Heavy Oil for Tomorrow

An illustration of the SAGD process; source: Value Creation Group of Companies.

Conventional production benefits from technology innovation; this article appears in the 2011 Heavy Oil and Oilsands Guidebook

By Peter McKenzie-Brown

The notion that since conventional oil production has peaked and the world will soon face a crisis of inadequate supply has a lot of true believers, but they seem to be in short supply in the heavy oil sector.

According to Cenovus vice president Dave Goldie, “Technology is opening up new frontiers for oil production – not just in heavy oil and oilsands, but also in light oil. Given everyone’s ingenuity, we are finding ways to access more oil.” The numbers seem to back him up: there are major heavy oil deposits on every continent, and global heavy oil and oilsands deposits embrace more than five trillion barrels in situ – at least potentially, enough supply to meet market demand for a long time yet to come.

At least two technologies developed in Canada that have become familiar in the oilsands sector are being deployed in conventional heavy oil to expand production and increase recovery rates.

Steam Assisted Gravity Drainage
The late Dr. Roger Butler’s steam assisted gravity drainage (SAGD) originated as a procedure for producing bitumen from the oilsands, and the technology has a huge impact on oilsands production. Recently, it has begun to change production economics at some conventional heavy oil reservoirs – notably Baytex Corp.’s Kerrobert project, Husky’s Pikes Peak operation and Senlac in Saskatchewan, owned by Southern Pacific Resources.

Baytex purchased its project from True Energy (now Bellatrix Exploration) in 2009. At present, Baytex Kerrobert produces 2,000 barrels per day, and those volumes are increasing. “We placed a new SAGD well pair on production late in the third quarter of 2010,” says Baytex spokesman Brian Ector. “Subsequent to the end of the quarter, this well pair produced at a 30-day average rate of approximately 1,000 barrels per day. We believe that, through the remaining life of this project, we can drill 11 additional SAGD well pairs. For 2011, we will likely drill two new pairs on the property.”

For Southern Pacific, the Senlac property in many ways was a company maker. The company acquired it from Cenovus for $90 million, and it enabled the company to move to the Toronto Stock Exchange by providing cash flow. “As soon as we had that we were a going concern,” according to company president Byron Lutes. “It enabled us to advance (from Venture) to the TSX. That means more due diligence, but a lot more investors now will put their money into the company.”

Since acquiring the property last spring, Southern Pacific has begun to face the reality of having to develop the property. The company has done some infill drilling, and at the end of last year drilled a SAGD well pair. The previous well pair produced about 1,300 to 1,500 barrels per day, according to Lutes. “From a rate perspective, (the new pair) won’t do better than our other wells (even though they include 650-metre horizontal wellbores) because we are not going to put on bigger pumps. However, we expect better recovery over the life of the well than if the well pairs had a smaller horizontal section.”

Southern Pacific is planning to spend about $10 million a year on the project. That will tie in one SAGD pair a year and will keep field production in the 4,000-5,000-barrel per day range, although he is optimistic that production will occasionally oscillate above 5000 barrels per day. “We estimate that this project will continue to produce at those levels for 10 to 15 years” he adds, and he is extremely optimistic about field economics. “The oil quality is better (12° API) than Athabasca (8° to 9° API), so the steam/oil ratios are typically lower and it takes less diluent to bring your oil up to spec. We will get a $39 per barrel netback on $77 per barrel WTI.”

Netback notwithstanding, Lutes pauses to brag about a recent field acquisition. “We were planning to replace a boiler this year, and the guys found it on Kijiji of all places. It was the exact boiler we needed, unused. It needed a few parts, but we bought it for about $90,000. When you factor in installation we saved ourselves maybe $700,000.”

Toe to Heel Air Injection
If Southern Pacific is a junior producer on the rise, PetroBank is one with global growth aspirations. The company’s THAI production technology involves using a vertical injector to feed air into a horizontal producer to keep underground ignition going. “There’s nothing magic about it,” according to company spokesman David McLellan, although the system has the potential to transform production from heavy oil deposits around the world.

PetroBank is developing its first commercial application of this process in Kerrobert, Saskatchewan. “We’ve had two wells on production there since November 2009, and this year we’re expanding to a 12-well total” says McClellan. “We’ve done the reservoir simulations and modelling and we feel as though each well will be capable of producing about 600 barrels per day. When you go through the pre-ignition cycle you’re trying to establish communication between the injector well and the producing wells. We think it will take 12 to 15 months to get up to full production.”

If the company’s calculations are right, when the project is up and running Kerrobert will be a 7,200 barrel per day facility. “What is really interesting about this project is that existing cold flow production is in the single-digit range – six, seven, maybe ten barrels per day per well.” With that kind of production the recovery factor for the pools would be only 4-7%. On the other hand, “with the THAI system we can recover between 70 to 80% (of oil in place). Five years ago, this was just theoretic. Today we have corroborated that we can do all this.”

