The Fuse

Canadian Oil Industry Starting to Shut In Production as Prices Plunge to $15

by Nick Cunningham | January 15, 2016

Oil prices plunged to fresh decade-plus lows by mid-January amid concerns over persistent oversupply and the faltering Chinese economy. A growing chorus is projecting oil to drop as far as $25 or $20 per barrel before all is said and done, with some even raising the prospect of sub-$20 oil.

There are some places where oil already passed those lowly depths weeks ago, most notably Canada. While WTI and Brent hover around $30 per barrel, Western Canadian Select (WCS), a benchmark for heavy crude in Canada, has plunged to less than half that level. WCS has dropped to nearly $15 per barrel, the lowest price on record, and Bitumen from Alberta actually fell to $8.35 per barrel on January 12.

While WTI and Brent hover around $30 per barrel, Western Canadian Select, a benchmark for heavy crude in Canada, has plunged to less than half that level. WCS has dropped to nearly $15 per barrel, the lowest price on record.

WCS trades at a discount to WTI for a variety of reasons, including lower quality, the location where it’s produced, and a shortage of pipeline capacity. With prices painfully low, many Canadian oil producers are now fully under water. Short-term variable costs for operating an existing project in Alberta are higher than today’s oil prices. Although cost structures fluctuate from company to company, even the largest oil sands projects need oil prices at $40 per barrel to cover variable costs. With WCS trading at $16 per barrel, the vast majority of producers in Canada’s oil sands are losing money on every barrel sold.

For the long-term outlook, investing in new oil sands projects in Canada has been off the table since at least early 2015 for most companies. Estimates vary, but new oil sands projects can easily require $80 to $90 per barrel, or even triple-digit oil prices to turn a profit.

Production being shut in

Some companies will continue to produce at a loss. A spokesman for Royal Dutch Shell told Reuters in early January that it had no intention of shutting down. “We believe in the long-term fundamentals of the industry, and these are operations that have long operating life spans of 30 to 40 years,” Shell spokesman Cameron Yost told Reuters, in reference to the company’s Albian Heavy Synthetic crude project in Alberta.

But some oil sands companies are in fact shutting in production. For instance, Calgary-based Gear Energy, a small producer of heavy oil in Alberta, is considering closing thousands of barrels of existing production as a result of oil prices dropping to such low levels. The company has already shut down 500 barrels per day in output, according to The Globe and Mail.

 “We essentially put our drilling plans on hold and, ultimately, it’s batten down the hatches, survival mode for us.”

“We essentially put our drilling plans on hold and, ultimately, it’s batten down the hatches, survival mode for us,” Gear Energy’s CEO, Ingram Gillmore, said in an interview. Some of Gear Energy’s wells cost at least CAD$30 to produce a barrel of oil. As a result, operations are deep into the red with WCS at less than $20 per barrel. “If I’m shutting in production, it’s because I think I’m slowing the bleed of cash flow,” Gillmore added.  “This oil price is not sustainable for the majority of Canadian production.”

Connacher Oil and Gas Ltd., another Calgary oil sands producer, decided to conduct maintenance at its Great Divide project in Fort McMurray much sooner than expected because of low prices. The move will reduce output by 3,000 barrels per day. “The Company will advise if further production decreases become necessary,” Connacher said in a statement.

Baytex Energy Corp. and Canadian Natural Resources, two more Alberta-based companies, have meanwhile shut down a combined 35,000 barrels per day of bitumen production.

More companies could begin taking output offline, hoping to time routine maintenance with the nadir of the oil cycle.

There are some concerns that lenders to Canada’s oil patch could also be damaged. Credit losses for Canada’s banking sector may jump by 40 percent in 2016, an analyst with RBC Dominion Securities Inc. told The Wall Street Journal, largely stemming from the crash in oil prices.

Broader contagion not yet a worry

Despite the turmoil the oil industry is currently experiencing, the Canadian economy is cushioned by the fact that its currency has significantly depreciated since the downturn in prices began a year and a half ago.

Despite the turmoil the oil industry is currently experiencing, the Canadian economy is cushioned by the fact that its currency has significantly depreciated since the downturn in prices began a year and a half ago. The loonie, as the currency is known, has depreciated to a 13-year low, having dropped below 70 U.S. cents per dollar in mid-January 2016. A cheaper Canadian dollar is giving a lift to exports of most other goods outside of the energy sector. Moreover, since it takes some time for the positive benefits of a cheaper currency to be felt, Canada’s export industries could continue to see improvement in 2016.

“While we have severe challenges in the Alberta economy, the contagion back to the rest of the country is nominal right now,” said David McKay, the CEO of the Royal Bank of Canada’s CEO.

The Canadian dollar may be set for even more declines, if the central bank cuts interest rates again. According to Macquarie Group, the loonie could fall to 59 U.S. cents per Canadian dollar by the end of the year.

For the oil industry, the weaker currency is also a silver lining. Costs for equipment and labor are priced in Canadian dollars, while exports bring in U.S. dollars. All things equal, a falling Canadian dollar lowers costs.

Pipeline obstacles

The discount for Canadian oil won’t go away anytime soon. In addition to lower quality, inadequate pipeline capacity is still a problem, despite efforts by companies such as TransCanada in trying to convince governments in both Canada and the United States to issue approvals.

Late last year, U.S. President Barack Obama killed off the Keystone XL pipeline, and other alternatives are not close to being realized. On January 11, the government of British Columbia formally requested the rejection of another pipeline that would carry Alberta crude to the Pacific Coast due to concerns over potential oil spills.

The problem for Kinder Morgan, the pipeline’s sponsor, as well as for the industry as a whole, is that the Trans Mountain pipeline was supposed to be the most likely out of the handful of long-distance pipelines that Alberta has been counting on to come on line. The proposal called for building a line to run parallel to an existing route – essentially an expansion of a pipeline already in place. If Trans Mountain can’t move forward, it is difficult to see any other long-distance pipeline having better success.

Canada’s oil patch is already burning through cash, cutting spending, slashing jobs, and starting to shut in production. The inability to build new pipelines will drag down the industry through the rest of the decade at least.

In other words, the outlook appears bleak for Canada’s oil industry. Its heavy oil is some of the most expensive in the world. By now, a good portion of unconventional oil in most parts of the world are unprofitable at $30 per barrel. But, at this point, with a double-digit discount relative to WTI, Canada’s oil industry is in dire straits.

 

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