Crafting oil's comeback

In the glory days of $100 (U.S.) oil, Crescent Point Energy Corp. could do no wrong.

For years, the Calgary-based oil producer, known for hydraulic fracturing operations in neighbouring Saskatchewan, rushed to add production through a series of big deals financed with hefty share issues. By July of 2014, its stock price topped $47 (Canadian).

Then oil collapsed, savaging an industry that had grown fat on triple-digit prices. Crescent Point's earnings turned to big losses, and investors have punched the company's Toronto-listed shares down by roughly 80 per cent to around $10. It's hardly unique: Over the same period, the TSX energy subindex declined 42 per cent. Today, Crescent Point is a humbled company in a battered industry.

But with global oil prices on the mend, Canadian oil producers are getting another chance to get it right. After years of slashing costs, executives are promising to not make the same mistakes of the past when they spent recklessly on low-return projects and let costs soar.

As Crescent Point looks toward its 2018 budget, chief executive Scott Saxberg insists the company won't outspend cash flow, as companies routinely did in years past. On the contrary, it has revisited nearly all aspects of its business in a bid to find cost savings wherever possible. At its operations in Saskatchewan, the company is using video to monitor wells remotely, sparing crews from visiting each site individually in the field.

Such moves by Crescent Point and other producers are giving the industry better leverage to even small moves in oil prices. "Every dollar for us is, like, $65-million of cash flow," Mr. Saxberg says in an interview. "So if oil's up $5, it's well over [a] $300-million increase in cash flow."

In Calgary as in much of the global oil industry, the days of "drill, baby, drill" are gone. Increasingly, the focus is on productivity – using technology, digitization and data analytics to produce more oil and gas.

Companies are now far leaner, and executives are pledging to avoid risky, capital-intensive production growth at all costs while returning more cash to shareholders. To wit: Oil sands giant Suncor Energy Inc. this week chopped its 2018 budget by $750-million, but the company expects production to jump more than 10 per cent, freeing up cash for dividends and stock buybacks.

And for the first time in years, the global oil market is showing signs of lasting fundamental improvements.

Optimistic view

Three years after the Saudi-led Organization of Petroleum Exporting Countries stunned the world by refusing to cut production to tame a global glut, the world's leading oil exporter is once again defending prices. Saudi Arabia has fuelled a global crude rally with its production cuts and high-risk political manoeuvring. In recent weeks, its headline-grabbing political turmoil has reverberated through the global market in the form of higher prices.

Crown Prince Mohammed bin Salman has shaken up the kingdom and its volatile, oil-rich neighborhood, simultaneously upending the decades-old power-sharing arrangement among the sprawling royal family and ratcheting up the conflict with the kingdom's regional arch-rival and OPEC partner, Iran.

His actions contributed to the growing perception of geopolitical risk among traders who until recently seemed impervious to such tumult. With the market already tightening after 10 months of OPEC production discipline, Prince Mohammed's aggressive moves helped propel crude prices to levels not seen in more than two years, albeit with a modest easing this week.

For Canadian producers, the autumn rally is being greeted with a sense of wariness. They've seen prices surge twice since the collapse of 2014, only to have them fall back under the weight of excessive inventories and strong American production growth.

This time, there are reasons to believe a floor has been established at $50 (U.S.) for West Texas intermediate and $55 for the international benchmark, Brent, at least for the next year. Since hitting a recent low of $42.53 in June, WTI rallied to 28-month high of $57.20 last week, before giving up some gains to profit-taking this week to trade at around $56.58 TK on Friday. Brent was at $62.57TK.

It's too early to declare an end to the prolonged slump that has savaged Canada's leading export industry. The rebound is fragile, depending on Saudi discipline and strong global growth in demand.

Still, several factors support a more optimistic view on prices. Saudi Arabia is again looking to calibrate its production levels in pursuit of a "Goldilocks" price – high enough to fuel its political requirements but not so high as to finance growth in the highest-cost sources such as the oil sands.

