China: Panda or Dragon?

This article appears in the August 2008 issue of Oilweek.

By Peter McKenzie-Brown

A symbol of unrivalled wisdom and power, China’s dragon is a long, scaly, snake-like creature with the paws of a tiger and the claws of an eagle. This chimera is an emblem of ancient imperial power. Indeed, the dynastic emperors were known as dragons.

The revolutions of the twentieth century made a break with the past, and the present regime does not think the dragon is a proper symbol of China. Instead, the country’s rulers prefer to use the giant panda – that loveable, bamboo-eating member of the bear family – as the national emblem. By tradition a rare and noble creature, the panda has been part of diplomacy since 685 CE, when an emperor of the Tang dynasty sent a pair to his counterpart in Japan.

As the world sets its eyes on Beijing, where the Olympics will showcase progress since the death of Mao Zedong two decades ago, this commentary asks a simple question. Is the panda in charge of Chinese energy strategy, or is it the dragon? From the security of its bamboo forest, the gentle panda would stress comparative advantage. The dragon would rely on cunning, speed and power.

The charts below show growth in China’s oil consumption (top) and the country's oil production - both since the death of Chairman Mao

Until 15 years ago, China exported oil to neighbouring countries. Today, it has an almost insatiable appetite for the stuff. Since the Great Helmsman’s death in 1976, the People’s Republic has become the world’s second largest oil consumer (behind the U.S.) During those years Chinese consumption has quadrupled to about 7.7 million barrels per day while production – about 3.7 million barrels per day – has barely doubled.

The International Energy Agency thinks China will burn 16.5 million barrels per day by 2030, after buying 13.1million barrels abroad. Think about it: Saudi Arabia’s total output is now less than 11 million barrels per day.

Thrift: This article suggests that such parabolic growth requires the skills of the dragon to survive. In that spirit, China is now applying its extraordinary energy in four ways to meet its petroleum and other resource needs. The first is domestic resource development. Diplomatic manoeuvres on behalf of its petroleum industry are the second. The third involves partnerships with Western companies. Last is what the mandarins call “thrift.”

Based on efficiency, conservation and innovation, thrift is sometimes called the fifth form of energy.

China’s rise is making the world a more energy-efficient place. The country’s energy intensity – the amount of energy it uses per unit of GDP – has dropped by about 75% in the last 20 years, largely because of more efficient industry. Its energy intensity higher than America’s but lower than Canada’s, in 2006 China adopted the slogan “Save energy, cut emissions” as part of a drive to cut energy intensity even further. The country is thus improving its energy efficiency while increasing its energy-intensive role as workshop of the world. So don’t blame the Chinese for the world’s energy woes. They are doing an effective job of managing energy.

A latecomer to the world’s petroleum stage, China is now simultaneously the world’s second-largest oil consumer, the third-largest net importer, and the fifth-largest producer. In the last 15 years the dragon has been sending its agents into the world to secure the new energy supplies it desperately needs. Compared to the West’s international producers, China’s national oil companies arrived late to the petroleum Olympics, and they are not large contenders. The prizes left in play are expensive, and often in countries where Western companies refuse to operate because of human rights issues and geopolitical risk.

Through petroleum-related state-owned enterprises (SOEs) – China National Petroleum Corporation (CNPC), China National Offshore Oil Corporation (CNOOC) and China Petroleum and Chemical Corporation (Sinopec) – China started investing outside the country in 1993, just as the country became a net oil importer. China’s first petroleum acquisition was in Thailand, but CNPC acquired exploration acreage in Canada and Peru the same year. The amount of equity oil generated by those projects was relatively insignificant, and this remained the case for several years.

In terms of Canada’s ties with China, 1997 was an important year. As the British were preparing to return Hong Kong to China, Sir Li Ka-shing, the colony’s richest man and chairman of the Hutchison Whampoa conglomerate, became the owner of Husky Energy. Husky’s headquarters continued to be in Calgary, and the acquisition did not affect the company in the short term. However, Husky has since expanded its assets offshore China, and is now the largest foreign owner of exploration blocks there. All its holdings there are in the South China Sea.

Since 2001 Husky has signed eleven production sharing contracts in collaboration with the China National Offshore Oil Company (CNOOC) – now publically listed, but 70% owned by the government of China. Husky can participate in these projects up to 51%, and the company describes its entry into China as part of a strategy to develop conventional oil and gas outside North America. Certainly the company is also part of Chinese strategy, also. It is one source of capital for mandarins focused on securing energy supplies by developing the Middle Kingdom’s domestic resources.

The Venezuela Card: China cannot secure Canadian oil supplies as long as the only export pipelines from Alberta lead into the United States. Especially after the two countries announced in 2005 an agreement on energy cooperation, it was therefore astonishing when CNPC announced last year that it had pulled out of an agreement to take a 50% stake in the proposed Enbridge-operated Gateway Pipeline. When completed, the pipeline will transport 400,000 barrels of oil per day to Kitimat BC for overseas export. According to the terms of the original deal, CNPC would take 200,000 barrels per day of throughput, with the balance being exported to refiners in California. If the line had been expanded to 800,000 barrels per day capacity, CNPC could have acquired a larger stake.

For a country with rapidly rising oil demand, what’s not to like about this deal? When PetroChina vice president Song Yi-wu announced the dragon’s decision, he put it in the political context of a nation re-evaluating its commitment to Canada’s oilsands.

Projects take too long to get off the ground here, he said, and the political environment “frustrates” Chinese investors. Song said China would slow down its involvement in the Canadian oilsands business, give up its involvement in the Gateway pipeline project and wait for better investment policies and politically friendly opportunities in the future. Translation: Chinese policy-makers were frustrated over the unwillingness of Canadian producers to partner with CNPC in a production/refining venture that would see Canadian bitumen and heavy oil sent to Asia for processing.

Forecasting that CNPC couldn’t begin to produce bitumen from the oilsands for at least another decade, he made it clear that China’s near-term heavy oil strategies were pointed directly at Venezuela, where a “warm-hearted” President Hugo Chavez has taken steps to nationalize oil operations. Song said China is building energy security for its people in “politically friendly” countries, which include Venezuela, Saudi Arabia, Russia and a host of Asian and African nations – Burma, for example, and Sudan. Call it the Venezuela card.

The Venezuela card suggests a competitive advantage for China that Western countries often will not play. The dragon sees oil security as an urgent need, and is willing to exert whatever cunning, speed and power it must to meet its future needs. Not surprisingly, given its political structure and domestic situation, China will not let issues like liberal democracy and human rights stand in the way of its quest for energy.

Do Western oil companies let political and human rights niceties stand in the way of business? It’s a matter of degree, of course, but it is not difficult to find examples of North American and European companies pulling out because of political risk and public pressure based on human rights abuses. In Canada the most famous case is that of Talisman.

Ten years ago the company acquired a 25 percent interest in a developing oil project in Sudan. The production facilities, pipeline and offshore loading terminal were being built and the wells were being drilled. By the summer of 1999, oil was flowing and being exported. By 2002, the project was producing 240,000 barrels of oil a day, with the equity oil being distributed to the project’s participants, three of which were subsidiaries of state-owned oil companies from China, Malaysia, and Sudan. The only privately owned company in this consortium, Talisman bowed to public pressure based on Sudan’s human rights record and sold its 25% interest to an oil company owned by the government of India.

The pattern is clear. The Asian players were unconcerned about human rights. There is a subtext here about Asian strategies toward energy. Especially in the face of a high-profile divestment campaign like that launched against Talisman, Western companies will buckle in the face of pressure related to human rights, environmental integrity and so on. Chinese and other Asian companies will not. For example, all three of China’s oil and gas SOEs are active in Burma. Latecomers to the petroleum Olympics, they measure petroleum victory in terms of land, reserves and production.

