Ryan Bushell

Continued from US Energy Self Sufficiency Part 1

3. Environmental Opposition – It’s Coming for US shale plays:

It has been painted quite clearly in the media: Oilsands = dirty, evil, carbon intensive, while on the other hand Shale Oil = clean, made in America, way of the future… simple right? Not so fast. When you look at total environmental impact I think its possible that shale oil is worse than oilsands, or at least equivalent. Why? Well for one, you can now see North Dakota (state population ~700,000) from space due to all the natural gas byproduct being flared (burned into the atmosphere), because there is neither infrastructure to gather the gas, nor a viable market price to incent better management. The reason the gas needs to be flared is that it is hazardous to let it build in the atmosphere because it could explode if a localized concentrated pocket develops. The end effect is that Central North Dakota looks similar to a city the size of Chicago (population ~5 million) with <1/10th the population from space. Don’t believe me? – Google “North Dakota View From Space”

Now they definitely burn a lot of natural gas in the oilsands as well, both to run upgraders that melt mined bitumen (the real oil sand) and to heat steam for bitumen produced in steam assisted processes that produce heavy oil by heating the sand below the earth. At least some of that heat can be recovered to be used to heat facilities, gas in North Dakota and other big US shale plays is simply burned off and wasted. Gas flaring has been common practice for many decades by the way, but what has changed is the decline curves force elevated drilling levels and shale gas reservoirs have significantly higher associated natural gas content.  All of this means there is a LOT more gas to be flared than ever before. Doesn’t get a lot of press… it should.

Additionally the hydraulic fracturing required in tight oil plays uses a LOT of water and most of it gets injected deep into the earth (kilometers below the water table) never to be seen again. US tight oil players typically recover less than 30% of the water they use and what they do recover is so mixed with chemicals that it needs to be heavily treated before it can be reused. Most companies don’t bother with this additional cost because it is simply not economic. This is less of an issue in North Dakota, but a much bigger issue in Texas. Contrast the water usage again with oilsands companies who recover and reuse up to 70% of the water they consume for operations. Is it because they are better, more conscious citizens? I’d like to think so but the real answer is that the more steam they recover the less natural gas they have use to heat more steam which directly affects profitability.

In the end neither process is environmentally superior but the debate is far less one sided than the average person understands. Oilsands companies have already dealt with environmental backlash and are managing it, the same cannot be said for US (and Canadian) tight oil players. Getting resources out of the ground is not a green process no matter what, but I’ve been to Ft. McMurray and I would encourage anyone looking at this industry to do the same and make an informed judgment. Only 10% of the oilsands resource can be mined, the rest has to be produced thermally (by using steam) which is less environmentally destructive than the mining operations that get all the press.

Additionally on the environmental impact, US shale oil is very light which is good for refineries that are set up to process it, but bad if you are shipping it by rail. The train that derailed in Lac Megantic was carrying light oil produced in North Dakota which is far more explosive because of the higher associated gas content and lower gravity when compared with Oilsands bitumen.

4. Economics 101 – Tight Oil is NOT Cheap:

Because of the massive declines discussed earlier and the costs of extracting oil from increasingly deep and increasingly complex reservoirs, the economics of tight oil are not excellent. Most cost estimates I’ve seen range from $30-$70/barrel which is right in line with oilsands producers. The tug of war on costs will continue; Technological and process improvements will try to pull costs down while decreasing reservoir quality (they drill the best stuff first) and competition for inputs will no doubt try to push costs higher. Oilsands comparatively are much more predictable from a reservoir point of view but face a similar tug of war with costs and transportation issues. Additionally because of the refinery dynamics mentioned earlier heavy oil actually traded at a premium to light oil for a good deal of 2013, but unfortunately Canadian producers did not fully participate due to transportation bottlenecks. Overall Canadian oil is very competitive with US tight oil from an economic point of view and the falling loonie only helps matters. The economics are the most important dictator of Canada’s future as an oil producer. High costs of tight oil mean that it is just as marginal as Canada’s production and it will shut down just as fast, if not faster in the event of a severe price disruption to the downside. Fortunately, this dynamic should limit the downside on global oil prices.

