SECTOR
OUTLOOK
Energy Sector
November 13, 2014
Analysis of the Competitive Advantages and
Disadvantages of the Energy Sector
Prepared by:
[ABM Razin Hussain]
Research Associate
Sobey IMPACT Fund
The Rear-View Mirror
The Energy sector is positively correlated with the economy and the market
performance. At times of economic expansion, the sector outperformed the
market whereas during contraction, the sector underperformed. This characteristic
could be better analyzed during the 2008-2009 financial crisis and also during its
recovery period in 2010. Observation of the historical performance suggests that
the energy sector is highly volatile in terms of return primarily because of its high
dependency on the price of oil. Geopolitical tension in the Middle East, OPEC price
cuts, increase in US shale oil production, slowdown in the European economy, and
worldwide sanctions against Russia are some of the key factors influencing the
price of oil.
Exploration and Production companies are most affected by the recent plunge in
oil price due to their high dependency on the commodity.
Refining and marketing companies,which sell refined products like diesel, gasoline,
kerosene etc., were less impacted because of their partial control over the price of
the end products.
The Road Ahead
Price of oil will be an important determinant in shaping the performance of the
energy sector going forward. Increase in US production coupled with weaker global
demand will likely keep the price of oil depressed in the short run. However, in the
long-run, depressed oil price will motivate producers to cut down supply hence
creating a balance between demand and supply.
Furthermore, automobile sales and manufacturing, especially in North America, is
expected to increase in the upcoming quarters due to low unemployment rate and
high disposal income. This will help stimulate the demand for oil.
SECTOR
OUTLOOK
Energy Sector | November 13, 2014
Exploration and Production
Oil and Gas Exploration and Production companies are
responsible for acquiring, exploring, developing, and
producing natural gas, crude oil, and related products.
Production
Figure 1: HISTORICAL AND FORECASTED PRODUCTION
4500
Oil Sands
4000
Conventional Light
3500
3000
Conventional Heavy
Pentanes
Oil is extracted from conventional sources
primarilythrough vertical drilling and horizontal
drilling. Vertical drilling costs around $65 per barrel
which includes taxes, royalties, operating costs,
andcapital costs whereas horizontal drilling costs
$36 per barrel. With current price ofCanadian crude
at around $63-$64 range, many vertical drilling
projects will not be economically viable but
horizontal drilling looks quite profitable at current
price (Figure 2).
2500
Oil Sands
Figure 3: SUPPLY COST PER BARREL FOR OIL SANDS
2000
1500
1000
$100.00
500
$90.00
Supply cost/bbl
$89.62
$80.00
0
$70.00
$61.05
$60.00
Source: Canadian Association of Petroleum Products
$50.00
Canada is one of the largest producers of crude oil,
currently producing 3.6 million barrels per day and is
forecasted to produce 4.2 million barrels in 2017.
Production has increased at a rate of 4.27% in the last
seven years. Most of the increase in production had
come from oil sands. It is also predicted to be the
primary driver of production in the future whereas
production from conventional sources is likely to
stabilize at current level (Figure 1).
Economic Viability of E&P projects
Conventional Sources
Figure 2: CONVENTIONAL SUPPLY COST PER BARREL
Vertical Drilling
Horizontal Drilling
Supply Cost/bbl
$83
$90
$75
Supply cost/bbl
$90
$65
$60
$64
$44
$45
$75
$60
$45
$30
$30
$15
$15
$0
$0
2
Source: Canadian Energy Research Institute
$43
$30 $33
$40
$44.75
$40.00
$30.00
$20.00
$10.00
$0.00
In-situ mining
Open-pit mining
Mining and
upgrading
Source: Canadian Energy Research Institute
Technologically advanced form of mining like in-situ
mining has helped oil sands producers to extract
large amount of resources and lower supply costs
per barrel. Two common forms of in-situ mining
include Steam Assisted Gravity Drainage and Cyclic
Steam Stimulation. Another form of mining is openpit mining which is used to extract resources near
the ground. Less output is realized using this
technique thus increasing total costs per barrel. At
current price, both in-situ and open-pit mining are
economically viable but in-situ is comparatively
more profitable (Figure 3).
SECTOR
OUTLOOK
Energy Sector | November 13, 2014
Demand Outlook
Key constraints affecting the demand for Canadian
crude:
 Transportation Infrastructure
 Crude oil Refining facilities
 Falling US Imports
Transportation Infrastructure
Most of the crude oil produced in Western Canada
need to be transported to other parts of the
country and to the US either through rail, trucks or
pipelines. Lack of infrastructure can restrict the
movement of crude oil from the production sites to
the refineries, decreasing its demand. 90% of the
crude oil refined in Quebec and Atlantic Canada is
imported due to lack of transportation.
