The letters began showing up at Pat Wilson’s central Alberta truck shop last month – demands from customers to cut rates in the face of rapidly sinking oil prices.
About 60 per cent of business at Mr. Wilson’s Camex Equipment Sales Rentals Inc. is tied to the battered energy sector, and clients are pressing for price breaks. In one case, Northwell Oilfield Hauling Inc. said it was under pressure from its own customer, Talisman Energy Inc., which was seeking “significant double-digit reductions” in costs, according to copies of the letters.
“For us to be able to accommodate their request, we require price breaks from our suppliers as well,” Northwell informed Camex, which supplies trucks and other equipment for moving drilling rigs and had revenue of about $160-million last year.
The demands put Camex in a tough spot, since the company doesn’t have much wiggle room as it is. So far Mr. Wilson isn’t budging.
“We don’t work off that big a margin,” Mr. Wilson said. “If they want a 20-per-cent discount, we’re not selling it.”
The squeeze is on across the Alberta energy sector. Oil companies are slashing costs in a desperate bid to keep the province competitive in a global industry rapidly restructuring to cope with crude prices that have been cut in half in just six months.
For the Alberta oil industry, however, the stakes are higher than most. That’s because a large portion of Alberta oil is among the highest-cost crude in the world.
Indeed, much of the Canadian oil patch was built to prosper with U.S. oil prices at $80 (U.S.) to $100 a barrel, or even higher. The question is – can Alberta bring costs down fast enough to stay globally competitive?
The early signs are worrisome. A recent study by TD Securities calculated that the average break-even crude price for the oil sands stands around $47 a barrel. With West Texas intermediate oil currently below $51 a barrel, that leaves little room to make any money. The longer crude prices languish around these levels, the more operations fall out of the money and add to the cost pressures facing Alberta oil companies and the array of supplier and service companies so crucial to the province’s economy.
And it puts Alberta at the forefront of a predicament facing a number of higher-cost oil-producing regions as they seek to develop new sources of oil.
“The entire non-OPEC oil industry has been built on and spending on the presumption that oil prices would be $80 or better for the foreseeable future,” says Randy Ollenberger, an analyst at BMO Nesbitt Burns Inc. “The challenge for many companies is that even if they have investment opportunities that generate investment returns at sub-$60 oil prices, most don’t generate enough cash flow [currently] to fund those investments and their balance sheets have been structured for higher commodity prices. This is the biggest challenge facing the industry.”
The growing tension on pricing between energy companies and suppliers in regions far from downtown Calgary’s head office towers is revealing a deep anxiety in Alberta’s dominant industry.
This week, the president of oil sands giant Canadian Natural Resources Ltd. warned that the industry is fast approaching a crisis as stubbornly high costs and sinking crude prices squeeze returns.
“The made-in-Fort McMurray cost structure must change,” Canadian Natural’s Steve Laut told business leaders in the northern Alberta oil sands centre. “It must change. It is not sustainable. And if we don’t work together to make a change, the oil sands industry will fall head first into a death spiral.”
What Alberta oil executives fear is an extended run of oil prices far below the triple-digit levels of recent years, as crude sloshes around in oversupplied markets in North America and overseas. Much of that oil is produced at a far less cost than in Canada.
The TD Securities report shows why. Some producing projects generate returns below the $47 oil level, including Suncor Energy Inc.’s Millennium mining project and MEG Energy Corp.’s Christina Lake steam-assisted development. But others, such as Cenovus Energy Inc.’s Foster Creek venture and Syncrude Canada Ltd.’s plant, require prices above that level to remain in the black while also investing the sustaining capital required to maintain operations, according to TD.
And many new oil sands projects that Canadian energy companies have long been planning have high break-even thresholds. Cenovus, MEG Energy and other major developers have deferred future expansions until commodity prices can support them. But other projects are plowing ahead, even though the current oil price wouldn’t appear to justify them. The $13.5-billion Fort Hills project, being built by Suncor, Total SA and Teck Resources Ltd., for example, needs oil prices above $90 to recoup all its costs and provide a decent return on investment, according to BMO.
Companies proceeding with such projects are betting that over time oil prices will rebound and stay firm. Since they have already sunk huge sums of money into projects, on items such as steel structures, vessels and other long lead-time equipment, they are reluctant to pull the plug, even as markets languish.
