Our post-pandemic economy depends on creating jobs and income through investments and exports. As the world’s fourth largest net energy exporter, oil and natural gas will be crucial to Canada’s economic recovery, say Scotiabank’s Swanzy Quarshie and Paul Lee.
Quarshi and Lee are directors of global equity energy sales at Scotiabank. They highlight trends they’re seeing in the Canadian energy industry, including growth, consolidation and who’s investing. They also highlight how investors are focusing on Canadian strengths like sustainable production, capital discipline, environmental innovation and supply reliability.
Full transcript of podcast:
Leighton: Hello and welcome to another edition of the Energy Examined podcast, the podcast that discusses the issues facing Canada’s oil and natural gas sector with the insiders in the know. I’m Leighton Klassen. Today, I’m joined by Paul Lee and Swanzy Quarshie. Both are directors of global equity energy equity sales at Scotiabank. Welcome to Energy Examined.
Paul: Thanks very much. Great to be here.
Swanzy: Yeah, thank you. Looking forward to this.
Leighton: Yes, so are we. Well, let’s start off. We’ve heard a lot about the importance of Canada’s oil and natural gas industry in our country’s economic recovery. So I’m interested to know what you can say about the importance of the sector to Canada’s economy post-pandemic. And, Paul, we’ll go to you first to address that.
Paul: Leighton, it’s a great question. The Canadian economy’s industry composition is already concentrated in oil and gas. And so, as such, the strength of its economic recovery from COVID-19 will ultimately be impacted by how well the oil and gas industry performs. And really at the core of this is the value of exports that are tied to commodity prices and global demand. And I make the point here: Canada is the world’s sixth largest energy producer, the fourth largest net exporter and the eighth largest consumer.
So, it shows you how important it is to our overall export strategy and our standard of living and some numbers around that — just as far as how important it is — oil and gas extraction, for example, made up about five and a half per cent of Canadian GDP. And it’s higher in the western provinces and in Newfoundland. But the sector accounted for about 15 per cent of our merchandise exports. And so, that’s by far the largest of any sector.
And there’s also huge impacts in other sectors like construction, manufacturing, financial services that inputs into the oil and gas industry and stand to lose out quite significantly too if we don’t recover. And just for context, on jobs, in 2019, Canada’s energy sector employed about 280,000 people and indirectly supported over 550,000 jobs. So, that gives you a sense of just how important the sector and it is to the recovery of the Canadian economy.
Leighton: Yes, very significant. And as far as the investment climate goes in Canada’s energy sector, what are some of the trends we’re seeing Paul?
Paul: Yeah, it’s definitely shifted if you think about the industry spending. And that’s what, when we think about investment trends, I’ll speak a little bit about what we’re seeing from companies upstream, midstream, downstream companies. Swanzy can give a bit more colour on the investor side. But really, the investor trends on the company sides have really shifted over the last three to four years, and the pandemic has only accelerated that change.
And so, what you’ve seen from companies is a lot more priority of free cash flow and debt repayment, getting balance sheets strong again and returning cash to shareholders. And that change has been driven by multiple factors. But it comes down to risk profile, the ability to finance and raise capital and then higher return expectations from investors. And, you know, companies are also looking at how to pivot towards more sustainable businesses. So, that’s true by their focus on free cash flow over production growth, but also companies looking at ways to lower their carbon emissions.
I think the second significant trend we’ve seen in the last five years is really significant consolidation. And that’s happened. A lot of the headlines would happen around oil sands and large foreign entities selling assets. And I know one term, a popular term is that the oil sands have become more ‘Canadianized.’ And I think we’ll expect that consolidation trend to continue: CNQ with Shell, Cenovus with ConocoPhillips at FCCL [Foster Creek Christina Lake], CNQ and Devon, you’ve had Suncor consolidate further the Fort Hills project. So, that’s kind of what we’re seeing more of, I’d say, on the company and the capital allocation framework.
Swanzy: Maybe I’ll take it off from the investor side. So as Paul discussed, I would argue that a lot of the trends that we’ve seen in industry has actually been driven by investors. Investors have been really challenged in investing in the energy sector, not just in Canada specifically. Globally, energy investment has been really, really quite challenged. They historically used to reward companies for taking on growth. Investors like to see growth in the energy industry, and we’re hoping to catch commodity cycles on the way up when they would get rewarded for taking on some of that risk and invest in those companies.