Comparative Advantages: Chinese industry’s willingness to overlook “soft” issues like human rights gives it a distinct comparative advantage. China’s willingness to bring diplomacy to bear on behalf of its SOEs gives it another. These advantages are rebalancing the planet toward East Asia. The dragon is rising.

Chinese energy policy is directed by government, and some 70% of the world’s petroleum resources are now controlled by national oil companies like Saudi Aramco and Petróleos de Venezuela. State-to-state negotiations are especially important when one of the participants is an emerging superpower.

Much of China's efforts are directed to the energy-rich nations of Central Asia, which can deliver energy overland instead of by tanker. For example, a trans-Kazakhstan pipeline is already delivering oil from the Caspian Sea.

Two other factors in China’s favour deserve mention. One is that Southeast Asia is home to many in the Chinese Diaspora – the descendants of the many waves of migration from China over the last millennium. Particularly as colonialism collapsed after the Second World War, they came to control great assets and even some national economies. By some estimates the third largest economic entity in the world, the Overseas Chinese began repatriating capital to China in the 1990s, thereby igniting the Chinese miracle. Today they occupy key positions in Southeast Asian business and government, and strengthen local ties with China.

Another factor working for China began during Cultural Revolution – that decade of social, political, and economic madness from 1966 until the arrest of the Gang of Four. Despite mutual fascination and incomprehension, during those years black African governments and African revolutionary movements were the recipients of Chinese aid (both military and economic) and other diplomatic efforts. African governments – many of them successors to those revolutionary movements – remember China’s efforts during that time. That diplomacy is now paying off with preferential access to petroleum leases and production sharing contracts.

A classic example is Angola, in West Africa. Mainly because of the expansion of its oil industry that country has the fastest-growing economy in the world, and its growth is mainly driven by Chinese explorers and producers. China’s SOEs got access to Angola’s offshore as a ‘Thank you’ to the People’s Republic of China. Despite desperate poverty at home during the Cultural Revolution, the dragon still found the wherewithal to support Angola’s independence movements during those critical years.

China’s Peaceful Rise: A final point deserves comment. In the late 1990s, China’s central government developed what it called “the new security concept.” The idea is that the Cold War mentality of antagonistic blocks no longer makes sense. In a globalizing world, nations can increase their security through diplomatic and economic interaction. This notion has become part of a foreign policy doctrine known among diplomats as “China’s peaceful rise” – a policy that, for example, encourages Chinese businesses to form partnerships with Western firms. For Canada, which is one of the few countries likely to increase production in the coming decade, it has important implications.

Consider, for example, that Enbridge is undeterred by CNPC’s decision to pull out of the Gateway Pipeline. “The appeal (of this pipeline) to Canadian producers is that you would get another bid on the crude oil from somewhere other than the United States,” said Enbridge’s executive vice president, Steve Wuori. Also, of course, pipeline costs would be less.

“When (Enbridge) first started we were aiming (to complete the project in) 2011,” Wuori says. “But now we are targeting 2012-2014.” Will Canada be able to supply new markets with heavy? Wuori thinks so. “Production forecasts up to 2020 for the oil sands support that kind of growth potential, even if you risk it for economics and environmental concerns.”

Although China has placed less than 1% of the $50 billion investment in the oilsands since the early 1990s, it is still part of the equation. China’s most significant direct investment has been the SinoCanadian Petroleum joint venture, through which Sinopec owns a 40% stake in Synenco’s Northern Lights project. CNOOC made its presence known with the acquisition of a small interest in MEG Energy, which is focusing on a project at Christina Lake.

Obsessed with diversifying its oil sources and avoiding dependence on a single supplier, Beijing sees Canada as a country in the U.S. sphere of influence, a country where oil could be held hostage to political concerns. It has little enthusiasm for multibillion-dollar oil deals in a country whose relations with China have been soured by human-rights disputes. Think Tibet.

“China doesn’t want to make a multibillion-dollar commitment to a country where the political contacts are constrained,” says Jiang Wen-ran of the University of Alberta’s China Institute. Professor Jiang adds that the Middle Kingdom worries about Canada’s business practices. Canadians can’t explain how they will triple production from the oilsands given environmental constraints. The costs of environmental protection seem out of control. Labour costs are reaching the moon.

The Panda Speaks: This article has focused on the areas of Chinese petroleum development where Westerners are more likely to see a dragon than a panda. Of course, in modern China it is the giant panda that speaks for the neo-imperial court. To conclude, let’s listen to what this species has to say.

According to China’s State Council, a policy-making arm of the People’s Republic, “The basic themes of China’s energy strategy are giving priority to thrift, relying on domestic resources, encouraging diverse patterns of development, relying on science and technology, protecting the environments, and increasing international cooperation for mutual benefit.”

The panda adds that its energy development is based on “the principle of relying on domestic resources and the basic state policy of opening to the outside world.” In its efforts to ensure a stable supply of energy, the country wants “a steady increase in domestic energy production.” It also wants to “promote the common development of energy around the world.” China’s energy development “will bring more opportunities for other countries.” It will “expand the global market, and make positive contributions to the world’s energy security and stability.”

All this will help perfect the national system of “socialism with Chinese characteristics.”

Losing The Arctic Edge

This article appears in the July 2008 issue of Oilweek.

Canada needs to move quickly to join international rivals exploiting the potential of the Arctic

By Peter McKenzie-Brown

Canada began to explore the far north for oil almost a century ago. In 1911 Jim Cornwall, a northern businessman, saw oil on the Mackenzie River and hired an Aboriginal named Karkesee to look for seepages. Karkesee found several. Later analysis showed the oil to be medium in gravity and low in sulphur.

Cornwall formed a syndicate with two Calgary businessmen and the group engaged T.O. Bosworth, a prominent petroleum geologist, to study the area. During his 1914 expedition, Bosworth staked three claims on behalf of his backers and reported enthusiastically on the area’s prospects. Ironically, given later events, Bosworth stressed that his supporters should take every effort to control pipeline transportation from the North to southern markets.

World War I put a halt to the group’s exploration plans, and by Armistice Day Imperial Oil owned Bosworth’s claims. The company began exploratory drilling along the Mackenzie in 1919, first drilling two salt water wells near Great Slave Lake. Farther down the Mackenzie, near Fort Norman, the third showed oil.

Led by Ted Link, who later became Imperial's chief geologist, the crew drilled the successful well with a cable tool rig. Legend has it that Link chose the site by waving his arm and saying, “Drill anywhere around here.” In August 1920, at a depth of about 1,240 metres, the world's most northerly oil well came in; Imperial put it on production the very same year.

Although just south of the Arctic Circle, the Norman Wells field established Canada as the world’s undisputed leader in northern exploration and production, and she retained that title for more than 60 years. Led by Dome Petroleum and a series of attractive federal grants, the industry’s golden age of Arctic exploration in the 1960s and 70s delivered huge natural gas discoveries and a number of small oil finds.

Let’s fast forward to the present. In petroleum terms Canada has become a second-tier Arctic nation. The US, Norway and Russia are all Arctic producers. In recent years, Denmark has done some drilling off the eastern shore of Greenland. Canada is clearly the laggard. Despite skyrocketing oil and gas prices and the many successes of Canada’s golden age, exploration in our Arctic is almost at a standstill.

As if to rub our collective nose in it, Enbridge Inc. and Gaz Metro recently announced that their proposed Rabaska liquid natural gas terminal in Québec had found a secure source of LNG. The source will be Russian energy giant Gazprom, which will deliver cargoes from an Arctic facility in the Barents Sea due to begin deliveries in 2014. By the terms of the agreement, Gazprom and Gaz de France will become equity partners with the two Canadian companies in the $840-million regasification plant.