McClellan says the Kerrobert project will produce an additional 7,200 barrels per day for capital cost of only $75 million. “That’s capex of only $10,400 per flowing barrel. Even if we got only half the production that we anticipate from those wells that would be a pretty good investment.”

Of particular interest to the company and its licensees is that the THAI process actually upgrades the oil underground, creating an oil with lower viscosity which therefore needs less diluent when it’s pumped into the pipeline. “It’s the heat that does this,” according to McClellan. The process takes 11° API heavy oil that underground and alters it to about 16°. “It is the heat that does this. The system cokes the oil underground, burning the heaviest asphaltines in the reservoir as fuel. The lighter stuff that’s mobilized out in front of ignition drains out into our production wells.”

He adds, “We have every conviction that this is going to be a game changer in heavy oil recovery. Once we have completely proven this technology, then the world will start to change.” Polymer Flooding

Polymer Flooding
Southern Pacific and PetroBank are medium-sized companies. Cenovus and Canadian Natural Resources aren’t. Respectively Canada’s third-largest and largest conventional heavy oil producers, each company has assets at Pelican Lake which exemplify how large producing properties are being used as laboratories. Experimentation in heavy oil production in this area receives important incentives from the province, which has designated it an oilsands production area. This means for royalty purposes the company equalizes production across all wells.

Cenovus initially began producing conventional heavy at Pelican Lake in 1997 from a series of horizontal wells; the field now produces about 24,000 barrels per day. According to Dave Goldie, who has executive responsibility for his company’s Pelican Lake assets, “The main method we’re using right now is polymer flood” – a technique partially pioneered by the Alberta Research Council, and which found one of his first commercial applications at Pelican Lake.

“The injection of polymers creates a more powerful piston effect, and it enables us to better push the oil out of the reservoir,” says Goldie. “Polymer is a pretty benign petrochemical – one of its uses is for disposable baby diapers. It turns water into a thick, viscous fluid which is great for heavy oil production. Over half our wells here at Pelican Lake are now based on polymer flood. We’ve applied this to over 170 wells.” Eventually, the entire field will use polymer flood.

It takes a while for the field to respond to the polymer. “After a period of time you see an increase in production which is associated with this extra push from the polymer flood.” Originally developed as a cold waterflood using horizontal wells, Pelican Lake’s original infrastructure included wells 200 metres apart. With that kind of spacing “it takes up to two years before you see a response. Now we’re infilling those patterns, and that’s increasing production rates. We’re constantly looking at new formulations of the polymer, adapting the well spacings to increase production. With cold waterflood we can get maybe a 12% recovery factor, but with polymer flooding we can more than double that. We keep on experimenting and it’s getting better.”

While polymer flood is the workhorse at the Pelican Lake project, Cenovus is testing a lot of other ideas on the property. According to field superintendent Gary Tebb, “Greater Pelican assets include the Pelican Lake project, which produces from the Wabiskaw. We’re also doing collaborative work with our Ventures team in the Grand Rapids (formation). We have an experimental project to access what we call the immobile Wabiskaw – an area where the oil is extremely viscous. We are also doing some work in the Grosmont zone, which is bitumen carbonate, and one part of the property we are experimenting with polymers plus surf it's actants.”

Dave Goldie clarifies that the Grand Rapids project will involve “in situ combustion using natural gas from a gas cap over the field in another formation. We have a patent pending on that particular scheme,” he adds. “Other companies are doing similar things; there’s a lot of experimentation going on. In these reservoirs different things work in different places.”

Canadian Natural Resources has a similar project at Pelican Lake/Britnell, where the company estimates original oil in place at 4.1 billion barrels. Like the Cenovus project, CNRL began with primary production, shifted to waterflood and, in 2005, to polymer flood. Now producing 38,000 barrels per day, the company expects project production to peak in 2015. It should plateau at more than 80,000 barrels per day – an amount equal to today’s total production from the company’s 10 largest conventional heavy oil projects along the Alberta/Saskatchewan border.

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.”

Q&A with Marcel Coutu

Syncrude's Chairman of the Board delves into operations, the environment and the demise of oil around the world. This article appears in the July 2008 issue of Oilsands Review.

By Peter McKenzie-Brown
Canadian Oil Sands Trust owns the biggest single share of Syncrude (37%), and the firm’s CEO is also Syncrude’s chairman. Oilsands Review asked Marcel Coutu about operating and environmental issues at the oil sands giant. His edited comments follow.

OSR: Developing new technology has been part of the business from the beginning. To what extent is that still the case?

