There Will be Oil Sands for Quite Some Time

Commentary, Energy, Ian Madsen

Recently, many climate change activists and their sympathizers have been cheered by the dramatic drop in oil prices that coincided with, and were partly caused by, the COVID-19 pandemic. Prominent among them is the outgoing leader of the federal Green Party of Canada. Apparently, she thinks that the crisis in the oil patch, and the currently parlous state of the oil sands producers, in particular, portends the demise of all involved. While there is certainly carnage and woe at the present time, reports of the death of the industry are an exaggeration.

The actual reason for the current low oil prices in the spot and the near-term futures markets is a war for market dominance between Saudi Arabia and Russia, with the mercurial despots in charge of each nation refusing to budge. However, their deteriorating finances may cause them to call a truce. Saudi Arabia may have a very low cost of production, but its national budget and economy are completely dependent on oil; and, to a much lesser extent, on natural gas and petrochemicals derived from oil.  

The Saudi government needs a much higher oil price than Russia does to balance its budget: USD$80-85 per barrel for the former, and just under USD$50 for the latter. Russia also claims to have financial reserves – about USD$500 billion – to withstand $20-30 oil for a decade, whereas Saudi Arabia is already depleting its reserves rapidly (down from $497 billion in February to $473 billion in March). There have already been peace overtures made, some of them involving the United States, where higher-cost, fast-declining shale well production is hurting badly from the price meltdown.

As all commodity producers and investors know, the cure for low oil (or gold, or copper, or grain, or lumber) prices is those low prices themselves; they compel drastic cuts in capital expenditures and sometimes in higher-cost production capacity, bringing supply down rapidly to match shrunken demand. The lower prices also tend to induce greater demand. The lower supply and higher demand will then bring about higher prices, which will eventually invite producers to produce more and to invest more to increase or replenish production capacity.

Oil producers around the world have drastically slashed their production budgets. Natural rates of decline in mature, conventional oil fields range from a (rare) low of 1% per year to highs upward of 5%; shale wells are even faster declining, as they must be constantly stimulated with higher pressure water and chemicals to maintain pressure. Sadly for producers this year, the decline rates alone, even for shale producers, will not be enough to offset an expected 20-30% drop in demand.  

Shutting in more expensive wells will help, but prices will likely stay low unless the major oil-producing firms, especially the politically controlled state-owned ones in the Persian Gulf and in Russia exercise more discipline. A true recovery in oil prices will require an economic recovery, whose timing remains unclear at present. Yet the current low prices will not mean an end to the industry, because of hedging.

Hedging is commonly used by oil producers to lock in near-term, and sometimes longer-term prices, at a fixed dollar value. This enables confident budgeting and reassures lenders and investors that a firm is not ‘gambling’ on the oil price. In fact, several oil sands producers hedge much of their production, including MEG Energy (48% of output) and Athabasca Oil (59%), at prices that are now much higher than the current prevailing market levels.

The actual cash costs of oil sands production (fuel [much of it cheap natural gas], operating working capital, royalties and other operating costs; income taxes are excluded, as these operations would be losing money for taxation purposes at current prices) are also much lower than is often publicized: $20.94 per barrel for steam-assisted gravity drainage, or ‘SAGD’; $31.27 per barrel for mining operations.   

Companies with ‘downstream’ operations such as refining and marketing (i.e., service stations), have a ‘natural hedge’: they sell to consumers and other customers at retail prices that absorb and offset much of the ‘upstream’ production losses in their profit margins. Major oil sands producers with downstream assets include Suncor Energy and Imperial Oil, which are large, well-financed companies.

This oil industry crisis is certainly very serious, and firms may indeed go bankrupt, including some oil sands producers. However, the assets will remain; shrewd and enterprising entrepreneurs and investors might seize opportunities to buy operations cheaply, finding ways to resuscitate them at much lower cost. They will reap the rewards when prices recover, as they will do, if not soon, then in a few quarters, when the COVID recession is behind us, demand recovers somewhat, and supply attenuates.  

Renewable energy, while steadily getting cheaper, is still not able to satisfy all societal needs, including transportation, and will not become so until promising but expensive, nascent forms of energy storage become commercially and practically viable. They are not there yet, despite all the earnest wishes and hopes and dreams of the Green lobby.

The oil industry, including oil sands producers, survived the earlier dramatic price crashes in 1986 and 2008, and others in 1993, 1998, 2001, and 2014; it will recover, adapt, and live on for quite some time. Oil and gas will keep their role for now, although the industry and its place in the economy and society will continue to evolve, as the disruptive emergence of shale production and rapid international trade growth in liquefied natural gas have shown. The petroleum industry obituary has yet to be written.  

 

Ian Madsen is a senior policy analyst with the Frontier Centre for Public Policy.