There has been a lot of discussion over energy here in Canada over the past few years. This makes sense as energy is one of our main industries in Canada, and especially here in Western Canada. I think there are a lot of misconceptions about energy and I thought I would try to dispel some of those misconceptions and hopefully uncover some potential investment opportunities.
Energy is one of the most important things in our modern society. It is second only to oxygen on a human hierarchy of needs, as even other necessities like food and water often require tremendous amounts of energy in order to produce them for human consumption. What is also true about almost all of the energy we use is that it comes at a cost, both financial and environmental.
One thing that usually gets lumped into energy production is environmental concerns. The majority of our energy produced worldwide still comes from the burning of fossil fuels. This includes coal, oil, and natural gas primarily. Most scientists agree that this burning of fossil fuels by humans is having an effect on our climate by adding to the level of greenhouse gases in the atmosphere. Although there is obviously still disagreement on this point amongst the public, for the sake of this article I am going to assume that the burning of fossil fuels is having an impact that we should try to do something about.
Another issue that is impacting energy is the movement towards renewables and greener technologies. This is related of course to the environmental concerns which I mentioned above, but there is also a business case to be made for many of these technologies. Some renewables can be a cheaper form of energy in certain parts of the world, and they certainly can complement an existing energy infrastructure. As technology improves, it is entirely possible that solar, wind, hydro, and other new energy technologies will play a much more important role in our overall energy infrastructure. As I’m often happy to tell people, many of our clients own shares of Berkshire Hathaway, which in turn owns Berkshire Energy, a large utility company in the Western US. Berkshire Energy has built the largest solar farm project in the world in California. They wouldn’t do this if they weren’t going to make money from it, even without subsidies. Profits and environmental protection don’t have to be mutually exclusive.
These two factors have led many people to believe that investing in fossil fuels in Canada will be a poor investment. Either governments will make it so difficult and costly to extract and transport fossil fuels that it will be hopelessly unprofitable, or new technologies like electric vehicles and shiny new solar farms will eliminate the need for fossil fuels altogether. While there is some small element of truth to these two theories, they are far from the reality of today’s world.
The demand for fossil fuels has consistently risen over the past ten years, even as supply has come under increasing scrutiny from governments and environmental groups. And no wonder given the range of uses. Oil can be used to produce gasoline and motor oil for cars or other transportation, but that is far from its only uses. It is also used to make asphalt, electricity at power plants, lubricants, propane, any and all kinds of plastic products, wax candles, and polyester clothes. It is also used in the production of agricultural products and pesticides, and the production of other industrial chemicals. Fossil fuels are still the only viable option for the production of steel which is the foundation of our modern industrial society. Even if all of the vehicles on the road became electric tomorrow, this would not eliminate the need for fossil fuels. Not even close. Given all this, there is no realistic way of eliminating fossil fuel use using today’s technology without a drastic reduction of our standard of living. And I’m not talking about people giving up their cars to ride public transit. Removing fossil fuels would drastically impact essentials like agricultural production and would likely lead to less food security even in developed countries. This is not a palatable solution for anyone who is thinking rationally about the problem.
So it looks as though demand will still be strong for many years to come. But what about supply?
One of the reasons why the price of oil has remained stubbornly low over the past 5 years has been the tremendous production growth in the United States. This production has come primarily from US Shale fields which require more capital to drill then conventional oil resources. This production has been fueled by cheap debt in the US over the past ten years. What compounds this problem for American producers is that these type of shale wells have much higher decline rates then more conventional oil. That means that they deplete their wells much faster than other parts of the world. This has led to an unsustainable dynamic where billions of dollars have gone into the oil patch by way of loans to energy companies like Chesapeake Energy. The money has gone in but not much has been returned to the investors, and the appetite for this kind of investment is getting less and less as prices have remained low. Since these energy companies in the US have found it harder and harder to find investors for their drilling, the production growth has slowed dramatically. Chesapeake Energy just issued a warning to investors that they are having a hard time paying their bills, and they’ve been forced to cut back dramatically on their drilling just to make ends meet. They may be the first of many. Production in the US may plateau in 2020 and even start to decline. The dream of American energy independence is most likely a pipe dream in the short term, and it is definitely unsustainable in the long term using today’s technology. What this will do to the prices of fossil fuels remains to be seen, but it will definitely be a positive story for prices going forward.
So, while it is still thought by many that we will have a massive oversupply of fossil fuels, we may in fact be heading towards the opposite problem. It’s also not clear that we will be able to ramp up production to meet the demand if the current supply growth tails off.
It’s been no secret that governments around the world have been making it harder for suppliers of fossil fuels. They’ve done this by implementing carbon taxes, heavily regulating their production methods, enforcing more stringent environmental standards, and restricting the industry’s ability to build pipelines and otherwise transport their products to markets. This isn’t necessarily wrong, but it is undoubtedly making it harder for energy companies to operate their business. This is especially true in Canada of course. Even still though, companies continue to find ways to get their products to market. Even though pipelines are becoming more and more controversial, Canadian companies have increasingly turned to rail transport where pipeline capacity is maxed out. In a way this is counterproductive to the environmental effort, as rail transport is less efficient and more dangerous than using a pipeline. Environmentalists who oppose the pipelines may find that the alternative is actually worse for the environment.
So, it seems as though we can’t get rid of fossil fuels, even if we wanted to. And it’s also becoming increasingly more likely that we may end up in a situation of under supply rather than over supply over the next few years. Does this mean that our environment is doomed? Far from it. In order to meet aggressive greenhouse gas emission reductions, we will probably need to rely on more fossil fuels, but just fossil fuels of the right type. If you convert a coal fired power plant to a natural gas power plant, you drastically reduce the carbon emissions of the plant. Asia Pacific gets 47% of their energy demand from coal. If Canada was to export natural gas to Asia Pacific in order to allow them to convert their coal fired power plants to natural gas, that act alone would reduce global greenhouse gas emissions by more than is required by Canada under the Paris Agreement. Of course in order to transport that amount of gas efficiently to Asia, we would need to build some pipelines.
All of this assumes that there is no disruption of international supply, such as a war in the middle east. If that were to occur, we could see a major jump in the price of oil far sooner.
So what have we learned? Well I think the following are true:
The demand for oil is not going away soon. Even though supply is being consistently attacked, the increase in demand has been steady over the past 10 years.
While renewables and greener technologies can and should play a bigger role in the future, there is no prospect of them replacing fossil fuels in the near future without massive technological developments and progress. As such, any realistic plan to reduce greenhouse gas emissions is going to have to still involve fossil fuels.
The massive growth in US production over the past 10 years has been largely fueled by cheap debt. It is not sustainable and is already showing signs of slowing down. If US production stops growing, global prices of fossil fuels are likely to rise.
While Canadian oil has been very out of favour by investors, it is still operating in a sustainable way and it stands to benefit from the 3 trends above. Opportunity is knocking.
- Craig White, BA, LL.B., CIM
Craig White is an Investment Advisor at Endeavour Wealth Management with Industrial Alliance Securities Inc, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.
This information has been prepared by Craig White an Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.