The Great Abandon: In a sobering presentation to the Canadian Society of Petroleum Geologists, Dave Russum (VP of geosciences for AJM Petroleum Consultants) made a compelling case that Canada has fallen behind its rivals in the development of Arctic oil and gas, and that she needs to catch up. Only five countries have claims to mineral rights in the Arctic – the others are the United States, Russia, Norway and Denmark.

The United States became a major oil producer at Prudhoe Bay in 1977, and continues to produce from that supergiant field. Last year Norway began producing LNG from its Snøhvit field. Russia, which already has Arctic production in Siberia, will begin producing from Shtokman in the Barents Sea in 2014.

And Canada? This country’s most northerly oil production still comes from the 88-year-old Norman Wells field. A tiny amount of gas production serves a few small towns and villages in the Mackenzie Delta, but this service has as much to do with local development as petroleum economics. When energy prices crashed and Dome Petroleum collapsed in the mid-1980s, the industry decamped from Canada’s Arctic with great abandon.

Why? Several concerns have discouraged Arctic exploration for a generation. The main issue is geology. “In the Arctic most of the expected resources are gas,” says Russum, “and they are devilishly expensive to develop. Except for Prudhoe Bay, (the Arctic basins) have pretty much been gas plays, and we expect about 75% of the resource there to be gas. Oil has been the prize. If you couldn’t find oil, you didn’t want to develop there.” During the last two decades the expense and difficulty of Arctic development was worsened by surplus natural gas supplies in North America.

The situation has greatly changed in recent years, says the executive director of the Arctic Institute of North America. Benoît Beauchamp agrees that the Arctic is gas-prone, but says this is no longer an obstacle to development. In recent years natural gas has become recognized as a premium source of energy, although it generally serves continental rather than global markets.

This continental character raises the spectre of Canada’s tradition of bitter disputes over northern pipelines. It now appears that the joint federal and provincial panel evaluating the social and environmental impacts of the present Mackenzie Valley Pipeline proposal – this one put forward by Imperial Oil in 2004 – will delay the environmental decision on the $16.2-billion project by at least another year. This adds to a string of such problems that date back to the mid-1970s.

Like previous proposals, Imperial’s pipeline project has been dogged by setbacks. The company has yet to resolve Aboriginal land access issues or come to an agreement with Ottawa on how to finance the project. According to Beauchamp, construction of this pipeline is critical for renewed exploration in the North. “The announcement of the Mackenzie Valley Pipeline will be the gunshot that starts the race up there. Then there will be a bonanza.”

Beauchamp is more sanguine about Canada’s place in the North than Russum. “It’s true that there hasn’t been much drilling in the Arctic Islands since the 70s, but there is a great deal of interest now in the Mackenzie Delta – no drilling, but seismic and other preliminary work. A few years ago an ExxonMobil/Imperial partnership acquired a large land parcel in the shallow Beaufort, on an extension of the Delta. That’s likely an oil prospect, and three parcels adjacent to that property will be up for grabs in June. It will be extremely interesting to see how strong the interest is.” As it happened, BP acquired one of those properties for $1.2 billion. The other two went for a mere $10 million combined.

Beauchamp expects an Arctic boom. “Interest in the Arctic is mounting. There are very few places left in the world with the potential of the Arctic, and companies need to develop reserves in order to grow. Canada is likely to be a focus because we are a stable country. Corruption is not a problem here, unlike Russia. We aren’t likely to abrogate signed agreements, as the Russians did at Sakhalin Island, for example. The problems in Canada are mostly related to the approval process.

Canada Rules! Russum sees the issue as being somewhat more urgent. “For security, sovereignty and economic reasons, Canada should take an active role in Arctic development.”

That’s an opinion shared by Federal Natural Resources Minister, Gary Lunn, who met in May with leaders from the United States, Russia, Norway and Denmark to sort out how best to deal with conflicting sovereignty claims in the Arctic, including Canada’s.

“It is critically important that it’s under our sovereign control so that we set the parameters for the environment and that we make the decisions whether or not even to allow exploration,” Lund said on the eve of the meetings, which were held in Ilulissat, Greenland. “We are going up to reaffirm our commitment on defending and protecting our sovereignty in the Arctic.”

On an immediate front, Russum notes that depletion rates have been accelerating in all of Canada’s gas-producing regions. “In every area, particularly those in Alberta, we have seen declines. This is not particularly surprising, given the drop-off in drilling,” but it is an important reason to move back into the Arctic. “Estimates suggest that there might be 10 billion barrels of oil and 181 trillion cubic feet of gas in the Canadian Arctic. With high production rates depleting gas reserves across Canada, we need to be considering all opportunities.”

“Conventional and unconventional gas in southern Canada will not satisfy future North American needs,” he adds. “We have to recognize the need to develop a wide range of energy sources.” Energy is the vital commodity, he says; it equals power. In a rather unCanadian way, he argues that “countries with abundant energy (like Canada?) will control the world. Net consumer countries (like the United States?) will be at the mercy of world economics and politics.”

In the case of natural gas, the Arctic will soon become a particularly important source of supply. According to Russum, a quarter of the world’s undiscovered gas is likely to be there. Looking at the entire transpolar region, 26 geological basins make up the Arctic. Of those, 21 have had some exploration activity, and explorers have found oil or gas in ten. There is commercial production in four basins (two in Russia, one in Norway and Alaska’s North Slope). Two - Canada’s Cameron Island and the Mackenzie Delta – have been the source of minor production volumes. Given the small number of wells drilled and the Arctic’s challenges to development, these results are impressive.

Imagination Beckons: Given the prospects for huge Arctic gas discoveries and the controversy over gas pipelines to the large North American markets – in addition to the Mackenzie Valley line, there have been disputes for 30 years over a line from Prudhoe Bay through the Yukon into the Alberta network – Russum argues that Canada should consider LNG production from the Arctic. “Although there are big problems with sea ice in the winter, these are problems the Norwegians have solved” he says, “and which the Russians obviously believe are solvable. Certainly one ‘benefit’ of global warming is ice shrinkage, which means more open water in the Arctic and a more easily passable Northwest Passage.”

Another advantage of LNG is that producers have more market options – especially since “world demand is now driving gas movement.” This point harks back to the geographical maps that Dome Petroleum made famous in the early 1980s. As those maps pointed out, the Beaufort Sea is roughly in the geographic centre of the developed world. If sea ice were no problem, LNG tankers loading up in the Arctic would find themselves about equidistant from London, New York, San Francisco and Seoul. Destination decisions for cargoes from that region could be based purely on best price; the calculation of transportation costs would be largely redundant.

By contrast, traditional pipelines have a number of drawbacks quite apart from political wrangling. One of those is greater terrorist risk. Others include long timelines, the enormous capital required and the fixed destination. Pipelines from stranded resources don’t have much market flexibility.

Whether developed through traditional pipelines or LNG or both, Russum believes it needs to be done. “In the Canadian Arctic, the long-term costs of frontier gas production are going to be similar to the costs of producing unconventional gas – shale gas, coal bed methane – in large volumes. Imagination will be required for development, and we will need to apply out-of-the-box thinking to all aspects of E&P. If we do this, there is no reason our Arctic production can’t be economically viable in the global market place.”

The resources are there and the technology is available. The world’s hydrocarbon markets have never been stronger. According to Russum, “We used to be the leader in exploring the Arctic, along with the Americans. Now we have a real opportunity. We have to move beyond discussing development. We have to pursue it in an economic, environmentally sensitive and socially responsible manner.”

He pauses for effect. “We only have four competitors. Three of them have already proved that Arctic development is viable in this environment.”