MC: The first few years of this business were about survival, because oil prices were low and costs were high. When oil prices were low and margins were thin the driver for this business was always lowering costs. That really hasn’t changed much. Both Syncrude and especially Suncor have been major developers of new technology. Suncor, for example, developed hydro transport – technology that enabled us to move oil sands ore by pipeline rather than truck. So all of a sudden we were operating satellite facilities, without having to truck ore to the processing site. That was a major innovation. The tailings ponds are a major challenge area. It’s an important functioning part of our operations, and enables us to recycle our water. It’s a major challenge. We need to find ways to separate clay from the water more rapidly. This will help us reclaim land better.

OSR: Oilsands inflation has been high in recent years. How has that affected you?

MC: The one inflation component that has dwarfed all the others is the price of natural gas, which has moved up in parallel with the price of oil. We buy eight-tenths of an MCF of natural gas for every barrel of light sweet product we produce. The rest of our costs are increasing by low double-digit to high single-digit numbers, and over the years those costs add up. Fortunately, oil prices have more than offset operating-cost inflation.

OSR: How much energy do you consume for every barrel of oil you produce?

MC: About 1.5 gigajoules (1.5 MCF of natural gas equivalent) per barrel. That’s higher than 0.8 MCF, the number I mentioned earlier; that refers to purchased energy. The total energy we consume in our operations includes energy we generate as a by-product to our upgrading processes. It is largely electrical energy, in which we are more than self-sufficient. We produce a lot of waste gas from our processes, and use that to fire gas turbines. We also have a lot of waste heat from our operations, and we raise steam with that heat and put that steam into steam turbines. This makes our operations more efficient. Beyond that we arbitrage against the price of electrical power around the clock, sometimes selling electricity into the Alberta grid, sometimes buying it, depending on how those conditions align. We arbitrage those markets in both directions. We do the same with natural gas. It’s one of the businesses we do to make ourselves as energy efficient as possible.

OSR: How are you managing carbon dioxide emissions?

MC: We’ve been reducing them from the time we opened the plant gate. Carbon dioxide emissions are all about energy consumption – they are exactly the same thing; reciprocals, if you will. You only create CO2 emissions by burning fuels. We have always been incentivized to keep our energy consumption as low as we can, and lowering consumption means lowering CO2 emissions. We have always been focused on reducing CO2 emissions because they represent a direct cost to us.

OSR: You are a member of ICON, the Integrated CO2 Network. Any thoughts on carbon sequestration?

MC: The plants at Fort McMurray are the largest collectible source of CO2, but it is an expensive proposition. You have three levels of major expenditure there. You could sequester a lot of CO2, but I’ve seen numbers that you are actually generating more CO2 than you are sequestering by going through this process. First you have to construct equipment to extract the CO2, then build a pipeline, then pump the carbon dioxide into the saline aquifers, salt domes, old reservoirs or whatever you use to host the stuff.

OSR: The notion that crude oil supply is about to peak or has peaked is gaining a lot of currency. What do you think?

MC: Natural gas is in vast supply around the world but oil is not. Crude oil production in most of the producing countries in the world is in decline. All OPEC can now do is raise prices by cutting production. They cannot lower prices by increasing production because they don’t have the capacity. We are in a very pure free market situation, with prices being set by supply and demand. When I look at that dynamic, I have stopped worrying about the demand side. No matter how much the US goes into recession, for any period that is important to any of us, any decline in consumption there will be offset by increased demand elsewhere – in China and India, but also in developing countries that produce their own crude oil. Those countries generally subsidize oil products, and subsidies accelerate demand growth. At these prices you are seeing some conservation somewhere, but it is being more than offset by increased demand somewhere else. Whether people are still going to be buying at $200 a barrel I don't know, but by the time we get to $200 it will be the supply side that will keep things tight and moving upward.

OSR: How serious a problem is maintaining global production?

MC: Very. World oil production is generally in decline. You can assume that out of global production of 87 million a day, productivity will come off by 5-10 percent every year, so you have to replace that production each year before you can even begin to satisfy global demand growth. So what we are seeing is the demise of the commodity, since we are never really going to be able to meet the demand. Prices will be volatile, but the trend in my view is that prices will continue to climb. The demand will be fully there regardless of anything that happens to the US economy. The decline is real and cannot be arrested, at least not in the short term. One hundred and fifty dollar oil is within striking distance.

OSR: What is the role of the oil sands in this environment?

MC: Oil sands production is close to a million barrels a day, a little more than 1 per cent of global production. It’s going to take a huge amount of effort, capital and time, maybe ten years, to double Canadian oil sands production. It’s true that the Canadian resource is huge, but accessibility is long and slow. Our impact will be very slow. One thing we need to bear in mind is that the size of our resource goes up with the price of oil; the higher world oil prices grow the greater our resources become. We have re-evaluated Syncrude’s leases, and that re-evaluation has taken us way up from 9 billion barrels, which was our traditional resource base. That’s good for Canada and Alberta and the rest of it.

OSR: How are you dealing with the labour shortages around Fort McMurray?

