mawer INSIGHT CANADA S CRUDE AWAKENING IN THIS ISSUE North America s surging oil & gas supply The technology that s leading to greater output

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1 mawer INSIGHT Volume 39 April 2013 CANADA S CRUDE AWAKENING IN THIS ISSUE North America s surging oil & gas supply The technology that s leading to greater output The transportation challenge Copyright 2013 Mawer Investment Management Ltd. Readers may forward electronic versions of this article. To order reprints or receive an electronic copy, please contact us at info@mawer.com

2 2 Volume 39 April 2013 Headlines proclaiming the coming age of North American energy independence seem in great supply of late. A reasonable reaction to these projections would be to think that it is no big deal because Canada has been a net energy exporter for many years; however, the underlying dynamic buoying North American energy independence is American Energy Independence. Considering that Canadian net exports of oil and natural gas represent approximately 38% of total production, and that the U.S. consumes approximately 90% of Canadian energy exports, the prospect of North American energy independence is a big deal to Canadians. THE OLD TECHNOLOGY Before we delve deeper into the underlying implications of North American energy independence, it is important to understand the technological drivers of the shift in supply fundamentals. While energy has been extracted from the earth for well over a century, a new term, unconventional oil and gas, has recently entered the language of the industry. What makes oil and natural gas conventional or unconventional? The term conventional is used to describe oil and natural gas reserves that can be extracted by applying long established methods. As such, conventional oil and gas is that which can be produced by drilling vertical wells into underground reservoirs from which oil or gas flows naturally or can be pumped easily to the surface. While technology has progressed since the early days of the Oil and Gas Industry, decades of conventional oil and gas production has resulted in a decline of these conventional resources. Essentially, the majority of the world s oil and gas deposits that can be extracted using vertical drilling methods are already being produced. 1 Thus, producers are now applying different methods and technology such as horizontal drilling and hydraulic fracturing to access unconventional oil and gas reservoirs that were previously unprofitable to extract. Unlike conventional oil and gas, unconventional oil and gas are much more challenging to produce. One of the challenges presented by unconventional production is due to tight rock formations in which oil and gas resources can be trapped. What makes these formations tight is that they exhibit low porosity meaning that the proportion of pores, or space, in a given volume of rock is relatively low. Tight rock formations also possess the characteristic of low permeability. The combination of low porosity and low permeability makes it difficult for hydrocarbons to move through the rock when stimulated by conventional vertical drilling technology. Put simply, when unconventional deposits are drilled vertically, oil and gas simply stays put. In order to help illustrate the distinction between conventional and unconventional oil and gas production, the Canadian Energy Resources Conservation Board uses the analogy of water, a sponge, and a piece of clay. The water contained in the sponge is analogous to conventional oil or gas; when saturated with water it is easy to squeeze out of the sponge. By contrast, water contained within the piece of clay represents unconventional oil or gas. If one wishes to release the moisture trapped within the clay, they are presented with a different set of challenges. 2 So, the next logical question would be: What method was conceived to release the metaphorical water from the piece of clay? THE NEW TECHNOLOGY As drilling capability progressed from the vertical to the horizontal, producers gained the ability to target and stimulate oil and gas reservoirs in ways that are not possible using conventional methods. The impact of this technological advancement becomes more significant when one takes into consideration the fact that hydrocarbon bearing zones tend to be horizontal and relatively shallow formations in stratified rock due to their past as ancient sea beds, river channels, and shorelines. For example, reservoirs that are relatively shallow can be stimulated more effectively and at a lower cost from a single entry point by drilling through the formation horizontally as opposed to drilling several wells vertically. When horizontal drilling is combined with hydraulic fracturing, some conventionally low-producing or unproductive rock formations can become significant producers of oil or natural gas. As described by the Canadian Association of Petroleum Producers: Hydraulic fracturing, (also known as fracking ) is the process of pumping a fluid or gas down a well in order to create enough pressure for the surrounding rock to crack, or fracture. A fluid (typically water with some additives) holding a proppant (typically sand) then flows into the cracks. When the pumping pressure is relieved, the water then disperses leaving a thin layer of the sand to prop open the cracks. This layer also acts as a conduit to allow the oil or natural gas to escape from tight (low permeability) formations and flow freely to the well so that it can be recovered. 