Last of a Breed

This article first appeared in the April 2008 issue of Oilweek.

By Peter McKenzie-Brown

Jim Kinnear makes it sound compelling.

During the last couple of decades, “the trust took over the mid-cap end of the market. The junior companies are the explorers. The independents are doing the large projects – EnCana and CNRL (Canadian Natural Resources). Then there are the super majors. This type of vehicle (the trust) is ideal to fit that part of the market. It’s a difficult business model – how much should we reinvest, how much should we distribute to our unit holders. (The trust) is a very efficient way to reallocate capital. If you acquire an interest in an oil and gas asset, there’s good margins and good cash flow. You’re buying a good income stream. Our concept was to buy a cash flow stream. I’m a financial analyst. BSc – very general degree – then became a financial analyst. These assets provide cash flow, part of which is depletion of assets. You put up $100, get $20 back per year for five years, say, then you own the property. You can get a 15-20 per cent rate of return each year.”

These notes give you an idea of the depth, intensity and direction of Kinnear’s thinking.

Trusts evolved out of managed limited partnership (MLPs) for the wealthy and professionals. They are a financial vehicle developed to answer the question, “Can we expand the closed-end trust?” Trusts and MLPs combine the cash flow business model with a tax ruling that exempts them from tax.

Pengrowth: Kinnear’s Pengrowth was the third trust; the first two were Enerplus and Royal Trust Energy. Kinnear remembers when Marcel Tremblay started up Enerplus in the mid-1980s. “He started his first fund with less than $10 million,” Kinnear says. “He got a comfort letter saying that he could distribute all this cash to his unit holders without paying tax. His unit holders would pay the tax on all the net revenue, not the trust. If unit holders lived in another jurisdiction, like the United States, they would pay tax in that jurisdiction.” Companies and corporations pay tax, but royalty trusts do not. They began as vehicles which pass oil and gas cash flow through to investors, and they still serve this purpose.

Pulling out a writing pad, Kinnear draws a graphic showing how trusts work. With an expensive-looking fountain pen he draws a graphic showing cash flow coming from operations and being dispersed to individual investors.

“You’re buying a cash flow stream,” he says. “We called it financial engineering. It’s like a REIT, except instead of owning buildings we owned revenue-generating oil and gas properties.” Taxes would be paid by investors, who could purchase trust units through stock exchanges. This very clever model enabled taxpayers to defer and avoid taxes – for example, by holding their trust in RSPs. The trust/RSP combination postpones taxes, sometimes almost endlessly.

During a shift as an oil and gas analyst in Calgary, Kinnear acquired some petroleum interests. He incorporated Pengrowth in 1987. The year was significant because, in the dramatic first two months of 1986, oil prices had dropped precipitously from $26 per barrel to ten dollars. The drilling industry was flat on its back. Large projects were being cancelled and postponed. Oil and gas companies were earning negative rates of return. In Alberta, housing prices crashed.

Yet the larger Canadian economy was doing well. “I felt like a turd in the fruit bowl” said the president of a major Calgary-based oil company (not Pengrowth) after addressing a business conference in Toronto in 1987. There seemed to be rising prosperity almost everywhere else – partly because energy prices were so much lower. Lower prices benefitted most of the country, but Alberta suffered.

In those days, the late 1980s, oil and gas properties were there, in the gloom, for the asking, and that’s when Kinnear began to buy properties for Pengrowth. Pengrowth is one of the largest and most profitable energy trusts in Canada. Now 20 years old, the trust is worth about $5 billion (total assets). Enerplus and Pengrowth have both become major players in the energy trust business, and they are close in size. In 2006 Enerplus had $2.7 billion in net equity on the balance sheet, compared to Pengrowth’s $3 billion. Marcel Tremblay left Enerplus quite abruptly in 2001.

Pengrowth Manager: Kinnear has created an organization on which, to a much greater degree than is common, he leaves indelible marks – especially in the area of corporate branding.

Pengrowth is one of a declining number of income trusts which still has a one-person manager – essentially, a management contract with the founder and CEO of the company. Pengrowth Management Ltd. is owned 100% by Jim Kinnear, and it puts millions of dollars into not-for-profit events and charities each year.

This arrangement means that Jim Kinnear’s management fees and bonus include millions of dollars for philanthropic sponsorship. Pengrowth’s major sponsorships tend to be high-profile events: The Pengrowth Saddledome, the Duke of Edinburgh Awards and the Canadian Open – the world’s third oldest open golf tournament. “For all (Pengrowth’s) community endeavours the money comes from the manager,” Kinnear explains, “and I am 100% owner of that.” Since the trust’s purpose is to pass cash flow on to investors, as a trust Pengrowth can’t sponsor charitable events directly. “When we invest in these programs, we don’t just give money, though. We get involved. We help make these organizations better. We really feel we can make a difference.”

Kinnear has an encyclopaedic knowledge of the business and of the energy industry as a whole, especially from the perspective of a dealmaker and a salesman. He brings an analyst’s mind, a quick tongue and a great deal of charm to an interview. How has the report of Alberta’s Royalty Review Panel affected his trust? “We don’t have all the details, but it seems to be only 4-5 per cent. What is really important for us is the maintenance of credits for EOR (enhanced oil recovery).”

Of more concern to him was Jim Flaherty's Scary Halloween Trick. Also known as the Halloween Massacre, federal finance minister Flaherty announced this new tax on October 31, 2006, and it will start taxing trusts in 2011. The tax, which will impose a 31.5% duty on the net income of energy trusts, has a catchy acronym, SIFT. The word stands for “specified investment flow-through tax”.

As a result, the price of Pengrowth units “has declined by about 20 per cent on the markets and (the new rules have) made it more challenging to do our business.”

Besides SIFT, Kinnear gives a litany of problems facing the Canadian industry. “The high dollar has affected costs and adversely affected margins. Over the last two years costs have really skyrocketed. They are now twice what they were in 2001. Globally, everything is way up, construction costs, drilling costs, everything. The cost chart in the last two years has become parabolic. Then there was the royalty review in Alberta. The gas market in North America has had major problems and there’s talk of recession. Stock markets around the world are volatile. We call it piling on. What more can happen?”

Outlook: Given all that piling on, Kinnear seems sanguine about Pengrowth’s future. “We have a number of potential development projects down the road that can offset our depletion over the years,” he says. And “we have a huge accumulation of tax pools, we have about $2.5 billion in tax pools, and we can use those to offset this new tax. We continue to be a high-yielding Canadian energy trust. We want to deliver as much cash as we can to our unit holders before we become taxable.”

He argues that a flight to quality in the industry has driven a lot of investors to Pengrowth. “We have a lot of heritage assets. Judy Creek, Sable Island, Swan Hills and the Weyburn field in Saskatchewan. Weyburn,” he adds parenthetically, “is currently the world's largest carbon capture and storage project.” Producing these assets during this period of high-priced oil means high rates of return. “In 2006 we were among the top ten oil and gas property acquisitors in North America. We can double the size of our assets under the SIFT rules.” He also notes with satisfaction that the federal government expects to have Canada’s tax rates at the lowest level in the G-8 by 2012.

Asked about the price outlook, he says “We’re not very good at calling prices. We think there will be recovering gas prices over the next year or so. Storage in Canada is closer to the five-year average than it was, and gas drilling is down” both in Canada and, recently, the US.

Will oil prices climb or collapse? Kinnear is just back from a CERA (Cambridge Energy Research Associates) conference in Houston. One speaker was Matt Simons – author of Twilight in the Desert, and a fierce sceptic of Saudi Arabia’s ability to increase or even maintain oil production capacity beyond the next few years. In a recent pronouncement, Simons proposed that the world reached maximum production two years ago. The apparent increase in supply since that time has been essentially a drawdown in global inventory. The interview turned to a discussion of peak oil.