MC: To answer that, you have to think of labour as being in two buckets. The people in the operational bucket are there for the duration. They have great careers, pension plans and so on. Everyone puts their shoulder to the wheel, and we get the job done. We lose some people, but the situation is manageable. Then there is the contract bucket – construction workers, pipefitters and so on, who are mostly there to work on expansions. They are there on a temporary basis and they are hard to hold onto. They are the challenging part of the work force. The labour problems we face are focused in that area.

OSR: Having waterfowl fly into the tailings pond brought international attention to Syncrude. Do you want to comment on it?

MC: We’ve extended apologies to everybody. It was really a heartbreaking incident for us. Why did it happen? Because we didn’t have our equipment deployed before the ice thawed. It’s something we have been managing for decades with success, but we got caught by the weather. We didn’t have our deterrents in place.

OSR: What are some of the other environmental issues you face?

MC: In general, our environmental story has been glowing. Where we have done a poor job has been in telling the world about it. I’d like to comment in three areas – water, air and land. Let’s start with water. At Syncrude we consume two tenths of 1 percent of the water from the Athabasca River for our operations. We recycle as much as we can. If you extrapolate from that, the whole oil sands industry consumes less than 1% of the Athabasca’s flow. Air is a more serious issue. We reduce our CO2 emissions because it makes economic sense, as I said earlier. But there are nastier things that we have been managing for years and they cost us a lot of money, and the nastiest of them all is sulphur dioxide. Our SO2 emissions peaked at 250 tonnes per day when we were producing around 250,000 barrels a day. In our last expansion we moved from 250,000 barrel per day to 350,000 barrels per day, and we invested about $1 billion in SO2 scrubbing equipment. We not only stopped the growth of SO2 emissions but reduced them slightly from our peak levels. Now we are spending another billion dollars to reduce those emissions to about 150 tonnes per day. On the land side, in March we were the first company in the whole industry to get certification for land reclamation. We have returned that property to the province. It’s really impressive. You would never know there had been a mine there.

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.

Colin Campbell and the Cracks of Doom

By Peter McKenzie-Brown
For many peak oil believers, this is the scariest chart you can imagine. The blue lines show historical oil discoveries. The gold lines project discoveries into the future. The line that looks like a rising serpent shows annual production up to about 2005. The chart was created by peak oil guru Colin Campbell in 2004 for a deliciously ironic article titled "The Heart of the Matter". The chart looks like a road map to the Cracks of Doom, and it has been quite influential.

In this column I have frequently provided arguments in favour of peak oil theory, and I am an unabashed admirer of Campbell and his work. However, I believe this chart, though directionally accurate, is simplistic and alarmist. It needs to be nuanced. We can do that in three ways.

• First, note that the blue lines essentially track the world’s new-field discoveries of light and medium oil. The chart suggests that these volumes are the world’s oil reserves. It doesn’t nearly reflect the reserves additions that come through infill drilling, enhanced oil recovery and other standard oilfield practices. By applying simple math to the chart (subtracting production from discoveries), you will come up with world oil reserves far short of the roughly 1.2 trillion barrels that the Energy Information Agency and other authorities have booked.

As they are developed, most discoveries prove to be much bigger than the estimates at time of discovery. This is partly because reserves are a function of economics. When you find a new field you calculate its reserves based on present conditions and price forecasts – say, in 1970, $2.50 per barrel into the foreseeable future. As prices rise relative to costs, you will get more oil out of that field – of that you can be sure.

The thinking by which M. King Hubbert forecast the year of peak oil production in the United States was incredibly successful. What is rarely discussed, though, is that Hubbert underestimated by about 50 per cent the amount of oil that would be available in the US after it reached the peak. To a large extent this was because new reserves became available through changing technologies and more favourable petroleum economics.

• Second, give heavy oil, bitumen and oil shale the credit they deserve. Because of the nature of the beast, these unconventional resources are not booked as reserves until they become economically and technically producible.

Alberta’s huge oil sands are a classic example. In 2005 America’s Energy Information Agency booked Canadian oil reserves as second in the world (after Saudi Arabia) because of the impact of higher prices and improved technologies on the oil sands. If that amount of oil – 174 billion barrels (174 gigabarrels) – were added to the gold-coloured reserves lines on Campbell’s chart, it would require a line that would tower over the rest of the chart by a factor of three. Campbell’s methodology does not account for this kind of event. And in all likelihood, much more of the oilsands will eventually be booked as reserves.

That point takes me to this chart (click to enlarge), which is also from Campbell’s article. The black wedge – characterized as “Heavy, etc.” in the legend – is his estimate of the contribution of heavy oil to the global energy liquids picture. Eyeballing suggests that he expected these unconventional resources to be about 4.5 million barrels per day by now, world-wide.

