To realize global pricing on the oil sold, the oil must reach an international hub (usually the ocean), so the delta between the price of an international benchmark (for example WTI for the US or Brent for global trade) to the price realized by a Canadian producer is usually the cost of transport between the two nodes. For trapped Canadian oil, this differential may be substantial.

There are numerous barriers to erecting pipelines quickly in Canada, including environmentalist sentiment, cost considerations (difficult to use foreign labour politically, strong labour laws and high union presence) and thus decent takeaway capacity for oil production in Canada remains underdeveloped. Due to the adversity faced domestically, major players such as Enbridge and TransCanada have found that there are projects with better returns to capital than in Canada, as evidenced by ample Mexican and US pipelines planned as well as the recent acquisitions of Spectra Energy (ENB) and Columbia Pipeline Group (TRP).

Additionally, almost all pipelines lead to the US and not tidewater, where they can realize global pricing (exception is the Kinder Morgan TransMountain pipeline and possible expansion to ~900k barrels of oil per day), leading to massive supply gluts, especially because Canadian heavy oil and bitumen cannot be serviced well by refineries in the Northern United States. The heavy oil is best treated in the Southern US or PADD III (Gulf Coast), where complex refineries have specialized crackers and other hydrocarbon treatment methods.

This leads to Canadian heavy oil (Western Canadian Select or WCS is the heavy oil benchmark) trading at a steep discount to WTI (the delta will widen when capacity constraints grow, and will fall to the cost of transport, being the tolls from the pipelines, when capacity is available). If the opportunity to move crude via freight (rail) or barge, this can help to alleviate the discount should pipeline capacity be full. Companies with good logistics platforms realize the best returns on their pricing. Suncor and MEG Energy are good examples of this.

It is important to recall that crude is an unfinished product, so the difference between the benchmark and the producer’s oil is affected by how far it is from being refined. Suncor often quotes that most of their crude realizes global pricing despite having most their crude never leaving the continent. This is due to their ownership of strategic refineries, and once the crude is converted into gasoline, kerosene (jet fuel for airplanes) and residuals (asphalt, fuel oil for tankers), it becomes a standardized refined product.

Canada does not have many refineries and since the recent oil price decline, refineries and upgraders (which are facilities that “upgrade” low price bitumen into synthetic crude oil) have not seen justifiable economics for new builds. As such, most Canadian production must go to the US where refinery capacity exists. When refineries undergo maintenance, the price of oil falls. When production is stalled on a project, the price oil rises, ceteris paribus.

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