Falling crude price squeezes Western producers

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Oil at $80 a barrel, once cause for frantic spending and growth in Alberta's oil patch, is now prompting some firms to slash their expansion plans.

Prices for crude have tumbled in recent months, weighed down by a slew of factors: Europe's shaky economy, a surge of new production in the United States, and a backlog of oil in the Midwest caused by pipeline constraints.

Energy companies operating in Western Canada are being hit especially hard because of a growing gap between U.S. and Canadian prices. While oil may sell for $80 (U.S) a barrel in Oklahoma, it is worth roughly $10 to $14 less in Alberta because of insufficient pipeline capacity to move growing amounts of crude to refineries.

Despite the squeeze on profits, Western Canadian energy companies have been loath to concede cheaper oil would put a damper on their spending, growth and production plans.

Now that optimism is fading. The first wave of budget cuts at oil companies hit Calgary last week, with a few firms admitting further exploration and production makes little sense given today's oil prices. The cutbacks underscore how rapidly the economics of the oil patch have changed, and raise concern that more expansion plans may be trimmed in the weeks ahead.

Longview Oil Corp. was the first to move, slashing 37 per cent of its 2012 spending budget. "These actions are being taken in response to the current weakness in global oil markets," it said in a statement, pointing in particular to the large pricing gap that has opened up between Canadian crude and West Texas intermediate (WTI), the North American benchmark for crude. Longview blamed the growing differential on "a lack of pipeline … capacity for Canadian crude oil."

The statement was the first outright admission from an oil company that pipeline constraints will hamper ambitions for growth. The industry has long insisted the existing export network had enough space to serve them well until around 2014.

Whitecap Resources Inc. and Bellatrix Exploration Ltd. followed Longview's lead and cut their budgets, with Whitecap attributing the decision to a "lower commodity price environment" and Bellatrix blaming "the uncertainty of the commodity price environment."

Not all energy companies are cutting back. Encana Corp., the natural gas giant, is pouring money into its oil and natural gas liquids plays, because they're more lucrative than the natural gas projects that dominate the firm's portfolio. Last week it added $600-million to its $2.9-billion budget for 2012.

The market has long assumed that natural gas companies like Encana would cut spending plans because prices for that fuel have been languishing for years. However, investors have not been expecting the same from oil companies, which until now have been pouring money into developing new reserves.

Oil first traded above $80 per barrel on Sept. 13, 2007, accompanied by massive spending in the oil patch. Pipeline capacity wasn't an issue back then because production in North America was not as high as it is now, and many companies were willing to spend more than their cash flow projections in order to benefit from climbing prices.

WTI dipped below $80 last week and is down about 25 per cent since January. Brent crude, the global benchmark, slipped south of $90 per barrel last week – its lowest point since December, 2010.

The companies that trimmed their budgets last week are specks compared to the country's oil sands giants, but the lack of pipeline capacity is being felt by companies of all sizes. Oil sands companies may be able to extract crude profitably at today's prices from existing projects, but funding new projects becomes tricky. Some big-budget projects are expected to be shelved if the price of oil does not move higher.

"When you have the oil price come down, it impacts their cash flow and that impacts their ability to pursue the growth that they are talking about it," Chad Friess, an energy analyst at UBS Securities, said. "Everything that they're drilling is highly, highly economic, they just don't have the money to go after it."

Limited pipeline space means Canadian producers can't get oil to refineries on the U.S. Gulf Coast or facilities in Eastern Canada and the United States. This infrastructure shortage, coupled with production growth, is feeding a supply glut in Cushing, Okla., a major oil hub, and explains why WTI is worth more than oil sold in Canada.

The energy industry argues that TransCanada Corp.'s proposed Keystone XL pipeline will alleviate the problem by linking the oil sands to the enormous refining complexes on the Gulf Coast. But the project has become a political hot potato in the United States. Proponents of Keystone hope the line will receive approval from the U.S. Department of State following the November presidential election, but Mr. Friess argues the project may still not be enough to close the gap between WTI and oil prices in Canada.

"[The gap] might widen out again as U.S. oil production overwhelms the Gulf Coast refining capacity," he said. "There's help on the way, but the full solution isn't going to happen until the West Coast pipelines [Enbridge Inc.'s proposed Northern Gateway and Kinder Morgan Inc.'s proposed expansion of its Trans Mountain system] are built."