The oil price war and the impact on Canada – 10 years in the making

The oil price war of January 2020 began 10 years ago. To understand what happened, you have to look back to 2009.  

As most of you know, 2010 saw oil prices punch through $100 per barrel.  Capital investment in North American oil and gas, from 2008 to 2012, was over $1 Trillion with over 100% of free cash reinvested.   Alberta alone has a run rate of $50 Billion per year by 2012 with $30 B of that in oil sands.  North American Debt and Equity markets injected over $0.5 Trillion in fresh capital during that period.   (To put this in perspective, Saudi’s Aramco Oil, the world’s largest company, is valued at $1.7 Trillion.)   So, the North American bet on $100 oil was enormous as revaluations of reserves and exciting new fracking methods attracted investors; and good returns over the next 20 years looked like a good bet.  So much so that literally ever drop of cash was put back on the table for more spins.   

However, within 5 years, world-wide production increases and tapering demand struck, and by mid-2019, more than $1 Trillion was wiped off the market cap of the oil industry.   Before the price war began.  The best way to interpret this is: oil prices, propped up by OPEC, could wipe out value, but were not able to wipe out production.  To wipe out production, stronger signals would be needed.       

That strong signal was most likely finally settled on November 18, 2019, with a report that changed history.    (More on that below). 

My personal recollection of 2009 included being part of a delegation of Calgary business executives that toured the Middle East with the Mayor of Calgary.  This historic tour was an important milestone, as Calgary was the headquarters of Canada’s strengthening role in global oil supply.  As a result, the Mayor was treated like royalty by royal families and officials.  On that tour, we had a number of important meetings with the very top of UAE and Qatar royalty and management.   We witnessed first-hand, two major milestones that are part of what is happening now: 

1)    QatarGas, owner of the third largest reserve of natural gas behind Russia and Iran and three times larger than the US, had just deployed Al Dafna Q-Max LNG carrier and announced they had over 75 million tonnes of LNG ready to ship to gas hungry markets.  This represented a tripling of their production in just 8 years, and it also announced major 25-year contracts with China, India and Japan.  Furthermore, they proudly disclosed their plan to have 80 LNG carriers (!) by 2025 at $250 M each and about 15 LNG trains at about $4 Billion a piece.  All told, an impressive $80 Billion water-based pipeline to Asia.   This was historic; as it was the beginning of the phase where the world would be awash with natural gas for the next couple of decades (and for Calgary’s micro-interests, it made converting coal electricity to gas, such as in the Shepard power plant, a good move); and

2)    The Mayor and I had a very interesting 3-hour confidential meeting with a very important person in the regional oil scene.  Many of what was discussed is not shareable, but I can say that news reports by the Financial Times at the time, speculating on China’s appetite for 10 year (and longer) physical oil contracts with the Middle East were true and central to many of the OPEC producing nations strategies. Sold at a discount in exchange for certainty, these contracts pulled big volumes out of the clearing price of oil. This turned out to be a very smart move; as it retained good relations with Asian superpowers and obviously lessened the exposure to OPEC risk.  Particularly clever since they were a part of OPEC and had quite good insight into the OPEC long term strategy.        

Why is this important to the oil price war we see today?

First of all, it highlighted that the use of long-term contracts by Saudi Arabia, UAE and Qatar was a major economic weapon for the long-term play.  This, as some of you know, is the opposite of North American thinking; where, among other things, IFRS rules relating to the Fair Market Valuation of Derivatives discourage long term contracts.  Not only that, it was conventional thinking in the Canadian oil patch that no CEO ever got fired for market volatility; but out-of-the-money hedging was likely fatal to one’s career.  Furthermore, to these nations, long term contracts backed by physical delivery created valuable optionality.  For example, if a fellow OPEC nation was ever curtailed for political reasons, (like sanctions on Iran for example), a swap to deliver that nations supply and releasing other contracted volumes at higher prices was possible.  

The importance of those contracts being set in the 2009 period, means they were likely renegotiated in 2019; a few months before the price war began.  The degree to which the Saudi/UAE/Kuwait/Oman cadre of OPEC nations immunized themselves from the effects of a price war will never be known.  This is not information that they, or their counterparties China/India/South Korea/Japan, are motivated to disclose.  However, you can imagine quite easily that if they were willing to sign 10-year contracts in 2009 at a discount to $100 per bbl prices, there would be no reason to not repeat that again when they expired.   In other words, the price war gutting North American producers would be muted substantially for those triggering the price war.  In addition, unarmed with similar protection, I would think Russia’s fate was quite similar to North American experiences. 

