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In China, 2015 was the Year of the Sheep. The Travel China Guide website writes, “Sheep is (sic) among the animals that people like the most. It is gentle and calm. Since ancient times, people have learned to use its fleece to make writing brushes and skin to keep warm. The cute creature often reminds people of beautiful things.”
For the Canadian oilfield services industry (OFS), 2015 was the Year of the Balance Sheet. As business steadily deteriorated from January 1 onwards, there was nothing that could be classified as gentle, calm or beautiful. The year would prove to be a battle between business conditions many once thought impossible and the strength of each participant’s balance sheet. With 2015 over, whoever is around to enjoy the recovery whenever it occurs in 2016 or beyond will have endured a very Darwinian process. Only the financially strong are likely to survive.
At an OFS outlook breakfast sponsored by MNP and Alberta Oil magazine in Nisku last March, panelist Scott Treadwell, oilfield services analyst for TD Securities, made a very sage observation. Treadwell remarked the success various OFS operators would enjoy during the slump would be predetermined by the financial condition and operations of the company as it entered this very difficult business environment of unknown duration. As another OFS veteran commented, “Your bed was already made.”
This is because once revenue, cash flow and opportunities begin to decline, it is a very difficult time to materially restructure the company or the balance sheet. You cannot borrow your way out of debt, the cost of equity has jumped and the market value of capital assets is falling fast. It is not easy to materially retool a company when the business environment is so negative; deteriorating market conditions force managers to be reactive, not proactive.
At another industry function a few months later, the CEO of one of Canada’s most successful private drilling contractors shared his thoughts (off the record) on the advantages of not being publicly traded during difficult times for the service sector. He said private companies can build cash when times are good to provide a cushion when they are not. When shareholders see cash in public companies, they demand dividends, expansion or share buybacks. Accumulating cash in companies that are supposed to be continuously growing to increase shareholder value is regarded, incredibly, as a liability and not an asset. Until a year like 2015 comes along.
A short summary of the twelve miserable months of 2015 will suffice. Virtually everything that could go wrong did. Few believed in January the year would end with even lower oil and gas prices. Pro-industry conservative governments were replaced in Edmonton and Ottawa, resulting in policy outcomes no one would classify as favorable. LNG opportunities tanked with oil prices. Not one joint of new crude oil export pipelines from Alberta was buried, while the White House buried the concept of Keystone XL completely. The Paris climate change conference and the lead up to it reaffirmed the belief of many – including governments – that the hydrocarbon fuels which power the world economy are, in fact, a menace to the future of mankind.
When activity began to decline early in the year, OFS capacity surplus allowed exploration and production (E&P) companies to demand and receive significant price reductions for goods and services. While the reaction was hostile in the early stages of adjustment, OFS soon learned their clients didn’t have any money either. With service and supply working at or below cost, E&P companies began cutting their own costs more aggressively. In an interview with Postmedia on December 18, CAPP president and CEO Tim McMillan estimated 100,000 lost their jobs directly and indirectly in Canada to the oilpatch downturn in 2015. That number could be conservative. In the current oil price environment, there will be more layoffs in 2016.
The behavior of OPEC in late 2014 and again in December 2015 is a completely new phenomenon. While OPEC has always been a peculiar organization, it has eventually acted with predictable self-interest, self-interest defined as restricting global oil supplies to maintain higher prices. Now the exact opposite is true. Who knew?
The domination of oil pricing by futures markets and commodity traders has always been a factor, but the price volatility and 24 / 7 / 365 reporting of absolutely everything that happens which might impact prices is, at minimum, unnerving. If the number of rigs drilling for oil in the U.S. rises by even one, the price of oil goes down. The most nominal changes in oil storage in Cushing, Oklahoma cause crude to gyrate one way or another. The shallow analysis of what these numbers really mean, as the most obscure information is instantly fed electronically to the masses, complicates an already regrettable situation.
