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Oil glut means we’re leaving money on the table

The reality is beginning to set in. Big money is being left on the table. Shortfalls in revenue are affecting Alberta's budget. The federal government knows there is a problem too. National spreadsheets are starting to show what is likely to happen when expected transfer payments don't transfer and trade deficits expand. The taxman is going to come up short too, after shaking the half-empty pockets of Canada's oil and gas industry.

Commodity prices are not what they should be. Our oil and gas is not reaching the highest bidders in the world. Consequently, between what happened last year and what's expected to happen this year, sales from the largest product-selling business in the land are coming out short about $90-billion.

Selling our various grades of oil at deep discounts to world prices – an average $35 for each of the 3.6 million barrels sold to refineries every day – has been the topic du jour lately, even though the issue has been weighing down financial statements for a couple of years now. Even more concerning, western natural gas is being given away at a fraction of world prices. On prevailing transactions there are little to no economic returns (profit, royalties, taxes) being generated at the wellhead.

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Being captive to the oversupplied American market, while unable to access coastal ports to reach higher-paying global customers, means that millions of dollars are being forfeited every day, billions per year. So much money is being sacrificed that it's hard to comprehend the amounts at a personal level unless you're Bill Gates, Warren Buffet or a Russian oligarch.

So how much money are we talking about?

The waterfall of money starts with the sale of crude oil and natural gas, where the wellhead meets the cash register. Revenue realized by the industry is the volume of its production – barrels of oil and cubic feet of natural gas – multiplied by the respective prices realized for the various product streams of hydrocarbons. Like coffee and Scotch, not all oil is created equal; there are different grades and blends. In Alberta, the smorgasbord of oil ranges from bitumen, to heavy oil, to premium light oil.

Canada is now the world's sixth-largest producer of oil at 3.6 million barrels per day (3.6 MMb/day) and fourth-largest producer of natural gas at 13.5 billion cubic feet per day (13.5 Bcf/day). Because of these large volumes, over half of which are exported to the United States, small changes in realized price translate into big changes in dollar revenue. The consequences amplify through to provincial royalties, federal taxes and the crucial cash flow needed to invest back into the replenishment of production. This latter factor, having enough cash to funnel back into exploration and development, drives multiplier effects in the overall economy. Bonuses paid on the leasing of new land, service industry taxes, manufacturing activity and licence fees are all direct derivatives of repeated investment cycles.

Figure 1a shows historical and expected annual revenue from the collective sale of three major product groupings – natural gas, conventional liquids (mostly light oil), and oil sands (bitumen, synthetic crude oil) – since 1990.

Up until 2000, upstream revenue used to ring in around $20- to $30-billion per year. Rising oil and gas prices last decade, combined with increases in output, propelled revenue above the $100-billion mark for the first time in 2005. The peak year was 2008, on the eve of the financial crisis, when $145-billion was generated. Commodity prices fell abruptly after the Lehman Brothers saga, cutting total revenue down to $90-billion in 2009. However, by 2010 oil prices were recovering and upstream revenue chinned up above the $100-billion bar again, which is roughly where it is today.

But the character of the industry changed after the financial crisis. Unlike oil, natural gas prices never recovered. The onslaught of American shale gas caused uncompetitive Canadian output to shrink by 25 per cent. On revenue, the gassy side of the business has shrunk 75 per cent in the last five years. What was once a $40-billion-a-year enterprise is now limping along at a mere $10-billion.

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The challenges facing the natural gas industry mean that oil sales have been pulling over 80 per cent of the freight in recent years. This is called "concentration risk," or too much dependency on one product set. And that dependency has made the industry especially vulnerable to any weakness in domestic oil prices – a risk that has now materialized. Discounted pricing is a consequence of North American production growth pushing up against consumption declines, especially in the United States, Canada's biggest marketplace.

Figure 1b answers the stark question, "What would 2012 and 2013 industry revenues be if pipelines were unclogged and the industry was able to capture unconstrained prices, as it used to before 2012?" Lightly shaded segments in the bars represent the forfeited revenue, adding up to an estimated $40-billion in 2012 and an expected $50-billion this year. Figure 2 shows the shortfalls more acutely, by product category for each year.

The largest fraction of lost revenue emanates from the oil sands, because of its large overall contribution and also because heavier barrels are experiencing the widest price discounts. Nobody likes to see money left on the table, least of all the government.

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