But the strategy historically has not really generated adequate enough returns for investors. So, today they are asking companies for different modus operandi. They’re asking them to really deliver returns that adequately compensate them for taking on the volatility that’s inherent in this space. So, they don’t want to just invest in oil and gas names, just based on cyclical outlooks. They really just are looking for real investments from oil and gas companies.
And then the other thing, too, that investors are telling us that they’re wrestling with a lot these days is just the trends that are going on with ESG investing. That’s environmental, social and governance. And they are also wrestling with where energy fits in in the whole energy transition theme. So, they want to stay invested in the space. Investors are certainly supportive of Canadian energy, but they also are facing a very difficult climate right now when it comes to investing in Canadian energy.
Leighton: OK. Now, CAPP issued a forecast earlier this year indicating that spending will be primarily in Alberta and B.C. with some modest improvement in Saskatchewan and some stabilization in Atlantic Canada. Given the unpredictability of the pandemic, are you seeing any shifts in this particular forecast? And I’ll go to Paul for that one.
Paul: Yeah, Leighton, no major shifts on that forecast. If you look at the way in which production is accounted for across the country, Alberta accounts for more than 80 per cent of the country’s oil production and a similar amount of natural gas production. So, Alberta is going to command the most capital allocation just based on that basis. And we’re seeing pockets of Montney growth, that extends from northwest Alberta all the way into northeast B.C. And that incrementally benefits those two provinces.
But if you look at overall capital investment, like we think it’ll be kind-of $20-25 billion within oil and gas, upstream oil and gas this year, oil sands will make up about a third of that. And so, Alberta will continue to track the most capital, even if it is only sustaining capital versus growth capital. And when you look at the broader picture, like I think the budgets for companies, 2021 over 2020, they’ll probably be 10 to 15 per cent higher. So, it’s still a higher level of spending than we saw last year. It’s kind-of the peak during the pandemic, but I’d say still relatively conservative relative to the last five years.
Leighton: OK, and back to the investing question in the investing climate, Swanzy, that you were speaking about earlier, who is investing in Canada’s natural gas and oil sector right now and who maybe isn’t as much anymore?
Swanzy: That’s an interesting question. I mean, there has been some change over the last few years. If I look back at my Bloomberg over the last 10 years, for example, it’s really mainly the U.S. and Canadian investors who have been most active in Canadian energy. I know we see a lot of headlines just coming out from European pensions in particular, just talking about how they’re divesting from fossil fuels and then also specifically on oil sands, there’s a lot of chatter out there that there’s some divestment out of oil sands from some of these European pension plans. And money managers aren’t really seeing them as meaningful participants in Canadian energy, however.
So, I think a lot of this is just headline risk rather than meaningful divestment of Canadian energy. What we’re seeing in in the U.S., unfortunately, with the pandemic, we have seen the falling U.S. ownership in Canada. You take a look at the two largest companies or producers in Canada right now are Suncor and Canadian Natural Resources. I’m talking about this from the perspective of just market cap. And when you look at these two largest producers, about two years ago, 55 per cent of the interest of ownership in those two names was actually from U.S. investors. And you fast forward to today post-pandemic, and it’s about 45 per cent ownership from U.S. investors.
Now, on the other hand, Canadians have stepped up a little bit to compensate for some of their loss of ownership that we’ve seen from the U.S. So, over the same timeframe for the same two companies, we’ve seen Canadian ownership rights about 36 per cent from 29 per cent previously. What we are finding just discussing these themes with investors is that there is a bit of a home country bias debate. A lot of investors are not putting a lot of money to work in energy. So, the money that they do put to work is staying close to home. And that also creates a bit of a bias towards larger cap companies as well. They stay closer to home, they want to take on less, less risk of benchmark risk. So, we are finding that a lot of people have been selling the smaller cap producers and sticking closer to home and also owning more of the larger cap producers right now.
Leighton: OK, as far as how investments actually happen, can you provide a brief 101 on how particularly how Canada has to compete for capital?
Swanzy: Yeah, sure, you know, investing really just starts with access to capital, right, and everybody is looking for access to capital. And so, essentially what Canada has to do is Canadian companies have to demonstrate to shareholders or potential shareholders that they are going to be good stewards of investor capital. So, investors are essentially looking to monitor things like management. They’re looking for geopolitical risk. Obviously, we’ve heard a lot of talk about things like egress. So those are the kind of risks that investors look for. And so, investors are looking to essentially do all that analysis to determine where they want to put their money.