3 In addition to increasing oil and gas production, advances in technology have also helped to reduce costs associated with the natural gas liquefaction process. During this process, a given measure of natural gas is condensed to 1/600th of its original volume by removing certain components and then cooling. With 600 times the cargo space afforded by cost efficient natural gas liquefaction, it becomes economically feasible to export Liquefied Natural Gas (LNG) across expanses where pipelines do not exist or where it would be uneconomic to build, for example, the Pacific Ocean. As such, innovation in this technology has put promising Asian natural gas markets on the horizon for Canadian natural gas producers. AN ENERGY POWERHOUSE With both conventional and unconventional oil reservoirs in play, Canada is in possession of the world s third largest proven reserves. As technology continues to improve, recoverable oil assets are estimated to increase from 173 billion barrels to as much as 343 billion barrels. 4 This potentially dramatic increase in supply is attributable to the impact that horizontal drilling and multi-stage hydraulic fracturing technology and other unconventional production techniques have

3 Volume 39 April had by revitalizing conventionally low-producing or unproductive oil reservoirs in the Western Canadian Sedimentary Basin (WCSB). In addition, Canada s output of approximately 3.6 million barrels per day makes the country the sixth largest producer of oil in the world. 5 While the contribution of WCSB oil production to total Canadian output is substantial, it is notable that development is also taking place in several other parts of Canada including the Beaufort Sea in the Arctic and the Gulf of St. Lawrence in the Atlantic offshore region. As one would suspect, when supplies are projected to increase, so should output. And output is projected to expand even further as extraction technology continues to evolve. The vast majority of the projected growth in production is expected to come from unconventional resources. The chart below 6 illustrates the acceleration in Canadian tight oil production since 2005: GLUT RUT Canadian Tight Oil Production by Province: Source: National Energy Board While the Canadian unconventional oil and gas production functions have increased due, in part, to the economic utilization of directional drilling and hydraulic fracturing technology, the development of transportation capacity, in particular pipeline infrastructure, has not been able to keep pace with surging production levels. As the most efficient and economic way of transporting large quantities of oil and natural gas, pipelines play a crucial role. Current infrastructure connects the centres of Canadian oil and gas production with refining and export hubs in the eastern provinces, the West Coast, and U.S. markets. In total, members of the Canadian Energy Pipeline Association transport approximately 3 million barrels of oil per day. 7 With current daily production levels already outstripping existing pipeline infrastructure capacity, inventories are piling up. This is a contributing factor to the so-called Bitumen Bubble. The Bitumen Bubble is a reference to the 27% discount (at the time of writing) of Western Canadian Select a heavy blend that serves as a proxy for regional heavy crude prices attained by western Canadian producers against Western Texas Intermediate (WTI) which forms the basis of crude pricing in North America. 8 In other words, there is such an abundance of oil in western Canada that for each dollar fetched by U.S. producers, Canadian producers must accept only 73 cents. Compounding the problem for Canadian producers is that unconventional oil and gas production methods are also allowing U.S producers to exploit prolific reservoirs south of the 49th parallel. As mentioned earlier, the U.S. consumes approximately 90% of Canada s energy exports. While the U.S. is the world s largest consumer of oil and natural gas by a sizeable margin, they are also ranked as the world s second and third largest producer of natural gas and oil, respectively. Like Canadian producers, they are endeavouring to develop and expand their unconventional oil and gas production. And they are finding success recent reports indicate that the notion of American energy independence could soon go from political bluster to economic reality. The U.S. Energy Information Administration estimates that Canada s best customer is not only on track to become the world s leading oil producer by 2020, but they are also expected to become energy independent by 2035, joining Canada as a net exporter of oil. 9 PIPE DREAMS With Canadian oil and gas production continuing to increase, and the potential that the buyer of the majority of Canadian crude will no longer require the supply in the future, a logical question to ask is: What can Canada do about it? As we ve touched on, increased oil and gas production is outpacing the existing infrastructure s ability to transport it to market. Not surprisingly, the three companies that operate the majority of Canadian export pipelines all currently have projects planned to expand capacity. TransCanada s proposed $5.3 billion Keystone XL pipeline would run from Hardisty, Alberta to Steele City, Nebraska. From there it would be linked to Cushing, Oklahoma (the price settlement point for WTI crude) via TransCanada s Cushing extension. Infrastructure would ultimately extend to the refineries and tidewaters of the Texan Gulf Coast by the time TransCanada s Gulf Coast Pipeline Project, which broke ground in August 2012, is completed. The added capacity provided by the