“That would be a hard decision to make, because if you go at the oil sands the way you go at a shale oil play, then you shouldn’t be in the oil sands,” said Robert Skinner, an adviser to companies, governments and universities on energy strategy, and Total’s onetime Canadian head. “You’ve got to be able to sustain the swings in price, and that is the history of development in the oil sands. And it’s not for the financially light players.”
Indeed, among the hardest hit have been small developers that had hoped to build one or two oil sands projects. Their troubles began long before oil prices sank as they struggled to deal with inflation in labour and materials costs that prompted cost overruns that required additional capital to pay for.
The skid in energy markets only worsened their predicaments. Among that group, Southern Pacific Resource Corp. filed for creditor protection in January and Connacher Oil and Gas Ltd. was forced to recapitalize with a $1-billion (Canadian) debt-for-equity swap to deal with a looming cash crunch.
Oil sands break even WTI crude prices (USD)
All thermal projects (CSS/SAGD) except Kearl, Horizon, Millenium and Syncrude (mining projects)
SOURCE: TD Securities Inc.
‘The worst I’ve ever seen’
In locales like Nisku, a sprawling industrial hub south of Edmonton that serves the oil sands and other energy operations, the downturn is hitting hard.
“This is the worst I’ve ever seen it,” Stephen Dodd, chief executive officer of Steelhead Fabrication Corp., said sitting at his office desk while a deep freeze lingered outside.
Mr. Dodd faces a grim year. Steelhead manufactures the jumbo steel framing that supports pipe used at steam-driven oil sands plants. It had about $7-million in revenue last year, but new business has dried up as producers scrap expansion plans. Customers are now asking for discounts of at least 25 per cent, which erases his profit.
Worse, an expected order of 30 new units recently fell through, shrinking the firm’s backlog. The company has enough work to last until May. After that, his 27 employees face an uncertain future. “In six months, I’ll be lucky to have four or five,” the crestfallen Mr. Dodd said.
“Our No. 1 customer informed us the other day they would be no more in the next four months and we’ve been servicing them for 15 years, and that’s 50 per cent of our business, gone, instantly.”
Others are waiting for the axe to fall. “We only get paid for what we work. It’s not like we’re on salary,” Ken Babyak, a long-time driller, said over a lunch at the Pipeline Alley Café in Nisku.
On a snow-covered road south of Edmonton, Rob Thiessen, owner of Little Robby’s Pilot Car Service, eyes a flatbed truck carrying the steel skeleton of an oil sands plant.
The giant frame supports a tangle of pipes and valves designed to lift tar-like bitumen from underneath northern Alberta’s boreal forests. Mr. Thiessen’s business is marshalling loads of equipment hundreds of kilometres up a series of highways to production sites. The procession is a rare one these days; fewer are making their way north from this region as oil sands activity slows, cutting demand for Mr. Thiessen’s services.
He charges $75 an hour for each truck that travels with the shipments. Sometimes they require up to four escorts. Competitors have cut rates. “But we try not to, because it’s just too hard to get them back up afterwards,” he said.
Outside the oil sands, oil and gas field activity has also slowed. This week, 317 drilling rigs were operating in Western Canada, just 41 per cent of the industry’s total fleet, according to the Canadian Association of Oilwell Drilling Contractors. That compares with 576 rigs, or 71 per cent of the fleet one year earlier.
Assuming an average of about 20 workers are tied to a rig, that translates into about 5,200 fewer rig workers in the field. As a result, companies that specialize in moving rigs from one drilling site to another have seen their businesses dwindle during what is normally the busiest season.
Family-owned KC Oilfield Hauling Ltd. has already cut rates and shuttered a location in Lloydminster, Sask., amid the steep drop in field activity. What remains are fewer jobs for less pay.
“Put it this way: An $80,000 rig move you’re offering for $40,000, and you’re still not getting” business, said KC’s operations liaison Brad Herrle.
