Alberta's oil patch is roaring. Oil prices are flying, pipelines are pumping millions of barrels a day, and companies are engaged in a rollicking spending spree.
Every 2½ weeks, companies shovel another billion dollars into oil sands projects. Drilling rigs across the province are tapping big new pools of oil. And firms desperate for skilled workers are scouring the globe to help them get on with ambitious growth plans. Western Canadian oil output is expected to surge by more than a third to 3.6 million barrels a day by 2018.
When Suncor Energy Inc. in February announced record 2011 profit and cash flow of $9.75-billion, chief executive officer Rick George couldn't quite restrain himself: "Internally, we actually thought we had a shot at a $10-billion cash flow number," he said.
"We didn't quite get there. But listen, it's all good, and really has been a great year."
Alberta's energy frenzy has all the makings of a hollering rodeo party. But there's one group conspicuously missing out on the action: investors.
In the midst of a boot-stomping boom, oil and gas has been among the country's worst-performing sectors of the stock market. Since the global economic crisis, benchmark oil prices have soared from below $40 (U.S.) a barrel to above $100. Many Canadian energy stocks, however, have been left in the dust.
Just in the past 12 months, the Canadian energy index has fallen about 19 per cent. Some of its most important players are faring even worse. Suncor Energy Inc. and Canadian Natural Resources Ltd. are down about 25 per cent. Canadian Oil Sands has dropped 35 per cent, while Talisman Energy Inc. and Encana Corp. shares have plunged more than 40 per cent.
It's not a small problem. Energy companies make up about 17 per cent of the Canadian stock market. That's down from 20 per cent a year ago. Sagging energy stocks are a big factor behind the broader TSX index's 12.6 per cent retreat over the past year, sharply underperforming the Dow Jones industrial average's 4.6 per cent climb.
Confidence in Canada's energy sector is being shaken by a host of issues making investors unsure about the payoff from Alberta's boom. The reasons for worry are many and varied, but they collectively point to a deeper issue. Faith in Canada's energy business is eroding. Those who once viewed the oil sands in particular as a glittering money factory suddenly have important new reasons to be skeptical. Despite the vast sums pouring into Alberta and Saskatchewan oil fields, the earning power of the sector is being strained, and its ability to fund its growth while also spinning big profits is now under question. That challenge is critical, since success for the energy sector's development is key to Canada's overall economic performance
Among the energy industry's many headwinds: Oil prices in Canada are suffering from a local supply glut created by a lack of export infrastructure; spending on many big new energy projects is far exceeding budgeted levels due to soaring costs for labour, materials and other inputs; there's concern about the profit margins and reliability of some projects around Fort McMurray; and natural gas prices have crashed.
It's enough to send even the most patient investors in some of the sector's flagship companies looking for better returns elsewhere.
The shift in sentiment is striking. In the darkest days of the post-crash market misery, Canadian Oil Sands saw its share price briefly crater to $16.65. Today, with oil prices nearly triple their 2009 low, the company trades barely above $20, a far cry from levels above $50 reached in 2008.
CEO Marcel Coutu has taken to telling investors that if they buy now, they get the company's infrastructure for less than what it's worth. The oil, they get for free. Plus, they get paid 6 per cent a year in dividends to park their cash.
"It goes to show you the impact the perception in the market, versus the fundamentals, can have on your share price," Mr. Coutu said in an interview. "It is ridiculous."
That, at least, is the view that dominates downtown Calgary, and its office towers filled with executives and fund managers and analysts scratching their heads about investors' pessimistic outlook.
"We ask all the analysts to understand why. But to be frank about it, we just don't know the answer," said John Ferguson, chairman of Suncor Energy Inc., pointing to a corporate outlook that "has never been better."
But others say the outlook leads to a more uncomfortable conclusion: The surge of cash flowing onto corporate books today isn't going to stay there. It is, instead, going to be diverted in future to higher construction costs and rising royalty payments. Already, many new oil sands projects need oil prices of $80 a barrel and higher merely to meet basic profit requirements.