For the past several months, global demand has outpaced supply, drawing down the bloated inventories that depressed prices for three years. Some key OPEC members – Iraq, Venezuela, and Nigeria – face political challenges that are undermining their ability to maintain production.

The balance between supply and demand is tight enough that traders worry about the impact of significant disruptions among key producers, and so put a price on that risk.

"We have a tighter market and because of that, you are starting to see the classic political risk issues start to matter again," Rory Johnston, energy economist at the Bank of Nova Scotia, said in an interview. "When the market was so glutted that you were building inventories every month, no one really cared if there was palace intrigue in Riyadh, or battles between Baghdad and Iraqi Kurdistan. All those things that could be swatted away because we had too much oil now matter because oil supply is tight."

Markets will be tested later this month when OPEC and leading non-OPEC producers such as Russia decide whether to continue their production agreement – which pledges to keep 1.8 million barrels a day of crude off the market – past the current March deadline and through 2018. While crude stocks have declined over the past several months, inventories would climb again early in the first quarter of 2018 unless the Saudis and their allies in OPEC keep a tight rein on production. Russia, in particular, has yet to commit to extending the production agreement beyond March.

Certainly no one is going to place big bets on higher oil prices. For one thing, the recent rally was fuelled in part by speculators flooding into the futures market at record rates. This week's pullback suggests some of those investors were taking profits.

"You've got really all three things going on right now: You've got less inventory, you've got less spare capacity in the world as demand has increased, and it's clear you also have more geopolitical risk than you had before," Anthony Marino, CEO of Calgary-based Vermilion Energy Inc., said in an interview.

But growing optimism is mixed with a recognition that the upturn in markets could sour again if the Saudis' grip on oil markets proves weaker than expected. Vermilion, for example, is still keeping a lid on its capital budget. Meanwhile, Crescent Point and others are boosting financial hedges – taking advantage of highs in the cycle to lock in prices for future production.

Speaking from an investors conference in Toronto, Mr. Marino said major cost reductions and a focus on higher-return prospects means the company can spend less without sacrificing growth. "It doesn't take us as much capital to grow as it used to," he says. "That's why you see the lower capital budgets for the last number of years."

'Biggest bang for the buck'

The Canadian industry has endured a three-year reckoning, evidenced by the relatively high unemployment in Alberta; empty office floors in downtown Calgary, and modest spending plans for the year ahead. Prior to the crash, the entire non-OPEC sector was built on the presumption of $80 crude prices or better. Today, cost structures have improved markedly, but the industry's return on capital employed remains weak, averaging less than 3 per cent, according to BMO Nesbitt Burns Inc. analyst Randy Ollenberger.

Domestic producers are also grappling with structural challenges. Among the biggest are looming pipeline shortages as a series of big-ticket oil sands projects – begun prior to the crash – start up later this year.

Longer-term, oil sands producers also face tighter fuel standards in the global shipping industry. Changes set to take effect in 2020 aim to slash the sulphur in marine fuels from 3.5 per cent to 0.5 per cent. Among impacts predicted by analysts at boutique energy bank Tudor Pickering Holt & Co. is a reduction in demand for heavy crude of at least 1.75 million barrels a day as ships switch to cleaner options, a shift that could offset price gains from new pipeline construction.

Despite those challenges, oil sands producers have not stood still on costs. Bitumen producers have chopped non-energy operating costs at existing steam-driven plants by 46 per cent since early 2014; at mining developments, total operating costs are down 39 per cent, according to consultancy Wood Mackenzie. Nevertheless, executives are signalling restraint.

"Every dollar we have needs to be focused on creating the biggest bang for the buck," new Cenovus Energy Inc. CEO Alex Pourbaix said this week.

"This is an incredibly competitive industry. You're competing on the margin, at times it's pennies per barrel. And in this kind of a business with volatile commodity prices, you just have to be extraordinarily disciplined when it comes to your cost."