Cuts in drilling are affecting business at heavy crude oil operations in areas such as Lloydminster, says Brook Papau, vice-president of energy research at ITG Investment Research. But there are also fewer wells being drilled in some of the oil-shale-type plays that companies have had rich success with in recent years, including the Saskatchewan Bakken and Pembina Cardium. That’s where debt-hobbled producers such as Lightstream Resources Ltd. and Penn West Petroleum Ltd. have severely curtailed activity.
One mitigating factor that could eventually bring rigs back to the field will be reductions in drilling costs as contractors reduce their rates to keep operating. Mr. Papau reckons the cost to drill and complete a multistage, hydraulically fractured well, the preferred technology in those regions, could fall by up to 20 per cent.
“If you believe in the higher end of that spectrum of cost reduction, you’ll see some return to normalcy,” he said. “Absent of the cost reduction, you’re going to see a significant decline in activity.”
Hoping for a price recovery
Some industry players and politicians still insist the downturn is a short-term correction. But several forecasts, as well as the longer-term futures market, currently call for crude to remain suppressed below $70 (U.S.) a barrel, which points to a much leaner Canadian oil industry than has been the case in recent boom years.
It was an abrupt shift. As recently as last June, the sector was riding a wave of high oil prices, attracting a surge of capital through equity issues and initial public offerings and plowing the money into drilling and acquisitions of assets and other companies.
Earlier, many companies even reaped rewards from an unusual spike in natural gas markets as demand for the heating fuel skyrocketed due to last winter’s polar vortex.
Cracks in the energy complex began to appear as the year wore on, though, as production of shale oil in the United States hit successive monthly records, reducing the need for imports from the Organization of Petroleum Exporting Countries and other suppliers. At the same time, economies in Europe and Asia began to look shaky, raising fears about energy demand. World oil prices started to slide.
By November, U.S. crude had fallen into the low $70s a barrel before Saudi Arabia and the other members of OPEC gathered and then refused to lower production to rescue prices while competitors such as the U.S., Canada and Russia pumped full out. The combination triggered a freefall that not all analysts are convinced has ended. The new reality for markets is that OPEC appears to have dug in to protect its market share at seemingly any cost.
Prices fell as low as $44 or so, but have recently crept back up modestly above the $50 mark.
Eventually, lower prices are bound to result in output declines in Canada and around the world, and increased demand for petroleum products as they become more affordable, says Garey Aitken, chief investment officer at Franklin Bissett Investment Management.
“However, this can take time to play out and sentiment is currently very negative,” he said.
In Alberta, which derives more than a fifth of its revenue from the energy sector, Premier Jim Prentice has warned of a $7-billion drop in revenues in the next budget, a shortfall he says requires an overall public spending reduction of 9 per cent. In recent days, he has announced the closing of three foreign offices and the government has raised the prospect of reinstating health care premiums for the first time in six years.
Last week, Canadian Imperial Bank of Commerce said the province is at risk of slipping into recession due to the massive drop in capital spending in the oil patch. Job losses that have been made public so far – by companies such as Suncor, Cenovus, and Trinidad Drilling Ltd. – number in the thousands.
The slowdown has quickly trickled down into Alberta’s real estate markets, with new house listings in Calgary jumping by almost 40 per cent in January versus the year before and sales down by 35 per cent to the lowest level in seven years.
Investors in energy shares have also been hurt, as the low oil price crimps the cash flow of oil producers.
Since climbing to a recent high last June as crude prices hovered well above $100 a barrel, the SP/TSX energy group is down about 32 per cent, after falling as much as 40 per cent in December.
For investors to recoup those losses, energy companies must first show they can transform themselves into leaner, lower-cost players in the global arena without relying on a big rebound in crude prices.
Spread out across 52 acres of prairie about 20 minutes west of Edmonton, workers are putting the finishing touches on several steel modules bound for Canadian Natural’s delayed Kirby oil sands expansion.
The industrial yard’s owners, Supreme Modular Fabrication Inc. and Fluor Corp., say it’s possible to knock as much as 20 per cent off the cost of developing such projects by standardizing construction processes and improving labour efficiency with legions of skilled tradespeople anxious to get back to work.
It’s one example of the kind of cost savings the energy industry will need to compete in the difficult new reality of lower oil prices.
As Steelhead Fabrication’s Mr. Dodd says: “It’s going to be a tough go for quite a while.”
With files from reporter Peter Scowen in Fort McMurray.