"The market is concerned that, while you may have an oil price that's over $100, companies won't be able to benefit over an extended period of time," said Ari Levy, a vice-president at TD Asset Management who oversees several energy and resource funds. "Costs are going to eat up a lot of the incremental gain."
For example, the price tag for Shell's oil sands mine expansion has gone from $4-billion to more than $14-billion, albeit partly due to design changes. Imperial Oil's Kearl project rose from $8-billion to $10.9-billion, which also came with some design changes.
In other cases, projects have encountered startling underperformance. Nexen Inc.'s Long Lake project was supposed to reach 72,000 barrels a day of production by late 2009. It has yet to hit half that. The sector has suffered a litany of other setbacks, from oil gushing out of burst pipes to flames leaping out of blazing oil sands plants.
The problem extends beyond costs. Markets are also beginning to lay bare some of the vulnerabilities facing Canada's oil patch, which is largely dependent upon exports to distant geographic markets, and has paid the penalty for that in numerous ways. In recent years, pipeline troubles have backed up crude in Canada, sending local prices relative to global benchmarks into a tailspin. Further troubles in building new pipelines have had a dramatic impact, pumping ever more oil along existing lines into the U.S. Midwest at a time when refineries there are already flush with oil.
The result: For much of the first quarter, Canadian crude was North America's dollar-store blend, selling at such a steep discount that CIBC calculated the Canadian oil patch would forfeit $18-billion of revenue in a year.
First-quarter energy results, which start in earnest next week, are expected to be the first real show of damage from that pricing. And with no major new pipes expected to enter service for at least two years, the prospect of pricing discounts extending into the future, compressing earnings, is real.
"We've had that overhang, and that's been a big issue," said Jennifer Stevenson, vice-president and portfolio manager for energy with Goodman & Co. Investment Counsel.
Even bigger problems for the oil patch lie with natural gas, which is in freefall amid a massive supply glut, tumbling some 40 per cent below last year.
Natural gas gets little of the attention of oil, which has been far more profitable in recent years. But it remains extraordinarily important to Canada. In 2010, the latest year for which Statistics Canada has compiled numbers, gas made up fully 47 per cent of Canada's oil and gas output. Even major oil companies send vast amounts of natural gas to market. Nearly a third of Suncor's production is gas. It's more than a third for CNRL, and 46 per cent for Cenovus Energy Inc.
For many investors, "when they see the Western Canadian sedimentary basin, their first thought is gas," said Rafi Tahmazian, senior portfolio manager with Canoe Financial LP in Calgary. "That is coming back to haunt us."
Indeed, some of the slide in the Canadian energy index parallels the tumble in natural gas prices, which are now so low that many wells barely break even.
Still, gas prices are only part of the story. Basement pricing is actually a boon to oil sands producers, since gas is an important input cost (although Cenovus, for example, doesn't make use of 80 per cent of its gas output). And even companies with little gas are being punished. Oil makes up 97 per cent of the energy produced by Renegade Petroleum Ltd., which is down a fifth in the past year – nearly 30 per cent in the last month and a half – and now trades at just over four times cash flow, well below the six that is normal.
Or take Legacy Oil + Gas Inc., a company that has fallen 41 per cent in value the past year. Nearly 85 per cent of its output is oil. CEO Trent Yanko says global economic concern, fuelled by continued anxiety about European performance mixed with slowing economic growth in China, Russia, Brazil and India, is to blame.
"People are just a little skittish in this market," he said.
Add to that a broader shifting in fund patterns, as investors leave Canada to profit from growth prospects in the United States. Canadian companies have been particularly shunned while global names have held up: In the past 12 months, Exxon Mobil Corp. is up 2 per cent. Royal Dutch Shell PLC is down just under 3 per cent.
