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Revenue back in fashion, in a ‘new-fashioned’ way

It's a great feeling to find an extra 10 bucks in a pair of jeans you haven't worn in a while. You might use the money to buy something special, or just slide the money in your wallet to spend as usual. But what if the neglected pocket held $10-billion?

That's the way it's shaping up for the upstream Canadian oil and gas industry with better commodity prices. A sudden narrowing of the oil differentials, or the "Diff," means that top line revenue for the industry's explorers and producers is now on a track to put $130-billion into the till this year (compared to the $120-billion being tracked earlier this year, and sharply up from the $110-billion estimated in 2012). Importantly, the extra revenue implies a 17-per-cent boost to earlier run-rate cash flow, about $9-billion. And that's after accounting for money that's been falling out of the hole in the other pocket of late, the losses from dismally discounted natural gas prices.

Extra cash flow, if sustained to the end of the year, suggests a robust 2014 for an industry that has a long history of recycling every dime of its own money back into the ground. On top of that, corporate spending is juiced by a further 10 per cent to 20 per cent in most years, using other peoples' money – that of investors and bankers.

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However, the spending behaviour of Canada's upstream oil and gas economy is far from predictable in this era of extremes. Only one thing is certain: The spending of any new-found, discretionary coinage will be far from uniform. Oil and liquids development will garner the lion's share of the extra upstream dollars. Low-priced natural gas will continue to be snubbed, being of interest only to a handful of big companies intent on proving up their reserves for future liquefied natural gas (LNG) exports.

Unlike past spending cycles, being more flush with cash may not translate into a rush to higher field activity. For one thing, the "other people" want some of the money back into their own trousers. Tetchy lenders want to be repaid and weary investors are looking for mechanisms to realize returns on patient equity that's long become impatient. Settling accounts and spending within means may absorb much of the extra dollars.

Higher costs may also chew up some of the extra revenue. Early second-quarter reports from a handful of big producers suggest some year-over-year inflation, as noted by Cenovus and Husky. However, both companies are reliant on natural gas as a significant input into thermal production processes. Compared to the second quarter of 2012, gas prices are up 86 per cent, which may mean the rise in operating costs may only be an issue for heavy oil and bitumen producers. That conjecture will be confirmed or hollowed out as a broader set of quarterly reports from producers come in over the next few weeks.

Profitability is the vital factor in determining the propensity for oil and gas companies to reinvest their gains, so any crimping of margins due to higher costs has the potential to furrow foreheads in the boardroom. Precision Drilling, one of the largest rig contractors in Canada, reported some oil field inflation radiating out of their operations last week. A 5.5-per-cent increase in day rates for rigs was mostly attributable to a rise in wages for drilling crews.

Despite some mild inflation, the long-standing industry relationship that more-cash-flow-means-more-spending is likely to hold. The causality that won't replicate the past is where the money will be spent. Transformative changes are happening in the industry – from how the oil and gas is found and extracted, to how and where it's delivered, to how it's all regulated. Capital investment will not be going toward the same old, same old business model, which means that the impact of the extra $10-billion is not likely to be cleanly captured in historical metrics like land sales, well licences, rig activity, completions and near-term production. We are in a new world of spending on things like pad drilling, water facilities, plant expansions, specialized equipment, railway loading infrastructure, new pipelines, export facilities and social licence.

Imagine finding a surprise ten bucks in your pocket, and then realizing the pants you found them in are out of fashion. That's what it's like in the oil patch. Things have changed; progressive companies will be putting the money toward a new wardrobe.

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