Much of the industry spending has already shifted away from the production complex surrounding Fort McMurray, Alta. This year, companies will have spent around $30-billion (Canadian) developing prospects such as the Duvernay in Alberta and the Montney in British Columbia, according to ARC Financial Corp. That compares with around $13-billion in the oil sands, where new investment favours wringing more oil from existing assets.

The key variable: Saudi Arabia

In the three years since prices tumbled, some of the world's biggest oil companies have fled the oil sands in pursuit of other priorities. Royal Dutch Shell PLC, Chevron Corp., and Norway's Statoil ASA are focusing on shale-oil deposits that offer fatter returns more quickly, offshore fields that can be developed more cheaply, or even natural gas deposits that many believe will be the key fossil fuel as the world shifts to a lower-carbon energy economy.

Even companies that have bulked up in the oil sands are looking to diversify. Canadian Natural Resources Ltd., which bought Shell's oil sands business and has poured billions into its expanding Horizon complex, recently highlighted light-oil prospects with potential to generate healthy returns at U.S. oil prices of $30 (U.S.) a barrel.

To understand fully the new mantra, consider Encana Corp. Its long-term debt now stands around $4.2-billion, down from $7.3-billion three years ago. Production is forecast to grow next year even as spending stays flat around $1.7-billion, reflecting productivity gains at its core holdings and a "relentless" focus on costs, CEO Doug Suttles told investors recently.

The company has shrunk its complement of employees by nearly half since Mr. Suttles took the CEO job in 2013. "But it performs at a higher level than it did before," he says. "We don't think [the number of employees] has to grow as we grow."

Over the next five years, Encana is basing its growth plan on an assumption of a flat WTI oil price of $50 and U.S. natural gas prices of $3 for every million British thermal units. "If we ramp up activity, if we believe prices are strong, we'd only do that if we believe it's going to generate quality returns and we're not going to see erosion through higher costs," Mr. Suttles says.

Such caution is warranted. The International Energy Agency warned this week that the global benchmark Brent crude – which has been trading above $60 a barrel since late October – could slip back under that threshold in early 2018 owing to slowing demand growth and rising production in the United States, Canada and elsewhere.

Saudi Arabia is the key variable, both in terms of market risk and its willingness to adjust production according to its political interests.

The Saudis are again donning the mantle of price defender, at least for the short term. The kingdom is clearly no longer willing to flood the market and drive down prices in order to maintain its share of the global oil market as it did from 2014 through 2016.

Analysts suggest it is targeting a $60 price floor for Brent crude in order to support its planned share offering in state-owned Saudi Aramco and to lubricate Prince Mohammed's risky political gambits.

"The Saudis no longer have flexibility," said Amy Myers Jaffe, a senior fellow at the New York-based Council on Foreign Relations. "They're committed to the [Aramco] IPO, which means they're committed to keeping prices up. They're probably committed to keeping them up anyway for their economy, particularly since they're taking other controversial political moves."

King Salman and his chosen successor, Crown Prince Mohammed, appear to have a firm grip on the Saudi state apparatus after jailing hundreds of members of the extended royal family on corruption charges. However, Prince Mohammed's ascendancy may be threatened if his more aggressive foreign-policy stance puts the kingdom at risk.

Sunni-run Saudi Arabia is engaged in a fierce proxy war with Shiite-dominated Iran, whose influence in Iraq, Syria, Lebanon, Bahrain and Yemen is seen as a major threat.

Riyadh rattled nerves and threatened a new regional war when it apparently forced Lebanese Prime Minister Saad al-Hariri to announce his resignation during a visit to Saudi Arabia. The resignation is the result of a continuing feud between the Saudis and Iran over the latter's support for Hezbollah in Lebanon.

Last week, crude prices jumped when Saudi Arabia banged the war drum after a missile landed in Riyadh from Yemen, where the Saudis have intervened in a civil war that is devastating the civilian population.