"I think it's somewhat of a macro call," Mr. Yanko said. "U.S. investors aren't putting a lot of money into Canada. They're pulling it out and putting it into U.S. equity."
Yet it's not merely a call on Canada – it's also a call on Canada's reputation. At the very pinnacle of the Alberta oil patch, there is acknowledgment that sentiment about the sector has been damaged by production and transportation mishaps. In the past year, at least four fires have interrupted work at major oil sands plants run by CNRL, Suncor and Syncrude Canada Ltd. Those fires came after a series of pipeline ruptures – in Michigan, in Illinois, in Montana, in several places in Alberta – interrupted oil movements.
Together, the events have helped set in place a broader narrative that suggests Canada's energy industry can't be counted on to do the very basic work of getting its product to market.
"A big factor with Suncor is the reliability of our performance," said Mr. Ferguson, the company chairman. "That's a big issue with us, and so we've just got to continue to show continued improvement on our reliability."
The problem is sufficiently serious that boards are fretting over stock incentives for executives at companies that have posted stellar operational performance, but dismal market returns.
"When you're performing at a high level and you're not getting rewarded in the market, it's very difficult internally," Mr. Ferguson said. Suncor, he said, is "looking carefully" at how it can adjust compensation programs.
All of this begs an important question: what will it take to bring warmth back to Alberta's energy party? Mr. Levy, with TD, suggests corporate behaviour may need to change by keeping forecast production targets in check.
"Companies are, perhaps by nature, optimists," he said. "Perhaps they have to make more realistic assessments."
Still, Canada's energy sector may have little to do but wait, and hope that its current malaise is short-lived. Some of its fate lies out of its own hands, being shaped by those now running from anything that looks risky in a world that continues to stumble through economic recovery.
"Whenever there's fear of something that might happen in the future, it's reflected in today's valuation," said Mathieu Philippe, investment director at London-based Audley Capital. "The equity market is a discounting machine."
TROUBLES IN THE OIL PATCH
Suncor Energy Inc.
Big oil sands producers like Suncor have an impressive story to tell. They are minting money – in 2011, Suncor set a series of earnings records – and they have enough crude on their land to keep pumping for many decades. Plus, oil has stayed locked in three-digit territory. Yet Suncor and others are down substantially. Why? In part because they've stumbled. A series of fires at oil sands operations, including Suncor's, have knocked out production for long stretches, and raised questions about the reliability of those operations. In March, a confluence of three outages unexpectedly took nearly 400,000 barrels a day of oil sands production out of the market. The expensive nature of the oil sands, where it costs billions to build new plants, has also stirred concern about vulnerability in the face of potential oil price declines.
Natural gas companies like Encana have been victims of their own success. As industry uses technology to unlock extraordinary new quantities of gas, the resulting glut has severely depressed prices. Layer on a warm winter, and prices have been brought even lower – to the point where many wells are barely breaking even. But it's not just gas companies. Western Canada is not traditional oil territory. In fact, outside of the oil sands, some three-quarters of production, even today, is gas. Even for major oil names, like Cenovus Energy Inc., gas is a major component of corporate output. That means low gas prices have a sweeping impact across Canada's energy sector.
Renegade Petroleum Ltd.
Small oil companies like Renegade are, in today's environment, profit machines. Fully 96 per cent of Renegade's production is light oil, the stuff that fetches the best prices. Those prices are so good that the company's margins exceed 50 per cent. Add to that fast growth – it's expecting to send 62 per cent more oil to market in 2012 than 2011 – and Renegade, like others with similar strategies, should be red hot. But it's not. A good percentage of the smaller end of the oil sector is trading at cash flow multiples far below normal. Why? Concerns over oil prices, and in particular the price of Canadian oil, are part of it. But so is the broad sweep of money movement. Fears about cost inflation and gas prices are prompting a broad pullback out of the Canadian energy sector. And Renegade, which is down 27 per cent since March 1, and its peers are caught in the tide.