Lending covenants defaults became commonplace. The amount of money an enterprise can borrow and actually repay is based upon the free cash the business generates after paying all expenses. Based on growth that has continued almost unabated (except 2009) since the beginning of the 21st century, the capacity of OFS and E&P to borrow grew significantly. Hundreds of billions of dollars were borrowed, with an increasing portion of it in the form of interest-only unsecured or subordinated bonds with a maturity date several years down the road. This new form of debt financing was employed because banks demand security and tend to work within the same general lending covenants regarding EBITDA multiples and asset coverage regardless of the state of the economy.
It is only when cash flow or EBITDA collapses that 20 / 20 hindsight kicks in and people wonder what they were thinking when they loaded up on all this debt under what seemed to be attractive terms. The pressure pumpers — which helped invent the shale gas and tight oil revolution which now powers the North American conventional oil patch through hydraulic fracturing — are a case in point.
In Q2 2014, privately-held Sanjel Corp. publicly announced it borrowed US$400 million, primarily to refinance its debt (The Globe and Mail May 28, 2014). Assuming none has been repaid - a reasonable assumption considering business started to decline only six months later - that works out to about C$560 million at current exchange rates. At September 30, 2015, Calfrac Well Services Ltd. reported total debt of C$850 million. Repayment terms have recently been restructured. At September 30, 2015, Trican Well Service Ltd. released total debt obligations of C$753 million. However, this was expected to be reduced by as much as C$195 million once the sale of its Russian operations was completed.
Going back to Scott Treadwell’s observation in March, these three OFS companies alone entered 2015 with some C$2 billion of debt on their balance sheets (depending on exchange rates for Sanjel’s share) in a marketplace that, for now, barely generates enough free cash from operations to support any debt whatsoever. The short and medium-term covenant relief OFS companies are receiving to keep these businesses intact until conditions improve reflects the hopelessness of lenders recovering a meaningful portion of their capital in the current market environment.
The executive teams and boards of these three superb, world-class Canadian oilfield service companies are not entirely to blame. In growing rapidly and adding capacity financed at what appeared to be the lowest cost, they were only responding to the demands of their clients that were often in the same debt markets raising money to keep drilling.
But perhaps three pressure pumpers alone should not have ever assumed total debt exceeding 10% of what CAPP estimates will be total conventional upstream capital spending for 2016.
The bigger question is – and this issue is increasingly being raised by thoughtful macroeconomic experts - to what degree has the spectacular growth in the North American oilpatch been stimulated by near-zero interest rates, so-called quantitative easing? Has oil and gas become the next major asset bubble, following the meltdown of North American real estate in 2008 which helped precipitate the 2009 recession?
The quest for yield in an environment of very low interest rates has caused investors to seek opportunities in industries which, upon further reflection, might not prove suitable for long-term debt investors. The oil industry has always been notoriously cyclical. Until recently, it was funded primarily by cash flow and equity because underlying asset values and cash flow were so volatile. Reinvest the cash and raise money through direct ownership from investors was the mantra. Exiting the great recession of the late 1980s, debt was a dirty word.
The low interest rate environment has resulted in the upstream oil and gas industry expanding with debt while paying a dividend on equity which, in fact, turns equity into another form of debt. All the free cash after paying the bills was destined for capital providers with little consideration given to a future downturn. Central bankers have held interest rates low for years to stimulate economic activity. It certainly seems to have worked for the oilpatch. Although bigger companies regularly “stress test” their income statements and balance sheets, nobody anticipated business conditions like we have now.
Other factors which make the current downturn different from those in the past is the degree to which the Canadian industry is dependent upon decisions made outside the country. One is the strength of the U.S. dollar and its negative impact on all commodity prices, not just crude oil. Another is a U.S. President limiting Canadian oil imports in order to please American environmentalists. The last is the degree to which U.S. environmental organizations have quietly immersed themselves in Canadian politics to block pipeline construction and oilsands expansion.