Heavy oil, synthetic oil and non-upgraded bitumen represent about two million barrels of production per day in Canada alone, and Venezuela and Mexico are also big producers. What’s more, Canada’s oil industry is working hard to develop export markets for heavy oil, because there is a great deal more production yet to develop. Indeed, Canadian producers are selling their heavy oil at a discount because they cannot get it to world markets.

According to one excellent and credible report, seven years from now Alberta alone will be producing about three million barrels per day of “Heavy, etc.” That estimate risks production for economic and environmental obstacles, so it is probably low.

• Third – and this is my main point – let’s acknowledge that the serpent-like production line in Campbell’s chart, while it is not a happy sign, is not the spectre of doom it appears. The world’s unconventional resources will greatly blunt the blow – relative to the steep declines described in Campbell’s chart, in any event.

One amazing feature of the oil sands is their incredible energy density. Imperial Oil’s Cold Lake bitumen plant, for example, is a tiny dot on the map of Alberta, yet it produces 6 per cent of Canada’s oil. The resource density of these unconventional resources is immense, and that density is what makes it such an important resource. The world is heading toward capital-intensive, technology-intensive, pollution-intensive and energy-intensive energy - bitumen from Cold Lake, for example.

The greater the capital intensity, though, the lower the geopolitical risk must be. Keep that in mind when you consider development prospects for Venezuela’s Orinoco heavy oil belt, which is so huge it rivals the resources of Canada. The geopolitical risks in that country are enormous, so the likelihood is small that new Venezuelan supplies will soon hit world markets.

Strongman Hugo Chavez is increasingly unpopular in his own country, however, and the economy is in disarray. Oil production is in decline even though the the country has the largest conventional reserves in this hemisphere. Given that situation, it is possible to imagine a post-Chavez Venezuela which will develop those resources and become a resurgent supplier to the world. If that happened, it would lead to another super spike in booked reserves.

I share the view that a global Hubbert’s peak is nigh. The world is facing serious energy supply problems, and they are related to peak oil. To too great a degree, however, the discussion has failed to recognize the immensity and importance of the world’s unconventional sources of oil. Those vital resources will radically change the shape of the chart as they are plotted into it.

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.

The Ultimate Dilemma for Oil-Dominated Economies

By Peter McKenzie-Brown

Energy security, always a critical mission for any nation, will steadily acquire greater urgency and priority. As it does, international tensions and the risk of conflict will rise, and these growing threats will make it increasingly difficult for governments to focus on longer-term challenges, such as climate or alternative fuels – challenges that are in themselves critical to energy security yet which, paradoxically, will be seen as distractions from the campaign to keep the energy flowing. This is the ultimate dilemma of energy security in the modern energy system. The more obvious it becomes that an oil dominated energy economy is inherently insecure, the harder it becomes to move on to something else.

I am a big fan of Paul Roberts, whose book The End of Oil: On the Edge of a Perilous New World (from which I copied this passage) is one of the best tomes available about the current energy situation. The book was published in 2004, though. Although Roberts accurately spotted the major trends and concisely explained the issues, the period in which he did his research and writing was one of high optimism compared to the situation today. Sometimes he seems almost naïve. The big word today is recession, with fears around the world that the US may already be there, and that Europe and Japan will soon follow. Perhaps the ballyhooed “disconnect” between growth in the developing world and that in the west is nonsense, goes the thinking: growth in China, India and other rapidly developing countries actually will respond to a slowdown in the West. Those fears have raised concerns in the oil markets: Will demand for the commodity decline so much during the recession that surpluses will wash around the world, driving prices down? Fearing a crash in demand, the price of West Texas Intermediate briefly dropped to its lowest level in three months at the end of January. Then, as I suggested elsewhere, reality began to intrude: OPEC doesn’t have a lot more oil (in the sense of productive capacity) they can produce. Geopolitics, rising demand and historically tight supply still govern the price of oil. Traders aren't likely to let oil prices decline from their current lofty levels. (Natural gas prices, by contrast, are likely to rise rather quickly.) Won’t a slowing of oil demand give the world a respite – buy a bit more time during which we can “do something” about the energy mess? Not if the decline in demand is caused by recession. The world’s energy problems need money to be solved. In an era of job loss, declining consumer spending, huge government and trade deficits (in the United States and other western countries), rising inflation, tightening credit and seemingly interminable religious and energy wars around the world, money for energy solutions is increasingly unavailable. Add to these problems the uninspired leadership in the US, Canada and much of the rest of the world (especially in respect to the intimately related issue of carbon emissions) and the outlook seems particularly bleak. How bad can things get? I’ll give the last word to Paul Roberts, who describes a grim worst case in which crude oil production has peaked, followed by “global recession, worldwide unemployment, economic chaos, and, perhaps, a dangerous and escalating competition among the big oil-importing nations over the remaining reserves in the Middle East.” In an afterword to the reissue of his book, Roberts describes an important change in people’s awareness – by which he mostly means that of the American people. He writes,

More people and policymakers now seem to understand that the energy system is in serious and growing trouble and that without a fundamentally new approach we are almost assured of a catastrophic failure. What our new awareness actually means is hard to say. It may be the first tentative step toward building a more sustainable energy economy. Or it may simply mean that when our energy system does begin to fail, and begin to lose everything that energy once supplied, we won’t be so surprised.