Peak Oil: Peak oil is the notion that the world has produced about half its producible reserves, and that implied demand will soon outpace available supply.

Kinnear begins in a humourous way. “You usually see a peak in oil prices in the spring, and the low point for oil demand is usually in December.” It is not clear whether he understood the question until he adds this: “In the second half of last year something very interesting happened. Look: we have $90 oil, and most companies are still missing their production targets. Maybe the oil just isn’t there.”

He warms up to the topic. “It took about 250 million years to create all this oil, and we have used about half of it in the last three generations. It’s amazing. Whether you do or don’t believe in peak oil, there just hasn’t been sufficient reinvestment in the business. There’s been a classic cycle of underinvestment. What are the major companies doing with their cash flow? Spending some of their cash on new development and buying back stock to increase shareholder value. Some major companies are replacing as little as 15% of their reserves.”

This underinvestment has several causes. For one, 80% of the world’s reserves are national oil – owned by countries where alien companies can’t invest directly. These countries are mostly not known for their efficient use of capital: Venezuela, Sudan, Saudi Arabia. Other known reserves and resources are located in places that are difficult and undesirable to explore, like the Arctic.

Kinnear echoes a century-old refrain: “It’s a capital-intensive business. You’ve got to keep offsetting depletion and there’s a massive amount of capital required just to maintain production. And suppose there’s not enough investment to both offset the decline and grow production in the near term. What’s going to happen if India and China continue to boom and expand their requirements for energy?” That is a good question.

After listing a number of large producing basins and giant fields in decline, Kinnear points out that “the only country that has the potential to grow production over the next 5-10 years is Canada, because of the oil sands.” He returns to his central theme: “Whether you believe in peak oil or not, there is not enough money going back into the oil industry to offset production. It’s a huge issue.”

There is an irony in this. Trusts like Pengrowth do not take large exploration risks or develop such megaprojects as oil sand plants. Instead, they acquire producing assets from other firms, and often operate them directly. For firms with that business model, the risk of peak oil can create an ideal business environment. Under peak oil, energy trusts would generate increasing cash flow as a result of rising energy prices. Those funds would come from existing operations, and they would fund future distributions and expansion. While not involved much in the hunt for new fields, trusts like Pengrowth provide an efficient way to harvest known reserves. This is a profitable business model.

Bedfellows: The Prices of Gold and Oil

By Peter McKenzie-Brown

I’ve been a gold bug since the beginning of 2001, and you will probably notice on this chart that my timing was pretty good – especially so since the market in gold shares turned before the price of bullion did. In my opinion, the volatile price of gold shown here is directly tied to the recent dramatic increases in oil prices.

I think this chart is the best available picture of gold prices over the last quarter century. It's a point-and-figure chart, consisting of columns of Xs (upticks) and Os (downticks) to represent price movements over time.

As Stockcharts.com explains, there are several advantages to using P&F charts instead of the more traditional bar or candlestick charts. Briefly, point-and-figure charts automatically eliminate the insignificant price movements that often make bar charts appear ‘noisy;’ remove the often misleading effects of time from the analysis process; make recognizing support/resistance levels much easier; make trend line recognition a no-brainer; and help you stay focused on long-term price developments. In that context, you will notice that there has been more price volatility in the last six years (when the present uptrend began) than in the previous 20 combined.

Within that context, please note that The Privateer's technical analyst recently identified an extremely bullish on this chart – the dashed green line on the far right. If this trend stays intact, we won’t see $900 gold again for a long, long while. Point-and-figure charts can’t tell you when gold will run through $1000 per ounce, but this one gives a very strong opinion that it will. Perhaps you should buy some gold producers - or, if you can handle even greater volatility, a leveraged bull fund like HGU.

Why? In my opinion the price we are paying for gold is directly related to the price we are paying for oil. And gold's fast-moving price reflects a rapidly deteriorating situation in the petroleum industry.

A few weeks ago I answered the big question of the day – will oil prices climb or collapse? – with arguments that prices are still on an upward trajectory. I recently had a discussion with an oilman - he has created a $5 billion enterprise in Canada, and is still in the saddle - who tended to agree. He was just back from the Cambridge Energy Research Associates conference in Houston, where one participant was Matt Simmons.

Author of Twilight in the Desert, Simmons is a fierce sceptic of Saudi Arabia’s ability to increase or even maintain oil production capacity beyond the next few years. In a recent pronouncement, he proposed that the world reached maximum production two years ago. The apparent increase in supply since that time has been essentially a drawdown in global inventory.

Gold prices reflect political instability. And if Simmons is correct, the near-term geopolitical outlook is quite dangerous. Imagine battles for supply, complicated by Jihadism, disrupting the world order. Imagine regional conflict between large landmasses, as in the US vs. the Middle East and Islamic terrorism (already reality); Putin keeping his hand on the valve to dictate terms to parts of Europe (already reality); regional struggles between India and China for Southeast Asian resources, especially petroleum; America using the terms of the US/Canada free trade agreement to demand ever more of Canada’s oil and gas production.

Peak Oil: And that, of course, takes us to the topic of peak oil - the notion that the world has produced about half its producible reserves, and that implied demand will soon outpace available supply.
You usually see a peak in oil prices in the spring, and the low point for oil demand is usually in December, but that is not what peak oil is about. What it is about can be seen more clearly in this simple fact: we have $90 oil, and most companies are still missing their production targets. Maybe the oil just isn’t there.

Let's look at that in a broader context. It took about 250 million years to create all this oil, and we have used about half of it in the last three generations. That’s amazing.

Worse, western oil companies are now decapitalizing – buying back stock and otherwise returning cash to shareholders, rather than exploring for large new fields which aren't there. Decapitalization is one way to acknowledge the problem of peak oil.

Whether you do or don’t believe in peak oil, there hasn’t been sufficient reinvestment in the business. There’s been a classic cycle of underinvestment. What are the major companies doing with their cash flow? Spending some on new development and buying back stock to increase shareholder value. Some major companies (e.g., ConocoPhillips) are replacing as little as 15% of their reserves.

This underinvestment has several causes. For one, 80% of the world’s reserves are national oil – owned by countries where aliens can’t invest directly. These countries are mostly not known for their efficient use of capital: Venezuela, Sudan, Saudi Arabia. Other known reserves and resources are located in places that are difficult and undesirable to explore, like the Arctic.

The problem has been articulated for a full century. The oilman I was talking to put it in these no-nonsense terms: “Petroleum is a capital-intensive business. You’ve got to keep offsetting depletion and there’s a massive amount of capital required just to maintain production. And suppose there’s not enough investment to both offset the decline and grow production in the near term. What’s going to happen if India and China continue to boom and expand their requirements for energy?” That is a good question.

After listing a number of large producing basins and giant fields in decline, he pointed out that “the only country that has the potential to grow production over the next 5-10 years is Canada, because of the oil sands.” He returned to his central theme: “Whether you believe in peak oil or not, there is not enough money going back into the oil industry to offset production. It’s a huge issue.”

There are a couple of ironies in this. For one, a logical conclusion from peak oil theory is that, by accelerating production to meet demand, you are accelerating oil depletion. We consumed the first half of the planet’s oil reserves in three generations. How long will it take to consume the rest?

Using a geologist’s understanding of the underworld, peak oil prophet M. King Hubbert suggested that the world’s crude oil production will take as long to decline as it took to peak – roughly speaking, three generations. But isn’t it possible that, because of improved production technologies and much greater markets in the post-peak world, it will actually take much less time? The question matters.

