A Sobering Look At The Future Of Oil

The current discussion about the future of oil is how soon will it be before petroleum becomes a sunset industry. If it isn’t already. Flat or falling demand. Carbon taxes. Electric cars. Renewable energy. Oil has no future. It is only a matter of time, although how much time remains is subject to considerable discussion and debate. Various prognosticators put forth differing view about when world oil demand will peak. Some say as early as 2030, others much later. Nobody says never.

As for actually running out of oil, that issue has run its course. At least for now.

How long the world stays in the oil business is of critical importance. This is illustrated by a Financial Post article April 28 titled, “Next battleground; Enbridge’s aging Great Lakes pipeline stirs new protest in Michigan”. Until recently, the battle against pipelines has been opposing new construction. Now it is existing pipelines. This opens yet another can of worms the industry and regulators have never really grappled with.

Enbridge Line 5 crosses from Wisconsin to Michigan under the Mackinac Straits between Lake Michigan and Lake Huron, a distance of about 4.5 miles. Built in 1953 to the most demanding standards of the day, the Enbridge website says Line 5 transports about 540,000 b/d of Canadian light and synthetic crude and natural gas liquids to markets in Michigan and beyond. What has emerged is concern among campaigning Michigan politicians about the potential for a major spill into the Great Lakes, an event being politically branded as inevitable.

Gretchen Whitmer, a former Michigan senator now campaigning for the Democratic nomination for governor, was quoted in the article as saying, “Common sense dictates that a pipeline which is already 28 percent past its viable life will eventually be decommissioned. Government would be wise to plan for that proactively – before disaster strikes”. Viable life apparently means it was intended to be in service for 50 years and is now on year 64. Not wanting to be left behind on an emerging issue, Michigan Attorney General Bill Schuette, expected to run for governor as a Republican, has also expressed his concerns about the integrity of Line 5.

Replacing this submerged section of the line is reported to cost $2.4 billion. Where it would go and who would pay is not mentioned. Enbridge routinely inspects the line and claims it is in good shape. Unfortunately, the failure of Enbridge Line 6B in 2010 which leaked 20,000 barrels of oil into Michigan’s Kalamazoo River in 2010 is still fresh in peoples’ memories. Having a campaign issue in Michigan which allows politicians to appear concerned by raising alarms about a Canadian company’s assets is a no-lose proposition, at least in the short term.

The subject and cost of maintaining producing, processing and transportation assets doesn’t arise often. While the profile of decommissioning suspended wells has been rising, keeping what still works going is not frequently discussed. But it should be because after they become public, issues like the future safety of Enbridge Line 5 seldom go away.

The ongoing maintenance of producing, processing and transportation assets is the responsibility of the owner, the same as changing the oil, tires and brakes on a car. It is assumed operators will maintain their sets in good working order, and the vast majority do. Maintenance capital budgets are part of every company.

But what happens when cash gets tight? More importantly, what happens if and when the industry starts going out of business as so many hope?

Back in 2008 Matthew R. Simmons, founder of Houston-based oil and gas investment bank Simmons & Company International, gave a slide presentation at the Offshore Technology Conference (OTC) titled “Oil And Gas ‘Rust’: An Evil Worse Than Depletion”. Simmons was often outspoken on oil issues saying things people didn’t want to hear or hadn’t thought about. His 2005 book, “Twilight In The Desert”, was about how Saudi Arabia’s oil production from its gigantic fields was destined to fall.

Both “Matt” Simmons, as he was called by friends and associates, and his firm are no longer with us in original form. Matt passed away in 2010 and his namesake company was acquired by Piper Jaffray Cos. in 2015. But the issue of the deterioration of steel remains.

Simmons went back to the first 100 years of oil when the big fields were on land, in the shallow waters of the Gulf of Mexico or inland bodies of water like Lake Maracaibo in Venezuela. Starting in 1965 the focused shifted from what Simmons called “brown water” to “blue water” further offshore. In response, the OTC was launched in 1969. But by 2008 Simmons said the offshore industry was mature and the North Sea was already “long in the tooth”. This was nine years ago.

Simmons wrote, “The entire oil value chain is built of steel and steel begins to corrode the day it is cast. The oil industry never grasped this profound risk as it built a house for oil out of steel”. The thought was steel would last forever but forever was defined by investors as profits and by governments and regulators as secure and immediate supplies of essential hydrocarbon energy. Simmons noted much of the core assets of North America and the world – pipelines, refineries, storage tanks, wellbores – dated back to the big expansion years of the 1950s and 1960s.