The Decoupling of Oil and Gas Prices

By Peter McKenzie-Brown

Energy forms are not created equal. Gasoline and diesel are great fuels for transportation, and at the moment there are few viable alternatives. Coal, on the other hand, is just dandy for generating electricity and smelting metals. Natural gas is terrific for space heating, powering electricity-generating turbines and manufacturing fertilizer and petrochemicals. Because of their different applications and their different energy densities, hydrocarbons have different relative prices. And until recently, they were priced in a band which reflected their relative values.

That band is now falling apart. Perhaps this is a sign of things to come - but not before the market experiences what commodity traders call a "short squeeze". The chart shows the price of oil compared to that of natural gas in North America. Until recently, natural gas prices traded in a fairly close ratio to the price of oil. Depending on the state of the industry, the ratios formed a band which ranged from 10:1 to 6:1. Here’s a practical example of how helpful those ratios used to be.

Petroleum industry analysts make their estimates of the future price of petroleum stocks based on their future cash flow – that is, the amount of cash they will have available from production. If they wanted to estimate the future net worth of an oil producer, for example, they would make a knowledgeable assumption about the price of oil in the coming year and an estimate of the company’s total oil production for the coming year. A bit of fifth grade arithmetic then enabled them to estimate the value of that company’s shares. To illustrate, let’s begin with four assumptions:

• First, the company under review will produce a million barrels of oil in the coming year. • Second, the average price of a barrel of oil will be $25. • Third the company’s cost of oil production will be $10 per barrel. • Fourth, the company has 15 million shares outstanding.

Given these assumptions, the company’s cash flow for the coming year would be $15 million, and cash flow per share would be one dollar. To get a good idea of the likely price of the stock in a year's time, we would then ask ourselves whether we thought oil stocks would be in a bull market then or a bear. If we were bearish, we would estimate the price at year end by multiplying that dollar of cash flow by three. If we were bullish, we would multiply it by five. So shares of the company in question would have an implied value of $3-$5. What if the company’s production consisted of natural gas rather than oil?

You can see on the chart that until recently, natural gas prices tracked the price of oil fairly closely – so much so that immutable ratios about the relative value of oil and gas seemed to exist. When gas prices were strong, a gas producer would only have to produce six times as much gas as oil (6,000 cubic feet of gas equals 1 barrel of oil) to be on equal terms with an oil producer. For example, to generate the same cash flow as the little oil producer I just described, in good times a gas producer would only have to produce 6 billion cubic feet of gas a year. If natural gas prices were relatively low, the company would have to produce perhaps ten times as much gas – 10 billion cubic feet per year – to have the same share price as our oil producer.

Eternal Verities: For many years these ratios seemed to be eternal verities for oil and gas producers. Then, last year, the verities fell apart. Oil and gas decoupled. In 2006 gas averaged less than $6, while oil was $65. The 10:1 ratio had been breached. And the situation today? Natural gas on the NYMEX is $7, while oil is $96. That’s a ratio of more than 13 to one. The once seemingly immutable ratios have collapsed, and the gaps are widening. One outcome is that the shares of natural gas producers – especially Canadian gas producers – are in the toilet. The following chart of Rider Resources illustrates the disasters that befell investors in Canadian gas stocks during 2007. What does all this mean? On a continent and in a world facing hydrocarbon-related energy and environmental problems, the cleanest and most efficient form of hydrocarbon energy has become the ugly stepsister compared to its less secure and much dirtier competitor, crude oil. This is not a happy state of affairs – especially since the North American gas industry is in decline.

 Forecasters now commonly suggest that Western Canada's conventional gas production has peaked and will continue to decline. In the United States, reserves peaked years ago. The reasons are complex, but the practical reality is that the economics of gas production stink, especially in Canada. The $7 futures contract for gas on the NYMEX isn’t reality here. In Western Canada, our producers get $5-6 per thousand cubic feet for their gas, while the cost of finding and developing the stuff is in the $7-$9 range. Because of the strong Canadian dollar, a less attractive fiscal regime in Alberta, the lack of storage facilities and for other reasons, the Western Canada sedimentary basin is now the most expensive place in North America to find natural gas, and the least profitable in which to develop and produce it. This is the reversal of yet another verity. Until recently, Western Canada’s natural gas hunting grounds were among the most profitable and prolific in North America.