Ms. Myers Jaffe said the risk to global oil supplies from escalating conflict between Saudi Arabia and Iran cannot be overstated. The five leading producers huddled around the Persian Gulf account for 24 million barrels a day of crude production, fully 73 per cent of OPEC's total and 25 per cent of the world supply. The more likely scenario, however, is continued proxy battles in places such as Yemen and Bahrain, where a Saudi-backed government faces unrest from its Shiite majority.

At the same time, the Saudis' determination to defend a $60 Brent price will make it difficult for the OPEC leader to police the production agreement among producers countries such as Russia, Iraq and even Kuwait, said Greg Priddy, an OPEC-watcher at New York-based Eurasia Group.

Historically, the Saudis have enforced discipline within OPEC with the perception that they could withstand lower prices for longer than other cartel members. If OPEC members cheated on their agreed-upon production limits, the Saudis would drive down prices until the recalcitrant members came onside.

Knowing the Saudis are committed to supporting prices at $60 could encourage cheating, even as OPEC and leading non-OPEC producers agree to extend their accord through 2018, Mr. Priddy said. King Salman and Prince Mohammed are clearly aware of the dilemma, but they need higher prices more than they need coherence or market share, for now.

"The Saudis have really shifted into a short-term mode of thinking, which we think is all about succession," Mr. Priddy said. "It's not that they don't understand they're stimulating competing supplies, it's just that high politics have overridden that on a one-year time frame. Beyond that, it is going to make sense for them to start looking at market share again," he added.

Shale oil boom

In addition to its Persian Gulf neighbours and friends such as Russia, the Saudis have to worry about the Americans. Already, tight-oil producers are adding drilling rigs and fracking crews into fields such as the Permian in West Texas, where production growth continued despite the downturn.

The increase in West Texas intermediate has lagged Brent as lack of transportation infrastructure created a glut in Cushing, Okla., where WTI is priced. But as new pipelines come into operation later this year and into 2018, landlocked American producers will see WTI prices close the gap with Brent.

Despite concerns about pipeline shortages and the lack of experienced crews, U.S. tight-oil supply is expected to grow by some one million barrels a day next year, said Jodi Quinnell, manager of crude oil analytics for Genscape Inc. in Denver. And that's with WTI averaging roughly $50 a barrel.

It remains to be seen whether a new-found focus among U.S. producers on shareholder returns, versus production gains at all costs, acts as a check on growth. Ms. Quinnell said the industry continues to drive costs down through productivity gains, even as majors like Exxon Mobil Corp. and Chevron Corp. – who were absent in the pre-2016 shale boom – refocus on the resurgent tight-oil plays.

Scotiabank economists estimate the U.S. tight-oil production could grow by as much as 1.5 million barrels per day next year, if prices remain near $55 and infrastructure bottlenecks are solved. At some point, between a year and 18 months from now, the Saudis could find themselves having to refight the market-share battle that led to the industry's worst downturn in 20 years, Mr. Priddy said.

A new mindset

For now, the combination of a higher price and operating discipline is beginning to draw investors back to the sector, albeit slowly.

This week, Whitecap Energy Inc. said it would sell $332.5-million (Canadian) worth of shares to fund its acquisition of a major Saskatchewan oil property. A source said the issue sold briskly, but it follows a long dry spell in energy financings. In the third quarter, the industry raised $352-million in equity, a fraction of the $3.4-billion total during the same period a year ago, according to Sayer Energy Advisors. Debt financings were $809-million against the year-ago total of $1.1-billion.

At Crescent Point, changes are taking root. Using video to monitor wells has allowed workers to tackle problems where they're needed. The company is also testing solar installations at two sites in partnership with SaskPower. New hires are as likely to be technologists as rig hands.

"We can put that manpower to work on more technical aspects of the business," CEO Mr. Saxberg says. "There's a whole pile of technology that we are testing and moving on that is pretty exciting, and it's changing the mindset of how these fields are managed."