In order for Canada to compete for capital, we have to demonstrate that we are effectively a good place to do business and that Canadian companies will be really good stewards of capital. And historically, that has been really well demonstrated. We have seen Canada be really a shining star when it comes to energy investing, but we did lose a lot of that attention with a lot of the shale play that came to the forefront with some of the discoveries that we made in the U.S. So, access to capital is really what the game is all about. And demonstrating to investors that Canada is a good place to invest money and a good place for good returns is how we compete for that access to capital.
Paul: And I’ll just add from a company perspective, I mean, I think that access to capital is where companies are going to allocate that to jurisdictions that, really with the best project economics. And so, we’re crunching whether it’s IRRs or profit investment ratios or NPVs of projects that’s on a risk adjusted basis, that’s really kind-of what we’re going down to and other factors like on the risk adjusted side, right, companies have to weigh long versus short cycle projects. As Swanzy mentioned, U.S. shale or the oil sands projects are much longer term.
So, companies need to consider that in their investment horizon. Market access was a huge issue in Canada and still is, without existing market access or excess pipeline capacity. And then, regulatory and taxes. And so, companies take that into account all in those types of calculations.
But I think the good news is that Canadian oil production has been more resilient right through this than U.S. oil production. And you’ve seen that in Canadian oil production recovering much faster and it’s back at record highs. And that’s because we benefit in Canada from a lower decline rate. The oil sands are more of a manufacturing process. And you’re seeing this now play out in where producers in Canada, oil sands producers in particular, are generating a lot more free cash flow than relative to other enterprise values than U.S. counterparts.
Leighton: OK, and you kind-of touched on this in terms of how we can make Canada attractive. And what you said in your last answer there, at least there’s a little bit of silver lining, because I think we’re all, everybody’s really struggling right now because of the pandemic and it’s nice to hear that the oil and natural gas industry is seemingly recovering quite well. But how can Canada make itself attractive as far as investment goes, so we can continue to boost our economy?
Paul: I mean, that’s a good question. It’s a difficult question to answer. The one thing to think about is government’s set annual budgets and companies, like I mentioned, generally require longer cycle times, especially for oil sands projects. And so, I think the big picture, how do you make Canada more attractive is offering from a regulatory and tax perspective is stability and visibility.
And I think the other thing is having a firm view on where the carbon tax is going is going to be helpful, and that can spur investment around reducing emissions on its own right. I give an example like Canada has only one major LNG export project under construction, and there were several planned at one time. And right now, there’s multiple up and running in the United States. And so, I think in some instances there’s probably a larger role for the government to play in moving faster and helping build an industry from the ground up and de-risking some major projects.
Perhaps a similar thing will be said one day about hydrogen, for example. And we’ve seen now a hydrogen strategy for Canada released in December 2020. And you’ve seen the federal government step up and purchase the Trans Mountain pipeline expansion when the risks for the private sector were too high. But again, hydrogen and carbon capture, I think we need to be able to compete with the U.S. And the recently announced federal budget, I think that’s a step in the right direction. And they certainly are committed, it sounds like, to consulting about a potential credit, but all of that would incentivize some private investment, and that’s really what we need.
Leighton: OK, great, just to shift gears a little bit here, in partnership with CAPP, the Canadian Association of Petroleum Producers, your organization, Scotiabank, recently held a virtual energy symposium focused on connecting investors with oil and natural gas producers in Canada. Just interested to know how it went and how well it was attended. Swanzy, can you give us some insights on that?
Swanzy: Yeah, sure. So, this was a great event. It went really well. It was a two-day event that featured over 40 companies as well as industry and political leaders. I would say that despite the virtual setting, attendance was actually quite strong once again this year. Overall, what we’re finding from it, just speaking to investors after the fact and also just listening to company presentations, is that sentiment is starting to improve in energy broadly, but in Canada specifically.
There was a lot of talk about just all the advantages Canada currently has, just with the way that investors are looking at the space, looking for companies to actually show capital discipline as well as good rates of return. That’s something that Canada can really compete effectively on. I think part of that improvement in sentiment is also coming from just rising expectations around near-term improvements in egress for this country. We are now seeing that. Enbridge’s Line 3 replacement is going to be in service at some point this year. We’re also waiting for Trans Mountain expansion. And investors are really anticipating these new routes to get more product out of the country.
And as Paul mentioned, I mean, Canada’s production has been extremely resilient, and we are now back to record production levels. So, having that egress and continuing to demonstrate that Canada can be actually quite effective when it comes to capital discipline and capital allocation is something that investors have really been looking for.