The other irony is that oil companies, whether they understand the peak oil issue or not, are responding to developments through a program of decapitalization – as I have already suggested, returning cash flow to investors, with an eye to eventually leaving the oil part of the business. Giant and other large fields not being available through exploration, much of the private sector is now involved in the orderly and efficient liquidation of existing assets through mergers and acquisitions. This matter also matters.

Efficient Markets? How Noise Drives Prices

By Peter McKenzie-Brown
This week was remarkable. It began with the Americans twisting Saudi arms so they would increase oil production. Nervous that there might be spigots that could actually be opened, oil prices dropped off their lofty levels. Then a decline on global stock markets was greatly exacerbated by the squeeze forced on France’s Société Générale by a rogue trader. The Martin Luther King holiday market closures compromised an orderly unwinding of those futures contracts, and the decline in the markets turned into a meltdown.

Not knowing that the actions of a 31-year-old rogue had precipitated the collapse, the Fed’s Ben Bernanke flooded the world with cash by precipitously slashing key US interest rates. The markets were also flooded with rumours of a severe US recession impending – one that would take the world with it. Fearing a crash in demand, the price of West Texas Intermediate briefly dropped to its lowest level in three months. Then reality began to intrude: the Saudis don’t have a lot more oil they can produce, and geopolitics, rising demand and historically tight supply still govern the price of oil.

The chartillustrates two things. First, it shows the trading range of oil (the space between the red and green lines) during the last six years. Second, it shows an extended breach in that trading range – essentially, three months of trades above the red line. What used to be resistance has now become support. I consider it highly significant that oil prices popped up after touching their three-month low. In the future, oil is likely to trade above the red line.

One of the great things about technical analysis of this kind is that it is a way of imposing order (straight lines) on a market riven by noise (jagged lines.) However, technical analysis is not an excuse for not understanding what decisions help form the jagged lines of day-to-day trading. Oil prices are governed by a highly sophisticated market – one that can quickly balance innumerable pricing factors to establish appropriate prices for oil, but so doing creates endless charts of jagged lines. Herein I present my perception of how that market developed and of the major factors influencing it. As a Canuck, I will deal with the matter from a Canadian perspective.

The Background: As oil became a vital factor in western life during the twentieth century, exploration for the stuff – a new industry – found more than the world could consume. In response, big companies set prices for the oil they controlled overseas, while governments and regulators in the US helped create a parallel environment in which America’s huge domestic oil industry could prosper from higher prices. By 1970, these different policies had created a global pricing environment in which oil produced in the United States cost $3.18 (U.S.), while oil produced overseas only fetched $1.30 (U.S.)

This situation received a severe blow in 1973 when OPEC began to act as a cartel – an organization committed to keeping prices higher than the market would ordinarily allow. They were so successful that OPEC’s member states made price control the organization’s primary purpose, and for more than a decade a statement from OPEC was enough to give world energy markets the jitters.

The energy crises of the period were possible because the world was no longer awash with oil. In particular, production in the United States (then the world’s largest producer) had begun to decline. The Western world needed new supplies, and the volumes required were only available from OPEC members. This period culminated with the Iranian Revolution of 1979-80, which brought panic to oil markets. Dubai oil prices rose from about $2.00 (U.S.) per barrel in 1972 to $36 (U.S.) in 1980.

All this was far more traumatic a generation ago than the rapid oil price increases of the last ten years. The reason is that – at least, in relative terms – oil then played a much larger role in the world economy.

Spot and Futures Prices: The market responded dramatically, and predictably, to these painful price increases. Consumers used less oil while producers pumped more. OPEC soon lost the ability to keep prices high. Then, in 1986, Saudi Arabia, an OPEC leader, flooded the market with oil in an effort to re-establish market share. As a result, prices plunged. Dubai oil dropped to $13, and fluctuated around that level for more than a decade. It did not move decisively upward again until 2000, when tight oil supplies began to squeeze prices higher.

Aided by the convergence of computer and telecommunication technology and by increasing competition among global oil producers, the world’s response to these three “price shocks” – the price spikes of 1973 and 1980-1981 and the price collapse of 1986 – was to create a sophisticated global energy market. After much turmoil, this market, which now accommodates innumerable buyers and sellers, imposed a laissez-faire discipline on the matter of global oil pricing.

In this market, petroleum prices take the forms of “spot” and “futures” prices. Spot prices represent what traders charge for oil for immediate settlement – usually, delivery within two days. Futures prices are prices for delivery of oil at a certain date in the future – as soon as one month, as far into the future as nine years – at specified prices.

Driven by a global network of traders working around the clock (except weekends and holidays), spot trades take into account the needs of refineries and a constant stream of geopolitical and economic data. The markets are more strongly influenced by information about how much crude oil inventory is in America’s stockpiles than by OPEC statements about how much oil they are going to produce. News about hurricanes and other extreme weather events also figure into price calculations. So do rumours and worries about conditions in the world’s large economies.

The world’s energy traders bring uncountable resources, facts, needs, expectations and beliefs about the future into their collective trading decisions. This interplay of intelligence and knowledge creates a group mind capable of processing extraordinary amounts of information as it establishes global prices. Charts of spot prices changing minute by minute can be found on numerous web sites.

Benchmark Pricing: Spot prices represent the business end of crude oil pricing, but futures contracts are the ones that truly set prices. As their name implies, futures contracts anticipate what prices will be in the future. Investors and speculators buy these contracts on major commodity exchanges, and spot traders use them as their main references as they negotiate prices. Traders have developed many strategies using futures contracts. They are commonly used for financial speculation, but they also have practical business uses. Refiners can use them to secure the price they will pay for oil at certain points in the future, for example.

To create futures markets, exchanges had to settle on particular kinds of oil to serve as benchmarks. The price of a barrel is highly dependent on both its grade (which is determined by factors such as its specific gravity and its sulfur content) and its point of delivery. In North America, the benchmark price on the New York Mercantile Exchange (NYMEX) is West Texas intermediate oil (WTI), delivered at Cushing, Oklahoma.

There are other benchmark crude oil contracts. Of these, the most important is Brent light, delivered at a port in the north of Scotland. Traded on the International Commodity Exchange in London, this oil contract essentially determines the price of oil in Europe and Africa. Oman oil, which is traded in Dubai, helps determine the cost of oil in the Middle East.

The US government’s Energy Information Administration uses an entirely different approach to oil price calculations. It calculates the weighted average cost of oil imports (including oil from its biggest supplier, Canada) to determine the world oil price for the United States. Known as the Imported Refiner Acquisition Cost index, this is a lagging indicator. Instead of giving information about what prices are or will be, it describes what they have been.

Edmonton Par: Although Canada is a large and growing oil producer, we are a price taker rather than a price maker. Canadian prices are established by reference to the benchmarks of New York, especially, and of London. Those benchmarks are the price makers.

The “real” price of oil is its spot price – the amount a buyer will pay for oil for real, immediate delivery. One important Canadian pricing standard is Edmonton light oil. How prices for that oil are established illustrates spot pricing in action.

Initially, the price for Edmonton light is set by the companies – Imperial Oil, Petro-Canada, Shell and Suncor – with facilities at Refinery Row, near Alberta’s capital city. Each morning they post the price they will pay for Edmonton light. Those prices closely track the most recent closing price for NYMEX futures contracts. The daily average of the prices offered by those four refiners is known as Edmonton Par, and it is the standard used for calculating oil prices in Western Canada.

Foreign buyers (mostly located in Chicago) negotiate deals that take into account Edmonton Par, the futures price in New York, the spot price in Edmonton, the date the oil will be delivered, the difference in quality between Canadian light and WTI, the cost of transportation and the availability of competing supplies. As with other efficient markets, the price of Canadian oil reflects a balance of the needs and intelligence of many buyers and sellers.