For all these reasons we are not greatly concerned about Canadian oil production being displaced by US tight oil; the optimistic production growth math doesn’t work, heavy oil is in demand and will continue to be, environmental opposition is coming for tight oil, and Canadian oil production is economically viable. In the end the price of the commodity globally will dictate overall returns for Canadian oil producers and US tight oil plays. The additional supply from the US plays a part in the global picture to be sure, but given the comparable economics any talk of one displacing the other is simply noise and should be regarded as such. Taking the long view, there are not many better long term oil investment opportunities than exist in Canada… ask Warren Buffet if you don’t believe us.

Natural gas is a shorter and slightly different story. Mainly because of transportation difficulties associated with natural gas, it continues to be a commodity hampered by very regional and disjointed pricing. Canada IS currently at a disadvantage when it comes to natural gas economics due to our disproportionally large production of natural gas relative to the regional demand in Western Canada. Hydraulic fracturing has been much more impactful in the Natural gas industry due to the magnitude of the resource it has unlocked that was previously uneconomic (Similar to oil but on a larger relative scale). The result is that the regional demand for this much more homogenous commodity (not heavy vs light, like oil) has been satisfied by US production. Comparable Canadian production has been displaced because of the higher transportation costs associated with being at the “end of the pipe” in Canada. The comparatively warmer winters of 2008-2013 combined with flush initial production and lower manufacturing activity caused a doomsday scenario for North American natural gas producers in 2012-13. US natural gas prices plummeted to ~$2/Million Cubic Feet (MCF) while Alberta gas prices hit a level of $1/MCF in May of 2012 (both down from ~$14/MCF in 2007). Higher cost production was shut in on both sides of the border and producers survived by extracting mainly propane and condensate out of natural gas streams which are used as substitutes for some products produced from oil and receive higher prices. In the long run the natural gas market will likely self correct. Domestic demand will be stimulated (power generation, manufacturing, residential switching etc) by current lower prices and LNG export facilities will need to be constructed in order for excess production to be sold profitably. Unfortunately this is a slow process because these capital intensive multi year decisions are predicated on a long term natural gas price that makes them economic. For these reasons natural gas will continue to be volatile, but long term it is a big part of the global energy picture. Overall Canada has massive natural gas resources that will be in demand at some point in the future, and its amazing what one colder than normal winter does to revive optimism. (Alberta Gas prices recently traded at over $18/MCF… a 100% premium to its US counterpart)

In the end what matters to us is how we articulate all this information in the context of our portfolio. We currently have 30-35% of the portfolio allocated to the energy sector. Seems like a lot but lets break it down. Less than 20% of that is allocated to Canadian producers of oil and natural gas. The other portion is allocated to Energy Infrastructure (mainly Pipeline) companies. This is the most convicted position in our portfolio. The discussion above is debatable but the North American production curves of both natural gas and oil are going up… fast. Pipeline and Infrastructure firms make regulated long term returns on volume, not prices, of commodities. These infrastructure companies have more projects in front of them than they can complete, dividends are being raised among our pipeline holdings by ~6-8% per year and they still have an average dividend yield of 3.8% despite market appreciation of the past 5 years. We are very confident about our allocation to Energy Infrastructure. Our energy producers allocation has a mix of Heavy Oil Producers (~7.5%) Light Oil Producers (~6.0%), Natural Gas (~3.0%) and Royalties/Services Companies (~2.5%). Our goal is to maintain lower exploration risk exposure to the sector while collecting a solid dividend yield, by trying to own low cost and/or conservative producers. The average dividend yield on our E&P holdings is roughly 5%. Oil and natural gas producers are the higher risk portion of the portfolio, however the income helps to mitigate this risk from a total investment return point of view. We have maintained our exposure to our energy producers by adding to positions over the past 3 or so years while the stocks broadly declined. US investors largely abandoned the Canadian sector in favour of domestic investments recently, presenting a buying opportunity. We have not purchased any new Energy Infrastructure shares since 2011 but are maintaining positions as portfolios grow.


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