One of the things that companies kept on highlighting as well was just how much leadership there is in greenhouse gas emission technology. One of the best attended panels actually at the conference was our technology innovation panel. I think through this panel that there was actually a really good demonstration of just how much work has already been made towards really cleaning up the carbon footprint for oil and natural gas production out of Canada. So, it was really quite positive. After the event, we spoke to quite a few investors and they tell us that they are slowly returning back to the space. They are looking at energy. They’re looking for more certainty around commodity prices right now. They want to see the fundamentals catch up to the commodity price. But certainly, there is more interest growing in Canadian energy specifically, especially because our production has bounced back so much faster than U.S. production.
Leighton: It’s great to hear that there’s a lot of optimism on the horizon because like I said earlier, we all kind-of need that right now. I do want to ask about some of the significant obstacles and threats the industry faces right now and I know Paul kind-of touched on some of them, one of them being market access. But Swanzy, what are some other challenges and obstacles we face right now?
Swanzy: Well, it’s an interesting question because Canada has been facing quite a few threats for a while and some of these threats have become worse with a pandemic. Maybe I’ll start first with just talking about what we face historically. Paul and I’ve both been in energy for too many years right now. And over time, one of the things that we’ve both seen in our careers has just been how production supply has changed over time. And this happened with the advent of short cycle shale oil production and that mainly came from the U.S.
Now, that was something that really attracted a lot of capital, not just capital from the U.S. staying in the U.S., chasing growth from a lot of these new-found shale oil producers, new fund growth companies, but also Canadian investors also followed U.S. investors into the U.S. looking for production growth. And so, that was a real challenge when it came to access to capital. It was a real challenge for investors trying to also decide how to essentially spend your investment dollars between U.S. and Canadian companies. So, that was a major challenge for Canadian, certainly for Canadian companies.
And the other thing, too, that’s been a challenge is that investors generally are now starting to recognize that they have not been adequately compensated for the risk that they’ve taken in investing in the energy sector. There’s been a lot of volatility and not very good returns historically. So, that’s been a challenge and they’re looking for compensation for that challenge and for taking on that risk. And then also mentioned, like all the new themes that are arising in terms of ESG investing as well as energy transition, all that is really reducing investor appetite for fossil fuels.
And so, oil and gas companies looking to attract investors really have to demonstrate that they will be able to be good stewards of capital, like I mentioned before, in order to gain that access to capital from investors. They also have to demonstrate that they are part of the solution when it comes to reducing the carbon footprint. And we’ve seen that more and more from oil and gas producers. So, although we have seen these threats come about, we are seeing that the oil and gas companies, especially in Canada, they are rising to the challenge and they are starting to really demonstrate to investors that they are part of the solution and that Canada really has a lot to offer when it comes to all this technology that will help to reduce the carbon footprint off of the fossil fuel industry.
Leighton: OK, and I don’t know if you may have answered this already, kind-of in that question about the historical issues combined with the issues that we’re facing with the pandemic. Is there any silver lining to the pandemic specifically as far as investment goes?
Swanzy: Yeah, I do see a number of silver linings. If I think about it, like I feel like there’s three specific silver linings that came about from this pandemic. The first one is just on a macro level. There’s been a lot of talk about demand destruction, demand destruction. We’ve seen obviously COVID cases surging in India right now. And there’s a lot of concern about what that’s going to do to the global demand recovery story. But one of the things that we don’t hear as much about is supply disruption.
And Paul mentioned that Canada’s production has bounced back pretty quickly. The same cannot be said for the U.S. Before the pandemic, the U.S. was producing about 13 million barrels a day of oil, and today there are around 11 million barrels a day. So, that has actually accelerated the bull case for oil. The demand destruction will bounce back a lot quicker once we get through COVID than the supply disruption. So, we do feel like you look at what’s happened in the U.S. short cycle supply as well as some of the bigger projects globally that haven’t gotten the kind of funding that they need to keep producing, that is going to create an opportunity in energy for essentially higher prices. So, it’s good on the bull case for oil.
Now, the second thing is that there’s obviously been a lot of talk now about capital discipline and a return of capital model. And this is something that investors have really forced companies to move towards. Canada has been forced to move towards that model faster than the U.S., partly because of our egress issues. But now, after we saw the demand fall significantly, we are seeing that investors are now asking for U.S. producers for the exact same thing. And part of that is because people now, with the whole notion of energy transition are starting to really doubt the long-term growth potential for energy consumption. So, when you don’t think that we are going to be needing more than 100 million barrels a day of supply, ultimately you want investors or companies to start acting not just for the sake, not just growth, for the sake of growth, but actually also really returning capital to investors and really going after some of the most productive and profitable production.