Canada’s Split Personality: Global markets have had quite a big impact on the distribution of oil within Canada and across North America. In particular, they have helped determine which parts of North America use Canadian oil, and which use oil from the US and overseas.

Refiners avoid the high transportation charges required to pipeline oil from Alberta to Toronto and points east. Instead, they buy oil from offshore Newfoundland or from international markets. That oil is delivered to ports in eastern Canada or to a pipeline terminal at the ice-free harbour in Portland, Maine. From those delivery points the oil is piped to major refining centres in Come-by-Chance, Nfld.; Saint John, NB; Montréal and St. Romauld, PQ; and Nanticoke, Ont.; and to smaller eastern refineries.

Oil from western Canada is another story. It is highly competitive from Vancouver to Sarnia, and in parts of the US West and Midwest. Many refiners in those areas have developed equipment designed to refine specific kinds of oil from Canadian producers. That specialized equipment is one part of the industrial infrastructure that has created secure markets for Canadian oil. Another is North America’s complex network of interconnected pipelines, which make delivery relatively easy.

In practice, Canada has a split personality in the matter of oil imports and exports, and this is mostly a function of our planet’s market pricing for oil. We are the seventh largest exporter of oil in the world, but also the seventh largest importer. In 2006, each day Canada exported 1,784,000 barrels of crude oil, mostly from the west. At the same time, however, we imported 849,000 per day into the east. Canada was thus a net exporter of 935,000 barrels of oil per day.
Because a great deal of our oil production is lower-quality heavy oil, in 2006 Canadian production on the whole sold for less than the $66 per barrel fetched by West Texas Intermediate. However, those net exports added more than $55 million per day to our trade balance with the world.

The creation of a sophisticated global marketplace for crude oil coincided closely with the years in which Canada joined the big leagues of global oil producers and exporters. As we have seen, market pricing now suffuses the sector, and it has helped put the industry into its present form. An example is Canada’s decision to import oil for its eastern refineries while exporting oil from the west. In this instance and many others, efficient markets have helped create a cost-efficient industry.

Why are Canadians the World's Energy Pigs?

Want to know more about this pig? Click here!

By Peter McKenzie-Brown

Canada is rich, big and cold, and we share two borders with the United States. Those factors explain why we are the world’s energy pigs, but they do not justify it.

Only the United States comes close to our per capita annual energy consumption - more than 8,300 kilograms of crude oil equivalent for every Canuck. If that crude oil equivalent were bottled water exported from France, at 2.2 litres per day it would take you ten years to drink it all. However, you would be well hydrated throughout.

Lots of American energy consumption comes from nuclear-fuelled electricity, while Canada’s nuclear industry is proportionately much smaller. That means we are more dependent on non-renewable hydrocarbons than our neighbours to the south. So stand proud, Canada: The true north, strong and free, is number one in energy consumption and waste.

Rich: Unless you are living in Caracas, where subsidized gasoline sells for three cents per litre, you have noticed that gasoline prices are skyrocketing. This concerns us all. Indeed, three quarters of Canadians worry that they will be personally affected by a gasoline shortage in the next five years, but their actions do not seem to match their anguish. Last year, for example, 43 per cent of Canadians reported increasing their consumption of gasoline during the previous three years, compared to 21 per cent who reported lowering it. Yet during that three-year period, prices nearly doubled.

This partly reflects the economic good times of recent years. Many Canadians have seen their personal wealth (think house prices) grow greatly. For many, this has made gasoline price increases – a small part of most household budgets – seem less significant than they would in a recession, say.

The relative insignificance of fuel pricing today is one of the main reasons we are less likely to change our driving habits than we did during the last great run-up in gasoline prices - between 1975 and 1980. We have become addicted to gasoline, and that addiction is growing. The fact that we aren’t responsive to higher prices is contributing to the world's energy problems.

Big and cold: Why do Canadians use a lot of energy? For one thing, we live in a large country with a cold climate. We need a lot of gas and heating oil for our homes, to power our economy and to drive long distances. Winter affects us in not-so-obvious ways. In the winter cold, the fuel efficiency of our vehicles drops. Also, of course, most of us would rather drive than stand at the bus stop in a blizzard, so we avoid the cold by getting in the car.

Our driving habits and driving conditions are often fuel-inefficient. Many of us drive big vehicles, including SUVs and trucks, and we own more of them than in the past; the two-car family is the norm. Some of us drive at high speeds. Many of us carry extra weight (golf clubs) in the trunk. And city roads are more likely to be gridlocked during rush hour. All of this wastes fuel.

In addition, we have an increasing dependency on cars. Our vehicles are more fuel-efficient than in the past, but suburban development has created greater distances between home and the places where we work and play. Walking and cycling to work are less likely to be serious options for us than in the past. Suburbs often don’t have easy access to public transit, and the situation is worse in rural areas. So we drive. Nation-wide, only about one adult Canadian in four walks, cycles or takes public transit to work or school. Sixty-one percent of us drive our cars every day.

America’s neighbour: Most Canadians believe we do some things better than the Americans. In particular, we think we have created a more civil society.

Illogically, from that starting point we seem to believe we also do better in the matter of energy consumption and management. However, it just ain’t so. Among the nations of the world, Canada has the greatest appetite for hydrocarbon energy - you know, the types of energy that are getting scarcer and cannot be renewed. Oh, yeah: global warming.

In response to the energy crises of the 1970s, Western Europe kept its per capita consumption in check. (See small chart.) So did Japan and Korea, after they became fully developed economies.

For their part, the North Americans were quite a different story. Like the Eveready bunny, our demands for ever more energy have kept going and going and going.













In the United States, Americans have shown wizening aversion to high energy taxes. That isn't surprising. Let’s not forget how much the American economy's 20th century growth was fuelled by its vast energy wealth. Today, of course, energy imports have instead become a major drain on US wealth.

Also, there are big differences in distribution of wealth between the US and Canada. In Canada aboriginal reserves are a serious problem, but there are few pockets of deep poverty in our inner cities. On average, in this country everyone who needs a vehicle can afford one. That is less true in the US.

America's relative wealth gives it greater flexibility in energy. Rather counter-intuitively, the rich can cut their gas consumption more easily than the poor when prices rise. Imagine the schmuck with an old beater – his only car. Compare him to the rich guy who owns a truck, an SUV, a Ferrari and a Toyota sedan. When prices go up, the rich guy drives his Toyota more, saving fuel. The poor guy still drives his un-tuned rattletrap. It’s easier for the rich (read Americans) to save fuel than Canadians. That's reality.

Whatever the reason, successive US governments refused to impose high taxes on fuel in the way most other OECD countries did.

Compare the growth rate for hydrocarbon consumption in Canada (chart just above) to that in America (chart way above). Population growth was slightly higher in Canada than in the US.

The Canadian disadvantage: Neither did Canada, arguing that increasing energy costs would put the country's industries (many of them energy-intensive, resource extraction operations) at a disadvantage compared to those of its biggest trading partner and competitor. The result? The world’s energy pig got bigger and consumed, in relative terms, more and more non-renewable energy. And it did so as the world made striking advances in energy-efficient technologies, processes and procedures.

Canadian costs and taxes are higher than in the US, but still low relative to Europe. Gasoline in Norway, the Netherlands, Britain and France is more than $6 per US gallon - about twice what we pay in Canada. By comparison, our gasoline prices are cheap.

It's Canada's good luck to have the oilsands. They will be supplying the world's energy markets a hundred years from now. We have other world-class resources - natural resources, of course, but also people and social systems.

As a society, we have done many things right. Our schools are rated among the best in the world. We have relatively little crime and a social safety net for the poor and dispossessed. We welcome refugees, and we take pride in our social, cultural and linguistic diversity. We have universal health care and gun control.

