The oil sector’s tough year

First came the price reductions in oil when OPEC and Russia failed to reach an agreement on quotas, and then the dramatic demand destruction from the COVID-19 pandemic

To call 2020 an underwhelming year for the oil and gas sector may be an understatement.

In June, the Canadian Association of Petroleum Producers estimated that $23.3 billion would be spent in the oil and gas production sector in Canada this year, down from roughly $37 billion in its January forecast.

“I think it's fair to say that 2020 has been a very challenging year for the oil and gas sector,” says Robert Froehlich, head of the Canadian oil and gas practice for Norton Rose Fulbright Canada LLP, from his office in Calgary. “The economic factors are probably having the most acute influence, and, of course, that's hit Alberta and the oil sector twofold.”

First came the dramatic price reductions in oil when OPEC and Russia failed to reach an agreement on production quotas in early March, and immediately on the heels of that came “the dramatic demand destruction from the COVID-19 pandemic, when economies started to shut down,” he says. “Clearly, that's had a very material impact on all portions of the oil sector and the value chain from upstream producers all the way through midstream oilfield services companies. Everyone has been acutely impacted over the past six months.”

The result has been capital budgets cut substantially by nearly all participants in the industry and a significant fall in M&A activity, “and so it's been a very challenging six months for the industry,” he says.

But there are bright spots on the horizon. From July, there has been at least a start in demand for oil and gas products as economies are reopening, Froehlich says, with a stabilization in oil prices and stronger natural gas prices this year than last, as well as potential outlets for some of the gas supply including petrochemical developments. There has been some renewed interest in the oil and gas sector from private equity in the United States and from sovereign wealth funds.

“I’m optimistic that there’ll be more deal activity over the coming months and toward the end of the year,” he says. “A few transactions have been announced, and there’s more interest. So, there are definitely some bright spots.”

In the oil-rich province of Alberta, the industry has tried to stay ahead of the game by employing new technologies to reduce emissions from their operations, says Vivek Warrier, co-lead of the National Energy Industry Team for Bennett Jones LLP, based in Calgary.

“There’s been a massive emphasis on environmental performance and making sure that any environmental impacts are mitigated.” That is starting to move the needle a little on public opinion, he adds, where the public is starting to appreciate how much effort and money are being expended and research being done by the industry.

Alberta has had a problem with well abandonment and reclamation, says Alicia Quesnel, a partner at Burnet Duckworth & Palmer LLP in Calgary. In April, the federal government gave $1 billion to Alberta to clean up and do abandonment and reclamation work and $200 million in a loan to Alberta’s Orphan Well Association to clean up abandoned wells.

The Supreme Court of Canada’s January 2019 decision in Orphan Well Association v. Grant Thornton Ltd. — also known as the Redwater decision after the oil and gas company was not able to meet its end-of-life obligations to its abandoned wells — gave the provincial regulator and the public priority over lenders in Redwater’s bankruptcy.

“I think it was the right decision because banks can make a judgment call when lending, and the public shouldn’t take second priority,” says Sean Korney, a partner at BD&P in Calgary.

As a result of that change in priority, he says, the banks re-examined what they would lend to oil and gas companies. Their reserves-based lending supports loans that are a percentage of the estimated value of the company’s commercially producible oil and gas. When abandonment costs took priority, the banks had to then deduct the amount of value of the abandonment costs from the asset base before they would lend. It meant that oil companies could borrow less.

“Companies had to learn how to live off their cash flow,” Korney says. “The best-placed companies today learned how to do that.”

The federal government’s assistance to and impact on the energy industry follows a green approach, he adds — money for the cleanup of assets, policies to reduce methane production, carbon taxation and even the investment in the Trans Mountain Pipeline, “because it's much more carbon-efficient to move oil by pipeline.”

The Large Employer Emergency Financing Facility announced by the federal government in May offers bridge financing to large employers to cover operational needs during COVID-19, but it requires environmental, social and governance commitments.

“The assistance that's available [is] focused on making the industry greener, more responsible,” says Korney, but which also increases corporate expenses.

“Early on in this pandemic, a lot of commentators said, ‘This makes it harder for things to become green,’” says Quesnel. “When you’re cash-strapped, you use that cash for the existing business. For Suncor and Cenovus, those [ESG] programs were deferred because the cash is not there. So, it’s a bit of a Catch-22.”

A novel program that the Alberta government announced in late August will provide a framework for incentivizing value-added petrochemical development in the province, Warrier says. The Alberta Petrochemicals Incentive Program is part of Alberta’s Recovery Plan, providing grants to companies to attract investment in new or expanded market-driven petrochemical facilities and will launch in early fall. The program will stimulate investment “and take advantage of our very cheap natural gas feedstock,” he says. “It’s a very imaginative and logical program that the provincial government has put in place.”

More insolvencies and distressed-asset M&A in the sector are anticipated, says Froehlich, and well-capitalized buyers may see opportunities.

Consolidation in the industry is already occurring and expected to continue. In the summer, it was announced that Canadian Natural Resources would be buying the much smaller Painted Pony Energy and that Whitecap Resources was taking over NAL Resources. Obsidian Energy announced its intention to launch an exchange offer for Bonterra Energy, possibly on a hostile basis.

In July, it was reported that multinational energy company ConocoPhillips was acquiring all the assets of Kelt Exploration in the Montney area of Alberta. “It’s a shale resource play, one of the better ones in North America,” and there are six or seven examples of consolidating in that Montney area, says Korney.

He predicts that the U.S. election will have a significant impact on the economic landscape for investment and M&A in the oilpatch post-COVID. As well, he says, a recent poll of Quebecers showed they were overwhelmingly in favour of using and developing local energy resources from within Canada.

“If we start to see oil and gas as energy-friendly and getting that message out, maybe that will make Canadians more interested in getting resources from Canada, from resource-rich areas to resource-poor areas.”

This may serve to unite the country, says Korney, developing a better national energy policy and ensuring that Canada serves its own energy needs domestically before concerning itself with building pipelines to the U.S. or shipments to or from countries that may be less politically friendly.

Quesnel sees an advantage in international energy trade and Canada providing a clean product to China, India and southeast Asia. “We really need to get the message out that that’s where we need to go first,” she says.

“We all know that the more we can export ethically and cleanly produced Canadian product and use natural gas in particular to displace coal in places like China and India, then the whole world is better off,” says Warrier. “Most of the studies show that that would have a material effect on Chinese emissions.”

There are also good initiatives to get products to market more efficiently, such as the Trans Mountain Pipeline expansion and Keystone XL, and still some crude-by-rail projects going ahead, says Korney, although the number of barrels leaving Canada has been greatly reduced. Producer groups are working on new liquefied natural gas projects on the west coast to get the gas to market. Petrochemical diversification programs in Alberta help turn raw materials into something more valuable, such as polypropylene pellets, and ship them to market.

Foreign influences will also play a role in the health of Canada’s oilpatch. Froehlich notes that the Organization of the Petroleum Exporting Countries and Russia have had a détente over the past number of months after the failure to reach an agreement in March led to a significant reduction in the price of oil. “But it’s very much unclear how long that’s going to continue,” he says.

Still, Froehlich says, “I think we are hopeful, and there is some hope in the industry generally, that all levels of government will start to see the importance of oil and gas and the natural resource sector as a potential driving force to grow the sector.

“There’s a real opportunity for natural resources and oil and gas in Canada to help spur economic growth. It’s cautious, but there’s some optimism that all levels of government will start to see that as being a necessary path forward for the economic growth that Canada needs.”