Mastering Cycles
Violent market storms test the industry’s ability to dodge financial wreckage
In addition, small firms have limited assets generating physical production revenues to offset financial hedging prices. “Juniors are fairly conservative because they have to be,” says Ebbern. “It can be problematic. Financial hedges take on a financial commitment as well. Financial costs to hedging will increase not decrease.” The Tristone analyst says some producers would like to hedge if the tactic wasn’t so costly. “It makes more sense to be aggressive on hedging when smaller producers are closer to their production,” he adds, and hence their overall costs aren’t as high.
There are companies with natural hedges. The integrated oil and gas operators produce oil and then consume it in their refining operations. The diversity gives them built-in protection against market slides. Low crude prices hurt their production sides but cut raw material costs for their refineries. High crude prices squeeze refineries but enrich production departments.
Yet even that strategy can fizzle with fickle prices. Harvest Energy, for instance, became Canada’s first integrated energy trust by buying North Atlantic Refining in 2006. The plant, located in Come By Chance, Nfld., was problem-plagued in the 1970s before it became profitable in the 1980s. “This should reduce cash flow volatility through various business cycles,” Harvest chief executive officer John Zahary predicted when his firm bought the refinery. It provides “exciting opportunities.”
Two years later, soaring oil prices raised feedstock costs for the refinery. The company’s second-quarter 2008 results revealed a disappointing downstream performance, with the refinery barely breaking even. It was “challenged by the rapid rise of crude oil prices and the lagging finished product markets,” Harvest told investors in its financial statement. In a research note to clients, FirstEnergy Capital vice-president Jill Angevine highlighted risks. She observed that “weak refining margins, which are 46 per cent lower year-to-date versus 2007, have made it difficult for Harvest’s balance sheet.”
While Harvest remains committed to its downstream business, it’s also seeking a partner for a $2-billion refinery upgrade. Finding that partner, in the words of Harvest, “interested in participating in such an investment opportunity” is tough when the cost of oil is high and the economy is in flux. Yet Harvest also states, “Despite the financial challenges faced by the refining industry today, it is a cyclical business that we firmly believe will make a more significant contribution to our cash flow in better markets.”
Provident Energy is another integrated trust, but with a natural gas liquids midstream and marketing division instead of an oil refinery. Yet Angevine noted it is highly leveraged in both parts of its business. The integrated approach can also be a little confusing for investors familiar with companies that concentrate more on traditional exploration and production and less on refining.
That does not prevent firms from trying the diversification approach, known for generations in the oil industry as the “integrated” company. Connacher Oil and Gas believes its strategy of mimicking, on a small scale, the international oil giants enhances its oil sands business.
“We call it the Rockefeller solution,” says Connacher president Dick Gusella, referring to the 19th-century creator of the Standard Oil formula. John D. Rockefeller went into every aspect of the business from exploration drilling to fuel retailing.
Connacher’s second-quarter 2008 results highlighted strong bitumen prices but pointed to its Montana refinery as standing on guard against market reversals for the raw oil sands product. The plant’s profits were squeezed while oil prices stayed high, but it “enables us to recoup a portion of widened differentials (bitumen price discounts), should they re-emerge, so we have a less volatile and more predictable revenue and cash flow stream as a result of our integrated strategy.”
Although the fall financial collapse prompted Connacher to suspend plans for a refinery expansion, the firm earlier credited its integration strategy with obtaining long-term U.S. financing for its Algar oil sands expansion project at its Great Divide site south of Fort McMurray.
Hedging is complicated and challenging no matter what method is chosen. The strategy is also no guaranteed safety net. When the economy takes a chilling turn into an unmarked cul de sac, there’s only one thing left to do – wait for it to turn again. Until then, the only hedge that works is cash.
Nexen Inc. chief financial officer Marvin Romanow told the financial wires this fall: “We are carrying cash now. We’re fortunate that our capital needs are dropping down a bit and oil prices are strong. We might have some opportunity to take advantage.”
That’s unnerving news for companies bobbing below the water line.
Issue ContentsRelated Posts
Canadian Assoc. of Petroleum Producers helps industry adjust to new International Financial Reporting Standards • October, 2009
Canadian Association of Petroleum Producers signals sea change in communication strategy • August, 2009
Talent Erodes Gender Barriers As Determined Women Rise To The Top Of Energy Sector • April, 2009
Pipelines to Tomorrow • February, 2009
Arctic Marathon • February, 2009
Black Clouds on Green Horizon • December, 2008
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