Construction of Enbridge Line 9 pipeline,
connecting Western Canada to Montreal, by the
end of 2014 will help ramp up demand for western
Canadian crude.
Refineries in the US Midwest are the largest export
market for Canadian crude along with refineries in
US Gulf coast and East coast. Improving
transportation system between Canadian
production sites and these regions will enhance
demand for Canadian oil.
Crude Oil Refining Facilities
In 2013, Canadian refineries processed 905,000 b/d
of western Canadian crude oil, 70,000 b/d of crude
oil produced in eastern Canada, and 642,000 b/d of
foreign imports. As a result, more than half of the
crude oil produced in Canada need to be exported
to foreign countries especially US.
Most of the oil produced in Canada is heavy crude.
Lack of heavy crude refining facilities in Eastern
Canada and in other European and Asian countries,
is another factor that might affect the demand of
Canadian oil.
Lack of growth of refining capacity in Canada will also play
an important role in hampering the demand of Canadian
crude. This is because new refineries in Canada will not be
able to compete with US refineries in terms of costs.
Falling US Imports
Figure 4: TREND IN INCREASING US PRODUCTION
AND DECREASING US IMPORTS
12.0
Production
10.0
9.5
9.8
9.2
9.0
8.5
8.9
8.0
6.0
Net Imports
8.57.4
6.5
5.0
5.4
5.5
5.7
2008
2009
2010
2011
7.6
6.9
6.0
4.0
2.0
0.0
2012
2013
2014
2015
Source: US Energy Information Administration
As stated above, more than half of Canadian production is
exported to US. As a result, if US increase its production
and decrease its imports (Figure 4), Canada will be heavily
impacted by it.
Figure 5: CANADIAN WEEKLY EXPORTS TO US
Thousand b/d
Canadian Weekly Exports to US
3,500
Exports
3,000
2,500
2,000
1,500
Source: US Energy Information Administration
However, the effect of increasing US production cannot
still be seen in Canadian oil exports to US (Figure 5),
primarily because of weaker CAD to USD.
3
SECTOR
OUTLOOK
Energy Sector | November 13, 2014
Price Analysis
Figure 6: RELATIONSHIP BETWEEN PRICE AND
MARKET DEMAND AND SUPPLY OF OIL
WTI Price
World Consumption
World Supply
The worldwide demand for oil is also expected to
be sluggish this year with European and Asian
economies slowing down.
Overall, by analyzing the demand-supply
perspective it could be implied that excess supply
will persist for quite some time putting a
downward pressure on the price of oil.
Another reason for falling oil price is build-up of
excess inventory overtime. Excess supply is
expected to add more barrels of oil to inventory in
the upcoming months.
Figure 7: RELATIONSHIP BETWEEN USD AND
PRICE OF OIL
$/bblindex points
WTI Price
140
90
Dollar Index Spot
85
120
Source: Bloomberg data
Price of oil is determined by market forcesdemand and supply of oil. Excess worldwide
demand hikes the price of oil whereas excess
supply lowers its price (Figure 6). Excess supply was
the primary reason for oil to enter bear market in
2014.
US increased its production significantly this year
causing a demand-supply imbalance. Horizontal
drilling and hydraulic fracturing helped US
producers to extract oil at lower costs and be
profitable even at $75/barrel.
Furthermore, oil producers generally tend to have
high operating leverage due to huge capital costs;
as a result, many suppliers will be reluctant to cut
down production since they will not be benefitted
by it.
Moreover, Saudi Arabia is cutting price of oil to
compete with US shale oil which is putting
downward pressure on the WTI and Brent prices. It
can be an indicator that OPEC will not be cutting its
supply in4 the near term.
100
80
80
75
60
70
40
65
20
60
Source: Bloomberg data
Price of oil tends to have inverse relationship with
USD (Figure 7). As a result, recent appreciation of
USD against all other major currencies supported
the plunge in oil price. If USD tends to appreciate
in the upcoming quarters, we might see price of
oil going down further.
SECTOR
OUTLOOK
Energy Sector | November 13, 2014
Natural Gas
Cyclicality Analysis
Figure 8: SUPPLY COST PER BARREL
Dry
Dry
Vertical Drilling Liquid Horizontal Drilling Liquid
Figure 9: RELATIONSHIP BETWEEN GDP AND
PRICE OF OIL
Price
Percentage
12
12
10
10
100
8
6
80
8.62
8
7.46
8
2
6.46
5.67
6
4
60
6
4
4
2
2
0
0
4.99
3.84
4.46
3.64
0
-2
40
20
WCS Price
-4
GDP growth %
-6
-8
Alberta
British
Columbia
Alberta
British
Columbia
0
-10
Source: Canadian Energy Research Institute
Natural Gas is mainly extracted through vertical and
horizontal drilling. At current price of natural gas at
around $4/mcf, vertical drilling is not economically
viable whereas horizontal drilling is marginally
profitable (Figure 8).