Greenhouse Gases: In a world nearing the crude oil peak, you would expect something like this to happen. The simple, cold logic of economics 101 implies that tightening oil supplies would send price signals which would identify the problem, spur crude oil exploration and make previously marginal resources profitable. The irony, though, is that in North America these events are taking place to a large extent at the expense of natural gas – an energy resource that can be used to fuel vehicles, generate electricity and fire industrial boilers. As we approach Hubbert’s peak, we are neglecting development of one of the few viable alternatives available, and one which, compared to all other hydrocarbons, contributes less per energy unit of the greenhouse gases that appear to be warming our planet. In a world where oil and gas prices have decoupled in this way, it may seem to make economic sense to bail out of gas producers like Rider Resources: Put your money into companies developing pollution-intensive resources like the oil sands. If you subscribe to peak oil theory, and if gas is relatively plentiful while oil isn’t, then the decoupling I described makes sense and is a long-term trend. It also means – and this is a serious environmental problem – that a world desperate for energy will focus investment on oil and coal (environmentally unfriendly) rather than gas (environmentally friendly.)

Medium Term: I believe this is probable over the medium term, at least, because of the growing importance of liquefied natural gas (shipped by boat from plentiful overseas reserves) in world trade. LNG will help keep North American gas prices relatively depressed, since it can be landed in the US for as little as $4-5 per thousand cubic feet. If that trade continues to grow, then the decoupling will continue. However, nothing moves in a straight line, and there is a strong case to be made for rapid upward adjustments in gas prices. Perhaps the ratio of gas and oil prices will soon revert back toward the mean - either because oil prices drop or (in my view more likely) gas prices climb. As the above chart of the natural gas exchange-traded fund (ETF) shows, US natural gas stocks may have just about hit bottom.

From an investment point of view, if natural gas prices are about to rise and you can anticipate when they will begin to make this move. You could make a lot of money by buying companies like Rider Resources (I personally do not own this stock) rather than avoiding them. Evidence that such a situation may be upon us can be found in this chart, which shows net positions in natural gas contracts. The net long positions held by the commercials and small speculators are so extreme that they suggest that a "short squeeze" could be in the offing.

 A short squeeze occurs when short sellers start to feel pressure from a rising stock or commodity - natural gas, in this case. Their losses increase as prices move higher. This "squeeze" places pressure on those holding short positions by forcing them to buy back their bearish positions in order to limit their losses. Short squeezes often result in dramatic price gains over relatively small periods of time due to this spike of buying pressure. If that's what's happening here, the commercial buyers (who tend to win over the long term because they better understand the market) and the small speculators seem ready to cream the large speculators. Stay tuned: This could be more fun than the Grand Ole Opry.

Why are Canadians the World's Energy Pigs?

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 said, 63% of Canada's electricity is hydroelectric - third after Norway (97% hydro) and Iceland (100% hydro and geothermal).

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 house serious social problems, 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.

Oil and Gasoline Prices: The Crack Spread

When a major US refinery shuts down, why do oil prices go up? This is counterintuitive. After all, a shut-in refinery means reduced demand for oil, and less demand should mean less price pressure, right? Wrong. Here's an account of the strange ties between oil and gasoline prices. By the way, I could not find the original source of the excellent graphic above, although I know it comes from this blog.

By Peter McKenzie-Brown

The Question of Collusion: Motorists often express concern – call it anger, sometimes – about rising gasoline prices. Citing the reality that neighbouring service stations charge almost identical prices for gasoline, many consumers claim that oil companies illegally collaborate with each other to manipulate gasoline prices. It has frequently been shown, though, that market forces keep local prices the same. If a service station on one street corner charges a penny more per litre than its competitor across the street, motorists will buy from the competitor. It is in each dealer’s self-interest to match the competition’s price.

Economists have no trouble with this explanation of how companies set gasoline prices. It is nonetheless understandable how identical local pump prices cause motorists to suspect collusion by the oil companies – especially when those companies often raise gasoline prices, almost simultaneously, at the beginning of a holiday! Raising prices in anticipation of strong holiday demand is a marketing tactic, however, and not collusion.

Links between Oil and Gasoline Prices: The oil industry’s critics also argue that companies move gasoline prices up quickly when crude oil prices rise, but fail to bring them down when oil prices falter. This argument is also flawed, as a review of the ties between crude oil and gasoline prices in 2006 helps illustrate.

In the week of August 6, the average OPEC crude oil price hit what was then an all-time high: US$71.33 per barrel. That week Canada’s average price of gasoline also reached a peak, at $1.15 per litre. Compared to their averages during the previous two weeks, prices for both commodities rose by about 5 per cent. The following week, OPEC oil and gasoline prices dropped – in both cases, by about 5 per cent. By the week of October 1, which preceded Canada’s Thanksgiving holiday, OPEC oil had dropped by 22 per cent. However, the average price of gasoline for that week had declined to 86 cents – a drop of 27 per cent from its peak price two months earlier. Oil and gasoline prices do track each other, but they are also influenced by other factors. The most important are crude oil prices and taxes.

