Eric Nuttall: Fresh uncertainty grips investors
Volatile oil differentials and bloated natural gas storage among areas of concern
I read some time ago that we had entered the age of uncertainty. If 2008 and 2009 weren’t convincing enough, recent developments in the oil patch should be.
After all, this year was supposed to be the golden age for oil producers. Brent crude surpassed US$100 on strong demand fundamentals and then shot north of US$125 on political tensions. Service availability improved due to weak natural gas prices leading to reduced capital expenditures by dry natural gas producers, as well as an increase in overall fleet capacity.
Improvements in fracking fluids, meanwhile, radically improved rates in many zones (The shift from fracking with oil to slick water, to take just one example, saw Cardium well initial rates increase by over 200 per cent). Break-up in many parts of the country appeared normal. All in all, it wasn’t a bad environment.
It was at this point that the unexpected happened.
No one that I spoke with before January was talking about Canadian oil differentials. Yes, West Texas intermediate was trading at a discount to Brent, but this was thought to be a Cushing problem. With pipeline reversals and an increase in rail transport it was thought that the differential would subside at some point in 2012.
How quickly things change. Light- and heavy-oil producers alike must not only find, develop and produce oil; they now also face the unique challenge of finding a way to sell it. It is incredible that such a major issue could arise with absolutely no forward analysis from anyone, including sell-side analysts, oil traders, company executives, energy economists, and portfolio managers alike.
Current opinions on how long Canadian differentials (both light and heavy) will last vary greatly. A CIBC World Markets report suggested that they will last until 2014, while others say the narrowing should occur in 2012.
What should be obvious to industry is that as a country, Canada needs to diversify our customer base, especially when reports such as the one from Raymond James estimate that the United States may become a net oil exporter by 2020.
For an investor, oil differentials create yet another uncertainty, and while full-cycle economics are still attractive at even a $10 or $15 light oil spread, the net effect has been a round of selling by generalist portfolio managers.
The road ahead for natural gas producers is even more uncertain. We will likely have exited the natural gas withdrawal season with at least an 850-billion-cubic-feet surplus in the United States. To make matters worse, as of the beginning of April, Alberta storage was approximately 83 per cent full. Watch for the natural gas-directed rig count to fall precipitously, especially over break-up. Cashflow netbacks of dry natural gas producers are quickly approaching negative and shut-ins will likely increase materially from both majors and small-caps alike.
The extent of this, though, is highly uncertain due to the costs and logistics involved. For example, Cenovus Energy Inc. recently commented that it would need AECO [the price of gas in Alberta] to fall below $1 per thousand cubic feet before shut-ins made sense (perhaps the company won’t have to wait very long).
While banks have been very generous in their use of above-strip price decks, it is hard to believe that there are not some very difficult discussions taking place regarding leverage and hedging. It is likely in the coming months that we will see “non-core” asset sales by leveraged natural gas companies, likely oil-prone properties as they are the only kind getting a bid these days. Transaction metrics have remained strong, and this period should be a boon for mid-cap oil companies who completed equity raises before the market tanked and have the balance sheets to support material acreage additions.
The road ahead will likely lead to much lower share prices of natural gas stocks. They are still trading at high multiples even based on an improved pricing outlook in 2013, which means there is likely more pain to come.
We will only be saved by warmer weather this summer, much colder weather this winter, shut-ins, coal-to-gas switching, and a reduction in the natural gas-directed rig count. While $3 per thousand cubic feet was once considered a worst case scenario, today it is looking like an appropriate medium-term price deck.