Price of natural gas also influences the cost of
production of crude oil from oil sands. Natural gas is
required to produce steam that helps extract crude oil
through in-situ mining. As a result, if price of natural
gas goes up, supply cost of crude oil will also go up.
5
Source: Bloomberg data
Price of oil in itself is a leading indicator for the
economy. Economic slowdown will lessen the
demand for oil, lowering its price (Figure 9), which
will eventually be reflected on the GDP.
SECTOR
OUTLOOK
Energy Sector | November 13, 2014
Figure 11: RELATIONSHIP BETWEEN PRICE OF OIL
INDUSTRY PERFORMANCE
Index points
Price
Figure 10: RELATIONSHIP BETWEEN GDP AND
INDUSTRY PERFORMANCE
Index points
Percentage
450
8
400
6
400
4
350
350
SPTSEN
WCS Price
120
100
80
2
300
300
0
250
-2
60
250
40
-4
200
SPTSEN
150
GDP growth rate
100
-6
200
20
-8
-10
150
0
Source: Bloomberg data
Source: Bloomberg data
Energy sector performance has high positive
correlation with GDP (Figure 10), indicating that the
sector is highly cyclical. As a result, performance of
the energy sector will be highly dependent on the
economic cycle. Energy sector also has a raw beta of
1.28 which indicates that at times of economic
expansion; energy sector will outperform the market
whereas at times of contraction, the sector will
underperform.
Energy sector performance is also highly dependent
on the price of oil especially for exploration and
production companies, since they earn most or all of
their revenues from selling crude oil.
6
SECTOR
OUTLOOK
Energy Sector | November 13, 2014
Drilling Services and Equipment
The drilling services and equipment industry provides
the assets, technology, manpower, and project
management that enables E&P operators to explore
for, drill and develop oil and gas fields.
Key Drivers for the Drilling sector:
 Price of Oil
 Level of Inventory
 Exploration and Production Activity
Price of Oil
Figure 1: RELATIONSHIP BETWEEN PRICE OF OIL
AND DRILLING INDEX
Price
Index points
120
650
110
600
100
550
90
500
80
450
70
400
WTI Price
60
Drilling Index
50
350
300
40
4/6/09
250
4/6/10
4/6/11
4/6/12
4/6/13
4/6/14
Source: Bloomberg data
Performance of the drilling sector is highly positively
correlated with the price of oil (Figure 12). If oil price
remains depressed for a long time period, E&P
companies will cut down their investments negatively
impacting the drilling sector.
7
Many big players like Suncor, Athabasca Oil Corp,
Penn West Exploration, and Talisman Energy are
cutting down their Capital Expenditure for the
remainder of the year due lower oil price.
According to Bloomberg Intelligence, oil price
below $80 will weaken the outlook for drillers as
exploration and development activity will slow
down.
However, drilling activity in three primary
locations in US, Permian Basin, DJ Basin, and
Bakken, has positive return even at oil price below
$80, which indicates that drilling activity is likely to
remain strong in the upcoming quarters.
Furthermore, US shale oil production is likely to
increase over the next few years suggesting a
strong demand for drillers. Production in Permian
Basin is also shifting towards horizontal play
demanding greater drilling activity.
Drilling activity in Canadian oil sands is also likely
to be strong since production is predicted to grow
at a constant rate.
Drilling activity might slow down in the short run
but will gain momentum in the long run. Drilling
services and equipment companies with exposure
to both US and Canadian market is likely to
outperform companies operating only in Canada.
Level of Inventory
Buildup of excess inventory will put a downward
pressure on production thus decreasing the
demand for drilling.
SECTOR
OUTLOOK
Energy Sector | November 13, 2014
Exploration and Production Activity
Figure 2:NET EXPENDITURE TREND IN THREE
PRIMARYCOST POOLS
In millions
$70,000
Operation
Development
Exploration
$60,000
$50,000
$40,000
$30,000
$20,000
$10,000
$0
2007
2008
2009
2010
2011
2012
2013
Source: Canadian Association of Petroleum Products
Expenditure behind exploration activity in Canada has
become stagnant over the years (Figure 13), which is
an unfavourable indicator for the drilling sector. Most
of the revenue growth for drillers operating in Canada
is expected to come from the development activities.
8