Refining Problems and Gasoline Prices: In North America there has been a price disconnect between oil and gasoline in recent years. This is partly because the market for gasoline has been strong. This has worsened the limitations in America’s capacity to refine enough gasoline for its consumers.

Canada’s refining centres are at or near Vancouver; Edmonton; Sarnia and Nanticoke, Ontario; Montreal; and St. John, New Brunswick. There are also some smaller refining centres – notably Regina, Saskatchewan and Come-by-Chance, Newfoundland.

Canadians ordinarily produce more than enough gasoline for domestic use. We sometimes import gasoline because refineries need regular maintenance shutdowns or have unexpected operating problems. As the following chart illustrates, our imports are offset by exports to the United States.

The graph also illustrates the seasonal nature of gasoline consumption – we buy far more in the summer than in the winter – and the fact that Canada produces far more gasoline than we consume. Canada exports significant volumes of gasoline, primarily from refineries in Atlantic Canada to the U.S. eastern seaboard. Each year, Canadians consume more than 40 billion litres of gasoline and 25 billion litres of diesel fuel. The bar on the far right of the chart shows Canada becoming a large net-importer of gasoline – for the first time in recent history – in May and June 2006. This occurred because the industry needed to modify many refineries to meet new refining standards. These shutdowns reduced gasoline production just as summer driving was ready to begin, and Canada had to import large volumes to meet demand.

During that summer, motorists witnessed higher, more volatile prices than they had in a long time. Canada was extremely vulnerable to unplanned refinery outages. That brief experience was a small reflection of a large, chronic problem in the United States, and America’s problems affect gasoline prices across the continent.

American Vulnerability: The US has become highly vulnerable to refinery shutdowns, and gasoline prices have developed a volatility that reflects both oil price movements and problems in the refining industry. To some extent, this vulnerability and volatility have splashed across the border into Canada. Gasoline is increasingly a global commodity.

Americans consume about 1.51 billion litres of gasoline every day. The United States is thus the largest gasoline consumer in the world, but it is also the largest refiner. The United States does not produce enough gasoline to meet its own needs, however. It always needs imports, and imported gasoline can be expensive.

“Turnarounds” (scheduled maintenance programs) at US refineries put pressure on international gasoline supply, including supply from Canada. But in recent years unexpected breakdowns at refineries have added urgency to the challenge of meeting consumer needs. These events and stronger demand during the summer driving season contribute to higher prices.

As a rough average, in recent years the US refining sector has operated at 90 per cent of capacity. Put another way, 10 per cent of US refineries have been out of operation at any given time. In that environment, imagine what happens when one or two refineries shut down, reducing capacity use to 89 per cent, say. In a tightly balanced gasoline market, this can cause steep and rapid price increases – something the world witnessed dramatically in 2005, as Hurricane Katrina shut down refineries and closed ports that could have imported gasoline from overseas. The panic that followed briefly took Canadian prices to an all-time high of $1.26 per litre.

A Spiral in Gasoline and Crude Oil Prices: One of the oddest phenomena in the present world of gasoline pricing is its impact on the price of crude oil. As this article has explained, it is logical for gasoline prices to go up along with oil prices. After all, refiners manufacture gasoline from crude oil, and rising input costs contribute to rising total costs.

However, higher gasoline prices also result in higher oil prices. This is less intuitive, for a number of reasons. If a large refinery shuts down, it is reasonable to expect gasoline prices to rise. Less gasoline will be produced, lowering supply; prices will therefore increase. Since there would be less demand for oil to refine, one would normally expect crude oil prices to drop. What actually occurs, however, is the opposite: When a big North American refinery shuts down, both gasoline and oil prices rise. Welcome to the world known to traders as “crack spreads”. “Crack spreads” refers to the spread, or margin, that a refinery can earn by “cracking” (refining) a barrel of oil into such marketable products as gasoline, jet fuel and heating oil. Roughly speaking, three barrels of West Texas oil can be refined into two barrels of gasoline and one barrel of heating oil. If these products rise in value, the value of the barrel of oil they come from will also increase, even if refinery demand for oil has dropped. Thus an off-the-wall oil price spiral: rising crude oil prices increase the price of gasoline, and rising gasoline prices increase the price of oil.

Changing Dynamics: This article has reviewed many factors that are changing the dynamics of gasoline pricing. These factors include rising oil prices. Also, some taxes climb in response to escalating fuel costs, and this further complicates the issue of rising gasoline prices.

We are becoming increasingly reliant on gasoline as our society changes, and there are inefficiencies in the North American petroleum infrastructure that – because petroleum refining and marketing is such a huge industry – will take a long time to strengthen. Of course, this begs the question of whether the oil would be there to supply a larger, more efficient refining sector. That's a question for another day.