The Oil Crisis – The Big Picture

Steve Curtis is a 44-year old geophysicist based in Calgary, Canada. For the last 20 years, he has explored for oil and natural gas in the Canadian oilpatch, as well as internationally, in Australia and Southeast Asia.

In early February, Curtis and half a dozen other exploration staff were called in by their employer, Union Pacific Resources, and laid off as part of the Texas-based company's worldwide cost-reduction programme. "Nobody had a clue it was coming," said the father of two. "I had not prepared at all."

Curtis is just one of thousands of North American oilpatch professionals who find themselves suffering from the calamitous drop in oil prices. In early 1997, before increases in OPEC production and the collapse of Asian economies led to a chronic overproduction situation, West Texas Intermediate benchmark crude averaged US$27 per barrel. In January, 1998, the wellhead price that oil producers received in the U.S. averaged just US$9 per barrel, the lowest inflation-adjusted crude oil price since the Great Depression of the 1930s.

The Money Disappears

And, like the Great Depression, most oil companies are suffering. Gulf Canada Resources Ltd. lost $560 million in 1998. Imperial Oil's net income for the year dropped 35% from 1997's $847 million, to $554 million. PanCanadian Petroleum Ltd.'s earnings fell 55%, from $330 million to $150 million.

The plunge in profits sent stockholders fleeing from the sector. Gulf Canada shares lost 55% of their value in 1998. The Toronto Stock Exchange Oil & Gas subindex fell from a high of nearly 8,000 in early 1997 to below 4,000 this spring.

Equity investment in the sector also dried up. In 1998, Canadian oil industry financings fell to $6 billion, a 24% drop from 1997's $7.9 billion. "1997 was a phenomenal year [for equity investment]," says Tom Ebbern, a researcher at Newcrest Capital Inc., a major Canadian investment firm. "Now, there is none-it's completely closed off."

Low oil prices also hit petroleum company cash flows. Gulf Canada's cash flow was $371 million, down from $592 million in 1997. Unocal's total discretionary cash flow fell by over half, from US$3.3 billion in 1997, to US$1.5 billion last year.

Cash flow is especially important to bankers. "Most banks lend on proven, producing reserves and projected future after-tax-cash flow (cash flow in which all expenses have been deducted}," says John Swendsen, vice president of the National Bank of Canada, Western Region. The National Bank has approximately $750 million exposure to junior and smaller oil companies in western Canada.

According to Swendsen, banks use a "debt-to-cash flow" ratio as a rule-of-thumb to gauge acceptable leverage. The ratio is measured as the number of years that a company takes to payoff its debt with annual cash flow. If the debt-to-cash flow is two, i.e.. the company owes $1 million and has a cash flow of $500,000, then the company is in good shape. If the cash flow drops to $250,000 because of low prices, then the debt-to-cash flow rises to four, which is getting to the upper limit of acceptability. "Most companies are reasonably healthy because they are not highly leveraged," says Swendsen. "But the debt-to-cash flow ratios are starting to creep up now. "

When an oil company gets into financial trouble, banks generally recommend they cut costs, sell assets, or merge.

Slimming Down

Cutting costs is the first step. According to U.S. investment bank Salomon Smith Barney, worldwide spending on O&G exploration and production is set to decline 11% in 1999, to US$79.2 billion.

Canadian companies foresee a 3.6% drop to $11 billion, after an 18% drop in 1998. Gulf Canada Resources, for instance, will reduce capital spending to $300 million, from $1 billion in 1998.

The decline in exploration budgets has already had a profound impact on drilling. In the U.S., well completions for all of 1998 were down to 24,884, off 13% from 28,118 in 1997. The active rig count for the week of February 18, 1999, stood at 531, the lowest weekly rig count on record.

In Canada, drilling fell to 10,000 wells last year, compared to more than 18,000 in 1997, and activity is expected to drop to 8,300 wells this year. The Canadian drill rig count fell to 330 in February, down 36% from the previous year.

Seismic acquisition is also suffering. According to International Geophysical News (a publication of IHS Energy Group, of Boulder, Colorado), Canada had 35 seismic crews working in February, 1999, compared to 81 for the same time a year ago. "The low price has been quite significant to a lot of our member companies," said Ken Lengyel, chairman of the Canadian Association of Geophysical Contractors (CAGC). "We are running at 40-50% of last year's capacity."

Lay Offs

North American oil companies have been cutting jobs in an effort to reduce overhead. Since the end of 1997, the American Petroleum Institute reports that the U.S, industry has lost 42,000 jobs, a drop of more than 12 percent.

In Canada, the energy sector, which employs approximately 75,000 workers across the country, shed 10-15% of its workforce. Amoco Canada Petroleum laid off 275 workers. Canadian Occidental Petroleum Ltd. shed 112 jobs. Chevron Canada looks to reduce its 800 staff by 10%.

While attrition figures for geophysical professionals working the processing and analysis end of the business are not yet available, statistics for the acquisitions idea refirming up. According to Ken Lengyel, of the 5000 staff in total working for CAGC members, 50-60% are currently out of work. "And when you see seismic crews idle, other sectors of the industry are going to be idle in six months."

