Ian Madsen

While there’s certainly carnage and woe in the oil and natural gas sectors at the moment, reports of the death of the industry are exaggerated.

Many climate change activists and their sympathizers have been cheered by the dramatic drop in oil prices that coincided with, and were partly caused by, the COVID-19 pandemic.

Prominent among them is the outgoing leader of the federal Green Party of Canada, Elizabeth May. Apparently she thinks that the crisis in the oil patch, and the currently parlous state of the oil sands producers in particular, portends the demise of all involved.

The actual reason for current low oil prices in the spot and the near-term futures markets is a war for market dominance between Saudi Arabia and Russia, with the mercurial despots in charge of each nation reluctant to budge.

Saudi Arabia may have a very low cost of production, but its national budget and economy are completely dependent on oil and, to a much lesser extent, natural gas and petrochemicals derived from oil.

The Saudi government needs a much higher oil price than Russia does to balance its budget: US$80 to $85 per barrel for the former and just under US$50 for the latter.

Russia claims to have financial reserves – about US$500 billion – to withstand $20 to $30 oil for a decade, whereas Saudi Arabia is depleting its reserves rapidly (down from US$497 billion in February to US$473 billion in March).

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The peace overtures have been driven by the United States, where higher-cost, fast-declining shale well production is hurting badly from the price meltdown.

As all commodity producers and investors know, the cure for low oil (or gold, copper, grain or lumber) prices is those low prices themselves. They compel drastic cuts in capital expenditures and sometimes in higher-cost production capacity, bringing supply down rapidly to match shrunken demand.

The lower prices also tend to induce greater demand. The lower supply and higher demand will bring about higher prices, which will eventually invite producers to produce more and to invest more to increase or replenish production capacity.

Oil producers around the world have drastically slashed their production budgets. Natural rates of decline in mature, conventional oil fields range from a (rare) low of one per cent a year to highs upward of five per cent. Shale wells are even faster declining, as they must be constantly stimulated with high-pressure water and chemicals.

Shutting in more expensive wells will help, but prices will likely stay low unless the major oil producing firms, especially the state-owned ones in the Persian Gulf and in Russia, exercise more discipline.

A true recovery in oil prices will require an economic recovery, whose timing remains unclear.

But the current low prices won’t mean an end to the industry because of hedging.

Hedging is commonly used by oil producers to lock near-term prices, and sometimes longer-term ones, at a fixed value. This enables confident budgeting, and reassures lenders and investors that a firm isn’t gambling on the oil price.

Several oil sands producers hedge much of their production at prices that are now much higher than the current prevailing market levels.

Companies with downstream operations such as refining and marketing have a natural hedge: they sell to consumers and other customers at retail prices that absorb and offset much of the upstream production losses in their profit margins. Major oil sands producers with downstream assets include Suncor Energy and Imperial Oil.

This oil industry crisis is certainly very serious, and firms may go bankrupt, including some oil sands producers.

However, the assets will remain. Shrewd, enterprising entrepreneurs and investors will seize opportunities to buy operations cheaply, finding ways to resuscitate them at much lower cost. They will reap the rewards when prices recover, as they will do.

Renewable energy, while steadily getting cheaper, still can’t satisfy all of society’s needs, including transportation. And it won’t until promising – but expensive – forms of energy storage become commercially and practically viable. They’re not there yet, despite all the earnest dreams of the green lobby.

The oil industry survived dramatic price crashes in 1986 and 2008, and other lesser ones in 1993, 1998, 2001 and 2014. It will again recover, adapt and live on for quite some time.

The industry’s place in the economy and society will continue to evolve. It’s obituary has yet to be written.

Ian Madsen is a senior policy analyst with the Frontier Centre for Public Policy.

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