You can’t live with oil and you can’t live without it

 One day, the Cassandras are warning us we’re about to run out of oil; the next day, we’re glutted with the stuff and the price is plunging.

So says Sunil Vidyarthi, president of Oakville, Ontario-based Value Sciences Inc. A regular contributor to Investor’s Digest of Canada, Mr. Vidyarthi writes:

I’ve been a technology and investment pro in Canada for over 40 years. And I’ve found that apart from hockey, nothing is more important in this country than oil.

But I’ve also learned that the oil patch suffers from extremes. One day, oil is seen as the be-all and end-all, fueling no end of economic prosperity.

But the next day, we’re glutted with the stuff — as now unfortunately seems to be the case — and energy producers cut back left, right and centre.

Pattern always present

True, I’ve only been charting these swings since October, 1973, when the Arab bloc, sparked by America’s involvement in the Yom Kippur War, imposed an oil embargo on the West.

But these swings predate the embargo by many decades. Moreover, no one — wage earner, politician or oil and gas CEO — has been spared this wild ride.

Of course, the fear that the world might run out of oil is nothing new, having started back in 1974. Then, the experts warned we’d exhaust our supply of crude long before the end of the last century.

And although we’ve yet to do so, this hasn’t stopped the Cassandras from sounding the alarm every time the Mideast goes up in flames.

In the meantime, we’re drowning in yet another inexhaustible supply of “black gold,” thanks to cheap shale oil and gas, the boom in the Alberta tarsands, along with both secondary and tertiary sources from flamed-out wells.

That Canada has long been dependent on energy exports is nothing new, despite Ottawa’s unremitting effort to wean us away. Indeed, over the years, the federal government has spent billions of dollars trying to nurture technology and innovation. Still, we have yet to kick our oil habit.

In the interim, the speed with which petroleum has plunged is positively breathtaking. Only a few months ago, for example, no one apparently thought that crude would fall below US$80 a barrel.

Yet, not only is petroleum now around US$50 and change, but it’s on track, at least according to one Mideast nation, to tumble to $40. Natural gas is being whipped around in much the same way.

Oil still biggest input

But it’s easy to understand why oil yo-yos. After all, when it comes to taking humans out of mud huts and seating them on internal combustion engines, oil is still the single most important input.

But what’s often not so obvious is the cost of production. To export a barrel of light sweet crude from Saudi Arabia costs roughly US$10. Anything below US$70 a barrel leaves most producers in the Alberta tarsands seeing red.

Hence, the panic that’s now gripped Western Canada, the Canadian government, as well as many of the mountainous regions in the U.S.

But the cost of petroleum production in North America wasn’t always so high. To understand why, we have to go back to the doomsayers of the ’70s. They were partly right.

The world, after all, did run out of oil by the end of the 20th Century. But it only ran out of the cheap stuff, the discovery of which sparked the industrial revolution in the U.S. more than 100 years ago.

In fact, for a while it looked as if we had no choice but to import oil forever from the Mideast, a region hardly known for its political and economic tranquility, as the events of the past four decades more than testify.

Moreover, as with any product, oil obeys basic market forces. If demand remains high, while supply dwindles, prices rise and entrepreneurs start looking for an alternative.

Sources made sense

So, as oil headed to US$140 a barrel with no end in sight, newer sources like the tarsands started to make economic sense. But as any smart shopper knows, the retail price is no indication of how much fat is built in.

And a lot of fat was built into oil prices, making billionaires out of many folks around the globe. Then, too, when profit margins become obscenely high, competition sets in and the fat cats get slaughtered.

Unfortunately, along with the Saudis, Canada’s own cowboys had put on a lot of weight. Stories of any Joe with a truck heading to Alberta’s Athabasca region and then pulling down six figures for half a year’s work sent costs spiraling in both the tarsands and elsewhere.

North Sea is pricey

Although roughly $13 a barrel in the 1980s, oil from the foothills of Alberta, Saskatchewan and British Columbia now tops more than US$70. The cost for North Sea oil is even higher. In the end, the real cost of oil production in Canada has been wages, not the million-dollar trucks needed to haul the stuff.

Meanwhile, North American energy producers have fallen prey to a lot of wishful thinking. They’ve used US$70-a-barrel oil as the minimum price in their financial projections, ignoring the elephant in the room: cheap exports from both the Mideast and South America.

In fact, Canadians tend to forget that many countries are nearly 100 per cent dependent on energy exports. It’s as if your only employer gives you a choice of lower wages or no wages. So, these energy-rich exporters are taking the lower prices instead of being shut out by the new oil suppliers like America and Canada. And this isn’t likely to change in the short term.

Still, is there any good news out there? Not really. After all, this kind of free fall doesn’t come out of its spin in a few weeks, or even a few months, for that matter. So, we’re likely to have to deal with low oil prices well into 2015. Moreover, as some analysts warn, we’ll likely see bankruptcies and mergers in droves.

In fact, fears that Ivanhoe Energy Inc. (TSX─IE) is almost bankrupt have recently been making the rounds. Moreover, Talisman Energy Inc. (TSX─TLM), long an oil patch stalwart, is being snapped by Repsol S.A. (OTCMKTS─REPYY), the Spanish energy giant, for $13 billion.

But if you still want to venture into the oil patch, buy the best of the bunch as they too have fallen. The cock of the walk here is Imperial Oil Ltd. (TSX─IMO), now benefitting from its refineries, thanks to lower prices for crude oil.

You might also consider Vermilion Energy Inc. (TSX─VET). Thanks to its  growing operations in Europe, Vermillion is likely more diversified than many other oil and  gas plays — and, as such — better able to ride out volatility.

Pipelines a good bet

Other good Canadian energy plays are Inter Pipeline Ltd. (TSX─IPL) and Keyera Corp. (TSX─KEY). As petroleum transporters, they’re likely to take less of a whack than the exploration and development outfits.

 

Investor’s Digest of Canada, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846

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