Companies have also been selling assets to pay down debt. Gulf Canada Resources cut long term debt to $2.2 billion last year by peddling $1.2 billion of assets. It is withdrawing from the majority of its international projects, including Libya, Mongolia and Yemen (many of the properties were acquired in the $1 billion takeover of Clyde Petroleum in 1997). Union Pacific Resources, which purchased Noreen Energy Resources Ltd. for over $5 billion in 1998, has since disposed of $380 million in properties in Canada. According to industry analysts, there is a significant backlog of assets on the sales block, about $1.5 billion in Canada and $6 billion in the United States.

Mergers

Mergers have dominated the industry for the last eight months, such as Exxon Corp.'s plans to acquire Mobil Corp. for more than US$80 billion. The new company, Exxon Mobil, will have 122,000 employees and 10.8 billion barrels of reserves.

Oil companies aren't the only merger candidates. Baker Hughes and Western Atlas, two major oilfield technology and service companies, announced a US$5.5 billion merger last year. Headquartered in Houston, the new company, known as Baker Hughes, will offer fully integrated reservoir management, from exploration to production. It will have estimated 1998 revenues of US$6.5 billion and employ 36,000 staff worldwide.

Mergers driven by financial need are also hitting the geophysical sector. Enertec Resources Services lnc., of Calgary, which reported a 50% decline in business in the last 12 months, is being acquired by Houston-based Veritas DGC Inc. in a $24 million stock swap.

This year, petroleum sector mergers in North America will be governed by the need to service debt loads. Dominion Resources lnc., an energy and electricity giant based in Virginia, purchased debt laden Remington Energy Ltd. of Calgary at a bargain-basement price, buying proven and half-probable reserves for US$4 per barrel.

Natural Gas – A Bright Spot

Not all is doom-and-gloom in the North American oilpatch; prices for natural gas in the 4Q of 1998 averaged US$2.40/gj, up 50% over same period in 1997, and are expected to remain strong in 1999.

Buoyant natural gas prices are keeping many a company afloat. Revenues for gas-heavy AEC, of Calgary, were $1.9 billion for 1998, up from $1.7 billion in 1997. Earnings were $24.4 million, compared with $21.7 million in 1997. The company, which has $1 billion to in vest, intends to ramp up production 26% to 900 mmcf/d, and topping 1 bcf by 2000.

Shell Canada Ltd., with a strong gas position, is another success story. In contrast to parent Royal Dutch/Shell Group, which recorded its worst results in one hundred years, Shell Canada showed 1998 earnings of $432 million. Its oil products division, which makes gasoline and other products at three refineries and operates a national chain of petrol stations, pumped out record operating earnings of $275 million, up from $252 million in 1997.

"I'm very bullish on gas," says Ebbern, who cites a combination of declining supplies in strategic locations, reduction in transportation bottlenecks, and longterm growth in demand to keep the commodity price strong.

"One third of U.S. gas comes from the Gulf Coast, about 19 bcf/ day. Most of it is from shallow water, and those reserves are in steep decline, as much as 20%. In the past few years, they've been able to replace the decline by drilling, but now, drilling is way off."

And Canada is in an excellent position to take advantage of Gulf Coast depletion. "There is no longer trapped gas in Canada," says Ebbern. "A few years ago, there was a 2.3 bcf/d transportation shortage, but now, thanks to expansion of the pipeline system, we're 1 bcf/d over. Alberta produces about 13 bcf/d and exports 8 bcf/day. They could export 9 bcf."

Finally, the Canadian Gas Association says total domestic gas consumption is set to increase 30% to 100 billion cubic metres by 2010, with similar growth expected in the energy-hungry U.S. northeast.

Whither Oil?

Until global oil production drops below demand, however, the price of crude

• and the long-term viability of the industry - will remain in doubt.

According to Oil Market Intelligence, total worldwide supply was 74.5 million b/d in December, 1998, about 2 million b/d more than consumption.

There is already, evidence that low oil prices are forcing marginal wells out of production. The American Petroleum Institute estimates that more than 136,000 oil wells have been shut down since oil prices crashed in November of 1997. " Production is falling off," says Ebbern. "If you assume that Canada, the U.S, the North Sea and Venezuela are all in a situation where they can't afford capital (to maintain drilling programmes), you can assume there will be a drop of 2 million bid just from natural decline. "

"I think you will see worldwide oil production sub-72 million b/d by the end of July," said Martin Molyneaux, an analyst with First Energy Capital Corp., in an interview recently. "We're of the view that oil volumes are going to fall very quickly."

Another serious concern is the overhang of oil in the system. The American Petroleum Institute estimated that total stocks of all oils were slightly over 1 billion barrels at the end of January, 1999.

The U.S. Department of Energy (DOE), however, is predicting that world demand, fueled by historically low prices, will increase by at least 1.2 million barrels per day in 1999. The DOE will also begin replacing oil that earlier had been withdrawn from the Strategic Petroleum Reserve (SPR), helping to soak up the overhang.

"It will cross over from oversupply to undersupply quickly," says Ebbern. "When it crosses that critical supply balance, it doesn't have to go far below to cause a sharp increase in price. It will go up US$5-6 in a month or so. I foresee it occurring in Q3 or Q4 of this year."

And, for those who have money, it is a good time to be in the oil business, with drilling and seismic at decade-low prices. "A kilometre of seismic that was going for $5,000 two years ago is now down to $3,750," says Lengyel. "You pay the same price you did 10 years ago, and the quality is a lot better."

As for Steven Curtis, the geophysicist laid off from Union Pacific, he found a job with Cabre Exploration the following week." I think that things are going to turn around," he says. "The long-term outlook for oil is still very good, and I think that world demand will exceed world supply soon."