The price of oil dropped to its weakest point in six years, dragging Canadian energy stocks to their lowest in more than a decade as investors grow increasingly worried about plunging profits in the sector.
The benchmark price for oil in North America, known as West Texas intermediate, closed at $40.80 (U.S.) a barrel Wednesday. This week, Western Canadian Select oil sands crude fetched about $18.70 less than WTI. As a result, the S&P/TSX energy subindex fell more than 4 per cent. The unexpected increase in crude oil inventory in the United States served as the catalyst for Wednesday's slide. Further, the United States Energy Information Administration said it expects production in North America to decrease through to mid-2016.
The year-long slump means energy companies across the board have lost their ability to lock in more favourable prices for their future production, a strategy known as hedging and one that has helped some oil and gas firms skate through the slump. Further, troubled companies that have been trying to sell their less desirable assets may be forced to part with their more valuable projects to survive. Even comparatively healthy companies such as Cenovus Energy Inc. may be transformed into takeover targets as they struggle to turn a profit at current oil prices.
"The ability to hedge [remaining 2015 and 2016] production is non-existent," said Rob Lauzon, managing director in Western Canada for investment manager Middlefield Group. Indeed, WTI crude futures contracts for November delivery averaged $47 a barrel during the five-day trading period ending Aug. 6, according to the EIA.
Come October, when the federal election has wrapped and Alberta's New Democratic Party may have provided information on its royalty review, bankers might force further sales – whether assets or entire companies.
"The banks might finally call and say: 'Listen, I want some of my money back. I'm going to reduce your bank line, because if we have $45 oil for the next 18 months, you're going to be in trouble, and we want to get paid,'" he said. "You'll actually have some screws put to some of these smaller and mid-cap names."
The EIA expects WTI to average $49 a barrel in 2015, down $6 from its forecast last month. It predicts oil will be worth an average of $54 a barrel in 2016, trimming $8 off its previous forecast.
Lenders have already pushed less fortunate companies into creditor protection. Palliser Oil & Gas Corp. sought creditor protection in February and Exall Energy Corp., a tiny player, is in receivership, forced to liquidate.
But it won't just be struggling companies such as Penn West Petroleum Ltd. (down 7.2 per cent to $1.02 [Canadian] a share), Pengrowth Energy Corp. (down 6.7 per cent to $1.52) and Baytex Energy Corp. (down 15 per cent to $7.10 a share), that will be pressured to sell some of their better assets.
Menno Hulshof, an energy analyst at Toronto-Dominion Bank, said Cenovus Energy Inc. and MEG Energy Inc. could soon be takeover targets. Their depressed share prices, in light of their oil sands production costs, could make them attractive to competitors looking to expand.
"To boil it all down, one can buy completely derisked production (plus growth) for the same price or less than developing a new project with all of the execution risk," such as timing, the availability of cash and the quality of the reservoir, Mr. Hulshof said in a note.
Companies producing oil using steam-assisted gravity drainage or cyclic steam stimulation would be "bleeding cash on every barrel of bitumen produced," with WTI at about $42 (U.S.) a barrel and WCS at $24 a barrel, he said. The average break-even oil price for Canada's six major oil sands projects, excluding mining operations, is $43.90 a barrel, Mr. Hulshof calculates. His estimate climbs to $50.78 a barrel when sustaining capital costs are included. (Both exclude corporate costs such as interest and salaries).
U.S. crude inventory climbed to 456.2 million barrels last week, up 2.6 million barrels over the week before, according to the EIA. The market expected reserves to drop by 800,000. Oil production in the United States dropped by 100,000 barrels a day in July compared with June, the EIA said. It expects production to total 9.4 million barrels of oil a day in 2015 and nine million barrels a day in 2016. The country will not increase production until "late" 2016, it said.