So, that whole capital discipline and return of capital model that investors are going for is something that has actually been a winning theme for Canada. And I think Canada will continue to win because our oil sands production has lower declines. It’s more of a manufacturing project, as Paul discussed. And so, we have the ability to actually deliver higher returns and free cash flow from those kind of projects. And that’s something that investors are looking for right now.
And then, the final thing is that just on the reduced carbon footprint, people are looking for fossil fuels to reduce their carbon footprint. And if you look at the technology that’s coming out of Canada, that’s something that Canada is really well positioned on. So, if we can actually have some solutions for reducing the carbon footprint of Canadian oil because we compete so well on everything else, it really puts Canada in a great position. And I think that’s what investors are looking for and investors would really gravitate towards that in Canada if we equalize the carbon footprint.
Leighton: Speaking of that growing investment, Paul, what could growing investment in the oil and gas industry mean for its role, in the medium and then, of course, the longer term for Canada’s recovery as we exit this pandemic, hopefully soon?
Paul: Yeah, like I mentioned a few of those points, the economic importance at the beginning. And I think what it means is more investment means more economic growth, means more jobs, means wage gains for Canadian workers. And I think, you know, going back to that upstream oil and gas extraction spending, it’s around $22 billion. So, again, another context, data point on that, that’s about nine per cent of total Canadian investment capital.
So, just in one industry and on the upstream side, so that’s significant. And if you look at the weekly wages of Canada’s oil and gas industry averaged two to two and a half times the national all-industry average. And it gives you a sense again, back to that fact that importance of exports and growing our exports as a net exporter of oil and gas products. And I think for context, it’s really important for Canadians to think. about what that spending level does for the medium to longer term, and it’s just not the spending today for the jobs, but it’s the higher production, the higher value-added products, the increased value of our exports and those exports flow back into the cash flows of companies and ultimately the Canadian workers via wages.
And then the other really important point is, I mean, those cash flows flow back to provincial governments via royalties, and those are used for social programs and services. And that’s something very unique about Canada versus the U.S. is that those royalties are owned by the crown provincially and where that’s not primarily the case in the U.S. And so, there’s huge social benefits and they go on and on for years for Canadians and everybody benefits. So, that that gives you some context about kind-of the medium, long-term.
Leighton: Yeah, thanks for that. That’s great. And lastly, kind-of a loaded question, but I mean, what can industry, government, even the public, what can we do to make our country’s oil and gas industry more attractive? And I’ll also maybe just ask, are we doing enough?
Paul: Yeah, like I think I mentioned some of those points earlier about governments and I mentioned stability and visibility on the regulatory and the tax side. I think it would help, too, with governments, if they can really start choosing to pick what we’re good at and acknowledging the importance of the industry and some of the economic realities of, if you’re spending almost 10 per cent of total Canadian investment capital.
So, I think there’s probably a growing realization of that importance. And I mean, you’ve seen some of that through sort-of what’s been announced already and federal support programs. I know there’s various groups that would disagree that’s not far enough. But I think de-risking major projects and getting projects built from the ground up. And that’s why I mentioned hydrogen and carbon capture, because they have huge implications and huge opportunities globally and they need some incentives to make them happen and to make the economics go around. So, I think that it’s about championing some of these industries that can create wealth for not just the next five years, but for the next generation. And that’s what I think about — what oil and gas has done to Alberta and the Western provinces, for example, and for other provinces like Newfoundland [and Labrador]. But it’s just a huge opportunity for the country.
Leighton: OK, great, opportunity, optimism, I like what’s come out of this conversation. I hope we’re all correct and I hope we continue to get out of this pandemic as best we can for our industry and for all of us. So, thanks very much, both of you, for being on the show.
Swanzy and Paul: Thank you. Thanks Leighton.
Leighton: Yeah, no problem. Well, that was our conversation with Paul Lee and Swanzy Quarshie, both directors of global energy equity sales at Scotiabank. Stay tuned for the next Energy Examined podcast. If you like this episode, please share it with a friend and make sure you subscribe on whatever podcast that you have. For more stories and interviews on Canada’s energy industry, check out our website, context.capp.ca.