The Coronavirus pandemic, not expected when the price war was triggered, is an unexpected bucket of gasoline on the proverbial fire.  PetroChina might be compelled to claim force majeure under those contracts and there are snippets of news suggesting such claims might occur.  But regardless of the presence of this terrible surprise, the existence of these contracts offers immunization from coronavirus effects as well.

Natural gas, not controlled by OPEC, has the same basic dynamic.  25-year contracts signed in 2009 will ride out quite a lot of price compression and, with short physical distances, delivery to India, China and Japan can continue as other global movements shut down.  Surplus North American gas, can, and will become nearly unsellable and should be dedicated to replacing local coal.

But the existence of long-term contracts between OPEC nations and Asian superpowers is likely not the main reason for the price war. 

The main reason could be directly tied to the IEA Oil report released on November 18, 2019

This was a milestone that nearly went unnoticed; as IEA reports have been declining in their veracity over the past few years. However, the November release was very different than any other.  This report firmly forecast “flat oil consumption” as the base case.  But more importantly, it was the first report where the IEA openly declared that the oil demand could steadily decline over the next 20 years.  The “Sustainability Case”, driven by fuel efficiency and electrification, had volumes at 67% of current levels by 2035.   The same level of oil demand as the world used in 1990.  The IEA has never come close to saying this before, and, if you have the lowest cost oil in the world, the battle over which volumes will be draw on in 2035 is a very important issue.  Furthermore, if you are Aramco and have just completed an IPO at a $2 Trillion valuation, getting a higher price in a falling demand scenario would quickly become ‘job #1’.

There are two important things to note here:

1)    OPEC has long known that the price elasticity of oil is extremely fragile – a volume adjustment of 2% can swing prices 50%.  So much so, that they have set aside approximately 2 million barrels per day in their volume disclosures (see OPEC Reports in the 2010 to 2015 period) as unassigned production.  Think of it as a small slush volume excluded from the price setting mechanism.  This volume could be under long term contracts, an undisclosed flow of sanctioned volumes, black market supplies, or genuine unders-an-overs of production forecasting.  The key point is there is a 2 million a day buffer that, if pushed through the market, would crush the price.

And,

2)    Electrification is getting very serious. Electricity used in cars is 10c to 20c per litre in gasoline price terms (about $15 per bbl in oil terms).  Twenty major cities have announced bans on internal combustion engines in their cities after 2030.  Singapore, Norway, Sri Lanka, Netherlands have issued complete bans. The UK, France, China, Ireland, Sweden are allowing only electric cars to gain new permits.   In a 10c to 20c per litre world, for cost reasons, taxis, buses, Uber cars and self-driving cars are going to have batteries.  US CAFE fuel standards are essentially saying all ICE’s will be at least hybrids by 2030.  These decisions, embedded in the IEA’s Sustainability Case, are plausible and tangible and it is entirely believable that world oil demand would bend down – completely for selfish reasons seeking lower costs to operate.  

To conclude, the Oil Price War of 2020 is a strategic and timely move to ensure Saudi and OPEC are the dominant suppliers of the ‘67 million a day’ forecast.  They clearly don’t like it in the short term, but getting mass production cuts now could provide a decade of higher prices if competition drops out.   Perfect game theory; force people out of the market early to increase your long term NPV.  An announcement of mass industry-wide, global cut will be the first sign the play is working. That should come soon.

Are there lessons for Canada?

In reality, it was probably time for a National Energy Program in Canada before 2009; where East and West join together to protect the Canadian oil industry.    When prices were high an attractive offer could have been made.  At a time before the threat of electrification, a nation-wide plan to share resources at fixed prices was the genius move.  

However, with the horses now bolted from the barn, is there enough political capital on tap to make it happen now?   Could producing provinces make an attractive offer to demand side provinces when prices are low?  Can the offer be rich enough to pay for pipelines and refinery conversions?   Will the US cooperate and leave Canadian Eastern market to Western Canadian suppliers?   Would it ever be enough to get back to $50 Billion per year investment run rates when alternative (20c per litre) electrical energy is so cheap?  Could Eastern refineries be convinced to switch to heavier oil technology when imported light oil is so cheap?    

Looks pretty tough, but as the US President is so fond of saying, “We will see”. 

Final word:  I think it’s finally time to acknowledge where new wealth, new jobs and new investment for Canada might come from.  Rebuilding the power infrastructure on gas, solar and wind will create billions of dollars of opportunity and is employment intensive. While maintaining the current oil and gas production, focussing the future petroleum market on hydrogen would be smart. Making Canada a lithium mining powerhouse seems possible.  Building giga-factories for the transport value-chain will always be a good idea.   Getting a National Energy Program in place seems critical as well.  So much to do and so little time to act.