Much of our energy consumption goes into mining, forestry and other resource extraction industries. Also, it takes a lot of energy to manufacture light oil from the oilsands and to produce refined products for export to the States.

Even so, the disproportionately increasing demand for energy in this country is nothing to be proud of. It is a national disgrace.

Where is Alberta? Why Should You Care?

A barrel of crude oil supplies more than energy. It is also a building block for petrochemicals and other goods.

By Peter McKenzie-Brown

Can it really be true that - oil at $90 per barrel notwithstanding - the Canadian petroleum industry is facing an economic downturn?

It is true, and you should care. Traditionally ignorant about Canada, Americans in particular should understand the implications of the critical economic issues now roiling the sector here.

Canada is by far the largest source of imported oil for America, and one of the few large oil producers with the potential to increase production well into the future. The US Energy Information Administration has identified Canadian reserves as being second only to those of Saudi Arabia. So if you worry about peak oil and the world’s energy future, you would be foolish to ignore the geopolitics and energy economics that are racking Canada today.

Canada's petroleum industry is facing a perfect storm. Five main factors are at play. First, the Canadian dollar is at its highest level against the US dollar in 30 years. Second, the natural gas industry is in the tank. Third, environmental issues are getting critical. Fourth, industrial inflation is rocketing out of sight. And finally, governments have become greedy - very greedy.

Together, these developments augur ill for oil supply. Let’s look at them, one at a time.

1. Exchange Rates: In 2001, the Canadian dollar's value was just over 60 cents per US dollar, and Fortune magazine famously dubbed our loonie the "northern peso". Today it is worth $1.04 US. During that period, oil (priced in US dollars) has tripled in value.

These parallel movements have had some curious effects. Oil prices for Americans have more than tripled, based on nominal (US dollar) prices. In Canadian dollar terms, however, they have "only" doubled. That's a big increase, of course, but it's more modest than in the rest of the world.

Consumers have been hit much harder in the United States than in Canada - that's on the one hand. On the other, American oil companies have benefitted far more from oil price increases than those in Canada. And since Canadian oil companies have profited much less, they have less capital for exploration and development than you might expect.

Put another way, foreign exchange movements have made crude oil less profitable to develop and produce. The industry thus has less incentive to develop it.

2. The Natural Gas Sector: Forecasters now commonly suggest that western Canada's conventional gas production has peaked and will continue to decline.

The reasons are complex, but part of the reality is that Canadian producers can’t sell their gas at the prices American producers command. The $7 futures contract for gas on the NYMEX is not reality in Canada. In Western Canada, our producers get $5 per thousand cubic feet for their gas, while the cost of finding and developing the stuff is in the $7-$9 range. Once again, this means less capital for investment in domestic reserves.

And yet, as this article discusses below, that sector has just been hit with higher royalties. That's just what you need when new production is marginally profitable at best.

3. The Environment: Global concern about climate change is leading to higher taxes on crude oil, most of it imposed at the retail level. In Canada, this includes transit taxes in the cities of Vancouver and Montreal, and – effective this month – a carbon tax in Québec.

Retail taxes are not a concern for the oil producers, except to the extent they are inflationary. However, tough environmental rules in the upstream are creating a lot of problems. They increase costs and they delay project development.

No one disagrees with the importance of good environmental regulation, but good regulation does not come cheap. It costs both time and money. Environmental regulation is adding to inflation and delaying the onset of oil production that is increasingly critical.

4. The Boom: The general boom in Alberta is also contributing to oil patch inflation. The province hosts most of Canada’s petroleum production, and is the North American jurisdiction with the lowest unemployment rate.

In this province the petroleum sector faces rapidly escalating costs in almost every area. Office space in Calgary, the industry’s geographic centre, has quintupled in five years. Labour for oil sands development is astronomical. Productivity is declining.

How can there be an economic boom when the basic economics of conventional oil and gas production are in decline? The main reason is that conventional reserves, which were drilled in an era of lower costs, are now getting produced and sold as quickly and profitably as possible. High prices for oil are accelerating the resource’s depletion.

Costs for drilling and mineral rights have declined in the last year, but that is hardly cause for celebration. It has happened because the industry is less inclined to drill. From an all-time high of almost 25,000 wells in 2005, drilling has dropped precipitously. Estimated drilling this year will total only 17,650 wells this year and a mere 14,500 wells next. Most of the drop is in the area of natural gas drilling, but it is still something to worry about. If you don’t drill, you don’t find oil or gas.

5. Government Greed: The final piece of this puzzle is the matter of royalties and taxes. In Canada, oil and gas resources are mostly owned by government, and governments get revenue from producers in a variety of ways – primarily economic rent (royalties), sales of mineral rights, and a variety of taxes. In response to voters who are convinced high oil prices mean high profits for oil producers, Canadian governments are finding ways to increase their take from the sector. This is their right and privilege, of course. However, the more the industry has to pay, the less oil it is going to produce.

Today, things took a decidedly ugly turn for the petroleum industry in Alberta, the province that produces more than 90 per cent of Canada's oil. The province has no debt, has no sales tax and yet runs a huge fiscal surplus. This year alone the province projected the surplus to be $2.2 billion, based on lower oil price assumptions.

Its great wealth notwithstanding, this afternoon the provincial government announced a much-dreaded new royalty framework that will boost royalties by $1.4 billion per year (20 per cent) in 2010. The new rates, which will increase maximum royalties from current highs of 35 per cent to 50 per cent for conventional oil and natural gas, won't take effect until 2009.

In the critical area of a regime for oil sands development, the system also changed. The current royalty is 1 per cent per year on gross revenue until a project recovers its multi-billion dollar investment. The royalty then rises to 25 per cent of revenue minus operating and other costs. Under the new regime there will be a sliding tax which starts increasing at $55 a barrel. Assuming current prices, oil sands royalties will be about 5 per cent before payout and 33 per cent thereafter. The maximum rate will be 40 per cent.

Outcome: The chart projects Canadian oil production based on the first of these two royalty regimes - the one that has so successfully encouraged development in the past. Rest assured that, under the new arrangement, future oil production from both conventional and oil sands resources will be less than the volumes projected.

In a world anticipating peak oil, making oil production less profitable is a serious matter - and, by definition, the new fiscal regime will make oil and gas production less profitable in Alberta. Love ‘em or hate ‘em, oil companies are governed by the rules of capitalism. They put their money where it will generate the best return.

Canada, which has a strategically vital place in the world petroleum industry, is the world's seventh largest oil exporter, but also the seventh largest importer. In most of eastern Canada, the refining side of our industry is happily importing oil from overseas. Because they pay for it with our strong currency, it costs less. This is great for Canadian consumers.

When you have a strong currency, you have more options. Canadian producers will increasingly invest in production from riskier but lower-cost and therefore more profitable exploration provinces overseas. (One great under-explored region, for example, is Southeast Asia.) But they will do so at the expense of secure investment in Canada, including development of the vast oil sands deposits.

We should worry about this, and worry a lot.

Technical Analysis - Stratabound Minerals Corp.

This seven-year chart suggests some trends in stock performance. The blue line is rising resistance, which has recently been breached (a bullish signal). The red and green lines suggest a trading channel, formed over the last 18 months. For a current view of this chart, please click here.

Much of the excitement seems to be related to speculation about the Captain exploration project. Here is a photo of core from hole #1, a copper-gold play: For more photos, click here.

Post updated September 23, 2007.

Although the writer is a director and officer of Stratabound, the thoughts and views herein are mine only and not those of Stratabound. I am not registered in any jurisdiction as a broker or investment adviser, so nothing herein should be construed as advice on whether to buy, sell or hold shares of Stratabound or any other company mentioned herein.