Based on the dramatic fall in active drilling rigs and now the emerging fall in weekly oil production estimates, many in the industry and on Wall Street are feeling that oil prices are at a bottom and that we have experienced the worst of the market correction.  Of course, many of these optimists were among the community of believers that Saudi Arabia would orchestrate a global oil production cut to support prices last November.  We suspect many of the optimists were also among those most shocked by the speed of the drilling rig decline and the quick reaction by oil company managers to cut their capital spending.  But now, these same optimists are heartened by the trading pattern of oil prices.  In fact, one columnist pointed out recently that in the 41 trading sessions between April 1st and June 1st, WTI had risen 23 times and declined 18.  The average daily increase was 30 cents, with 12 sessions posting an increase of over $1 against four posting a decline of over $1.  He cited this trading pattern as confirming that the oil market has stabilized.  To check that conclusion, we plotted in Exhibit 1 (next page) the daily change in WTI spot prices since January 1, 2014 to June 16, 2015.  We also plotted the price of WTI.  When one examines the chart, the visual picture of daily price changes on the far right looks more subdued than the period of time when WTI was falling and then bouncing off its low before retesting the low.  That increased daily price volatility is not surprising given the turmoil the industry and oil markets were in due to the unanticipated actions of Saudi Arabia and OPEC.  What is interesting, however, is to examine the stability of oil prices during the first half of 2014 as reflected by the daily price change.  That low volatility period was marked with oil prices rising from the high $80s to $107 a barrel, the peak price in 2014 and for this cycle.  Is there sufficient evidence to proclaim oil price stability at the $60 per barrel level?  We don’t know.  We could make that argument, but then again we have no vested interest in making oil price calls.  

Exhibit 1.  Has Oil Market Reached Stability?
 
Source:  EIA, PPHB

The important question for the oil industry is whether a $60 a barrel oil price is low enough to accomplish Saudi Arabia’s objective of reclaiming market share.  At the time of the OPEC announcement, while most analysts assumed that Saudi Arabia was targeting North America’s shale producers, or possibly that their decision was designed to hurt the economies of Iran and their supporter Russia, we thought the goal was twofold – restart global oil demand and shutdown new long-term oil supplies – most particularly Canada’s oil sands and deepwater exploration.  We think the current evidence suggests that Saudi Arabia is accomplishing these goals.

We won’t dwell much on the offshore drilling business, electing to revisit that market in a future article.  However, there is clear evidence that offshore drilling activity is falling as offshore and deepwater drilling projects are being cancelled or delayed.  There are reports that 200 offshore projects have been either delayed or cancelled so far this year.  

As far as Canada’s oil sands are concerned, the evidence of capital spending cutbacks and their long-term impact on future oil output is becoming clearer.  Saudi Arabia surprisingly has received some help in its efforts to derail oil sands output growth with the recent election of a new Alberta premier.  The National Democratic Party (NDP) platform called for a review (hike) in royalties being collected by the province from its natural resource industries, primarily oil and gas.  Additionally, the platform calls for a re-examination of the regulations on greenhouse gas emissions from the oil sands and other fossil fuel activities.  Already, Alberta has moved to double its carbon tax over two years, raising the carbon tax from $15 a ton now to $20 a ton in 2016 and $30 a ton in 2017.  Additionally, the amount of large-emitters carbon emissions reduction against a baseline will rise from 12% to 15% next year and 20% in 2017.  

Exhibit 2.  Where Oil Sands Are Found
 
Source:  FT.com

The significance of the oil sands on global oil supply cannot be ignored.  Over the past five years, oil sands output has grown by 1.1 mmb/d, fully one-fifth of the total oil production growth for North America.  The impact of lower oil prices on the oil sands cannot be missed.  Early in 2014, Western Canada Select, a heavy oil price market, was selling at $86 a barrel.  By the end of March, that marker was trading below $30 a barrel.  This is when, according to oil industry consultant Rystad Energy, new oil sands projects require a price of $100 a barrel in order to breakeven.  What’s been the impact of the price decline on the Canadian oil industry?

Exhibit 3.  Oil Sands Among Most Expensive Fuels
 
Source:  FT.com

In February, Royal Dutch Shell (RDS.A-NYSE) withdrew its application to build a new 200,000 barrels per day (b/d) mine at Pierre River, north of Fort McMurray.  In May, the company announced it would delay for several years a new 80,000 b/d in situ oil sands project at Carmon Creek near Peace River.  The significance of these projects is highlighted when one realizes that Shell currently operates 225,000 b/d of oil sands production.  Other projects are being delayed as companies plan to bring much smaller in situ projects into production at a delayed pace in order to manage their cash flow and capital investment requirements.

A June 16th report from Ernst & Young LLP projects a 30% decline in Canadian oil sands spending, bringing this year’s investment to $23 billion, down from an expected $33 billion.  The result of this spending decline and the announcements by several producers to stop or delay new oil sands mines and in situ projects means total oil production will be 17% lower by 2030 compared to the target output in the 2014 forecast provided by the Canadian Association of Petroleum Producers (CAPP).  

Exhibit 4.  Falling L-T Production Outlook
 
Source:  FT.com

In addition to cutting new investment, oil sands producers are looking at ways to cut their operating costs to help improve their breakeven prices.  Suncor Energy (SU-NYSE), a significant oil sands producer, has said it plans to replace 800 dump truck drivers with automated trucks at its oil sands mines.  That move, which is a huge boost for autonomous vehicle technology, is projected to save the company C$200,000 per driver.  

While the economics of oil sands mines and in situ projects in light of low oil prices is a challenge for producers, it isn’t the only challenge the industry faces.  Besides the possibility of higher oil royalties and increased costs from more stringent greenhouse gas emissions, Canadian oil sands producers still face a challenge in getting this higher output to market.  The continued delay in the approval of the Keystone XL pipeline to move more oil sands volumes to the U.S. Gulf Coast refining complex and eventually to export markets adds to producers’ costs as they will have to rely more on rail for exports at higher-per-barrel costs than for pipeline transportation.  Logistical challenges will remain a problem for the industry until new export pipelines are constructed.  

Additionally, oil sands producers face continued attacks from environmentalists who have made this oil product their rallying cry for keeping fossil fuels in the ground, i.e., stranding the assets for their owners.  Now producers have to worry about the climate change battle being led by Pope Francis in advance of the Paris climate change summit in December.  

Exhibit 5.  Just What The Oil Sands Industry Needs
 
Source:  David Parkins/Globe and Mail

The favorable decision last August by the European Union panel considering whether or not to label oil sands output “dirty oil” and banning its use from the continent was hugely positive for Canadian producers.  It was also a primary reason why, we believe, Saudi Arabia orchestrated the oil price decline.  As a one product economy – crude oil and its refined products – Saudi Arabia needs to consider oil markets decades into the future.  The latest CAPP oil production forecast calling for considerably less oil sands output in 2030 is the first good news in Saudi Arabia’s struggle to regain, and retain, lost oil market share.  Our belief is that we are still in the first half of the oil price war, but Saudi Arabia has scored a major victory.  From here on, watch further oil sands project deferral announcements, further deepwater drilling and development postponements and falling U.S. oil production.  Higher global oil demand growth projections will also help the OPEC, but the status of long-term oil production projects are the most important variable.

G. Allen Brooks works as the Managing Director at PPHB LP. Reprinted with permission of PPHB.