In every downturn Canada’s upstream oil and gas industry has experienced in its modern era (which started with OPEC jacking up prices in 1973), the common denominator among every company that didn’t make it was too much debt. It wasn’t the product or service or management or geographic location so much as the balance sheet. Here we go again.
So, as everyone takes a few days off over the holidays to reflect upon 2015 and tries to figure out what 2016 will bring, perhaps more people should consider a fundamental reassessment of how companies working in this notoriously cyclical and unpredictable business should be capitalized. It should be funded with significantly less debt because another downward correction is, as always, just around the corner.
Maybe more companies should be private than public so more decisions are made by management rather than shareholders, capital providers and analysts. When E&Ps need more product and equipment, perhaps they should wait instead of OFS continuously adding capacity, which will eventually overbuild the market for both clients and vendors.
Again, this is 20 / 20 hindsight for some. But for others with memories dating back to the 1970s and the devastation each and every downturn has wreaked upon an overbuilt industry, it might well be a better way to do business.
Of particular interest to students of American politics is the way this policy change took place. It was what is called an “earmark” in a US$1.8-trillion spending authorization required to keep Washington functioning for the next year. As is increasingly common in the U.S., when the current administration needs money, politicians from both parties lobby to include their pet projects in the bill. The American oil export reversal was one of many initiatives including: incentives for wind and solar power; the prohibition of public companies from disclosing political contributions; a reversal of country-of-origin labelling on imported meat; a delay of several taxes to support President Obama’s healthcare program called the Affordable Care Act; an extension of the US$1 per gallon biodiesel credit; scaling back of federal nutrition guidelines calling for Americans to consume less meat and sugar; reversal of a plan prohibited broadcasters from owning more than one television station in a single city and greater restrictions on which countries will be allowed to have their citizens enter the U.S. without a visa.
Even when Canadian policy does not go in the direction the oil patch would prefer, it is certainly less complex.
The impact this policy change will have on Canadian production is as yet unknown. Canadian producers which have been exporting their crude from U.S. ports may now face competition. On the other hand, this should result in some reduction of American crude oil storage levels, which could improve prices.
This is hardly bullish. Optimism a year from now is now defined as crude prices at 50% of what they once were. But with oil looking to exit 2015 on the wrong side of $US40 per barrel, these predictions reflect a significant percent gain from current levels.
The continuing decline the Canadian dollar, which is approaching US$0.71, is providing some relief. On December 22, FirstEnergy Capital reported synthetic crude closed at C$51.04, Edmonton light crude at C$45.26 and Western Canada Select at C$31. 40. With the exception of the lingering heavy oil discount, Canadian prices are significantly higher than posted WTI prices.
Natural gas prices, however, are even worse. The AECO spot price for Canadian gas on December 22 was C$2.26, down from C$2.85 a year ago. The Henry Hub spot price for American gas was US$1.74 down from US$3.03 a year ago and the lowest price in years.
The Globe and Mail reported December 21 a group called Transition Initiative Kenora had, through a lawyer with Toronto-based Ecojustice, filed a request to the National Energy Board the pipeline regulatory agency halt is review process of the TransCanada Energy East pipeline, pending the release of new federal guidelines regarding whether NEB hearings should include the environmental impact of the production of the contents of the pipeline. This has never been done with the NEB before. This was a campaign issue brought forward by the new Liberal government.
Meanwhile, protests against the Enbridge Line 9 reversal (the line runs from Sarnia to Montreal) continue, despite the fact the pipeline is now operational following significant delays. On December 20, the line was shut down for about 90 minutes after three environmental protesters locked themselves to a valve facility east of Sarnia. Enbridge shut down the line briefly, but resumed production after the activists were arrested. This has happened before, since Line 9 resumed carrying oil. A spokesperson for the protesters said the reason for the protest was that during NEB hearings into the reversal, First Nations were not properly consulted.
One of those arrested told the newspaper, “The fact that Line 9 is currently in operation really just adds to the urgency for people to act. I’m here because of the negative impacts of the oil industry also taking place right now, every day.”
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