Simmons acknowledged the industry’s determination to prevent or control rust and deterioration. Cathodic protection. Downhole and surface chemical corrosion inhibitors. Smart pigs to inspect pipeline integrity from the inside. Ultrasonic and non-destructive radioactive testing of vessels, pipe and components. Internal and external coatings for everything. Improved metallurgy. Make it last as long as possible for obvious reasons of economic returns and public and worker safety. The original NACE (National Association of Corrosion Engineers) was founded in Houston in 1943 for the sole purpose of addressing all aspects of this subject.

But Simmons started raising alarms about infrastructure nine years ago. He alleged the 20 years following the oil price collapse of the mid-1980s to early this century when prices started rising again were tough on maintenance worldwide. Simmons concluded, “Bottom Line: The Energy Patch Has To Be Rebuilt”. He called this a reconstruction project along the lines of the World War Two war machine or the Marshall Plan to rebuild Europe stating, “If the world wants to continue to use energy, its assets need to be rebuilt. Simple law of nature”. He figured higher prices (which we don’t have) would help pay for it, but that this was a major issue the industry could longer ignore. In 2008.

Which brings us back to today’s reality. The point isn’t to be alarmist. Matt Simmons wasn’t right about Saudi Arabia or peak oil and he may have overstated the problem at the OTC in 2008. But as illustrated by the emerging Enbridge Line 5 issue, the infrastructure upon which the world depends isn’t getting any younger. The vast majority of western operators are very committed to the safety and integrity of their assets. But capital is precious. Where will the money come from?

The pressure from some governments and all regulators and environmental groups is for the industry to pay more for everything. More rules. More obligations. Higher corporate taxes. The highest possible royalties. More development restrictions. Obstruct infrastructure. Carbon taxes. Emission caps. Investment and endowment funds discouraged from owning oil investments. Standard tax depletion and amortization deductions for capital investment for any business called “subsidies” for oil and gas. If the people of the world won’t quit using oil then opponents are using every tool they can think of to starve the industry of capital.

Meanwhile, the industry’s financial commitments to keep aging infrastructure in good working order increase annually because of the age of the assets and despite the good work done by the companies themselves to stay in business in the face of collapsed oil prices and pro-active organizations like NACE. With money from where? Investors and lenders provide capital to grow the business, not sustain it. That’s up to the company.

The fork in the road has two options, neither attractive.

The first is the most likely. Petroleum will continue to be a key element of the world’s energy mix for decades. This means assets must be kept in good working order. Those demanding the industry do more with less better think this through and appreciate not only will the oilpatch require capital to sustain demand-driven growth through reserve replacement, but to keep everything in good working order to operate safely and efficiently. The current direction of taxes and regulations do not anticipate this outcome. The industry must rely on common sense, which outside of industry and capital providers, is in increasingly short supply.

The other option is worse. Technology and regulations combine to provide economically viable alternatives to petroleum. Now the industry must face decommissioning liabilities for assets no longer commercially profitable to operate. Except they don’t have the cash. And they won’t be able to get the money from debt or equity investors. Who is going to finance a company or industry going out of business?

The numbers are big. Take one example, Suncor Energy Inc. In its Management, Discussion and Analysis notes for its 2016 audited financial statements, Suncor reported sustaining capital investments primarily for oil sands and refining and marketing of $2.8 billion, nearly 50% of total CAPEX of $6.0 billion. A serious amount of money to sustain $71 billion in book value property, plant and equipment. But of course, Suncor is a serious company with no immediate plans for obsolescence.

But under Contractual Obligations, Commitments, Guarantees and Off-Balance Sheet Arrangements there are other numbers. For decommissioning and restoration costs Suncor estimates $382 million for 2017 and $419 million for 2018. This stays about the same through 2021. But the figure for 2022 and beyond is $9.6 billion and the total is $11.7 billion. This is a company which ended 2016 with $16.1 billion in long-term debt and another $2.1 billion in other liabilities, mostly pensions and post-retirement benefits.

Suncor’s total obligations for debt and decommissioning are approaching $30 billion. That’s a lot of capital to service if the company is going out of business because nobody needs its products. As was proven in the recent Redwater Energy Corp. case where Alberta’s energy regulator tried to insert itself ahead of creditors when the assets were sold – decommissioning obligations before debt repayment – lenders rank ahead of cleanup under current law. So, the Alberta Energy Regulator intends to appeal this decision to the Supreme Court.

There is nothing wrong with Suncor. It is a responsible company. But there is something terribly wrong with how the world regards the future of the oil business.

Whether the world decides to stay in or get out of the oil business; governments, regulators and opponents must learn to read an income statement and balance sheet before dispensing any further advice on how the petroleum industry conducts itself. This industry supplied the energy mankind demanded for generations and paid as much in taxes and royalties as governments could extract. Often governments took too much then had to give some back to keep the lights on. Now it is being asked to do much more with much less and perhaps, if the greens get their way, nothing at all.

Indeed, let’s talk about the future of oil. But from a much different perspective.

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