Keystone XL pipeline has the potential to transport 830,000 barrels per day. 10 That being said, the planned pipeline s route runs through eastern Montana putting it within range of producers operating in the prolific North Dakota Bakken where daily production has been estimated to become as high as 2 million barrels per day by Consequently, southbound pipeline capacity is likely to remain at a premium. Kinder Morgan intends to bring on additional westbound pipeline capacity by expanding their existing Trans Mountain system which runs from Edmonton, Alberta to terminals located on the coast of British Columbia s lower mainland and the northwest coast of Washington State. If the project is approved, recent reports indicate that it has the potential to transport an additional 890,000 barrels of oilsands production per day. 12 Meanwhile, Enbridge is in the preliminary stages of planning its own westbound pipeline project. The Northern Gateway Project would connect Bruderheim, Alberta to a marine terminal near Kitimat, B.C. The proposed $5.5 billion project would allow oilsands producers to avail themselves of an additional 525,000 barrels per day of transport capacity via pipeline. 13

4 4 Volume 39 April 2013 If all the proposed pipeline projects described above receive approval, infrastructure capacity could receive a 70% boost. For the moment, however, producers are not sitting idly by while the fates of proposed pipelines are being contemplated. In order to cope with infrastructure bottlenecks, producers have begun utilizing alternative transportation such as shipping crude by train. DON T FORGET THE GAS When it comes to natural gas, Canada ranks as the third largest natural gas producer in the world. With average annual production of 5.2 trillion cubic feet (Tcf), 14 Canada is also the world s third largest exporter of natural gas. The application of unconventional production methods to access tight gas reserves has already had a meaningful impact on the North American natural gas industry over the past ten years. A case that illustrates the changing gas supply fundamentals in Canada is the Kitimat LNG facility that was originally conceived as a gasification terminal to process incoming LNG shipments from overseas producers in order to ameliorate the projected domestic natural gas shortage. As a result of the surge in supply both in Canada and the U.S., the project is now slated to move forward as a liquefaction terminal. Producers (primarily operating in the Horn River and Liard basins of northeast British Columbia) intend to transport natural gas via pipeline to the Kitimat terminal for processing. LNG would then be loaded onto specially equipped double hulled ships bound for Asian markets across the Pacific. Among these markets are the world s second and third largest economies, China and Japan. Because of a dearth of domestic supply and high demand in those countries, prices are much higher in international natural gas markets making them much more attractive relative to North American markets. 15 Source: World Bank Commodity Markets:The Washington Post MAWER S TAKE While conventional oil and gas extraction has been falling off, unconventional production has emerged to more than compensate for the decline. With this trend expected to continue in the coming decades, the issue for Canadian producers becomes getting supplies off the shelf and to the market. Ultimately, this is of concern to Canadians as the lack of pipeline infrastructure restricts the ability to monetize vast oil and gas resources. At present, the proposed Northern Gateway and Trans Mountain pipeline projects would establish an opportune export outlet for the ubiquitous Alberta oilsands. As such, the argument for moving forward with the projects is compelling. Contributing to the significance of the Enbridge and Kinder Morgan projects is the fact that the proposed pipelines would allow supply to reach tidewaters and international trade routes on the West Coast. With U.S. energy independence on the horizon and markets in Asia requiring increasing volumes of energy to fuel growth, the economic importance of establishing this coastal link to Canada becomes clear. That being said, there are enormous hurdles to clear before additional pipeline capacity can be built. Environmental groups, along with numerous First Nations across Alberta and B.C., oppose the Northern Gateway project. These groups raise several concerns including the potential impact of an oil spill on the B.C. coast which would be heightened with increased tanker traffic; putting wild salmon populations at risk by building pipeline that intersects their freshwater spawning grounds; and, exacerbating global warming as a consequence of expanding oilsands development. Hence, economic incentives must be balanced with meaningful consideration of potential environmental impact and recognition of First Nations rights. Regular readers will be well aware that we shy away from trying to predict specific outcomes such as the approval of pipeline projects or other infrastructure proposals. Instead, our focus continues to be on the identification of companies that fit our investment criteria: wealth creating companies those that deliver a return on capital greater than their cost of capital over time by virtue of a sustainable competitive advantage that are run by excellent management teams, and are available at discounts to intrinsic value. Nonetheless, even bottom-up fundamental analysis needs to incorporate some degree of top-down work if a particular variable (in this case the prices of oil and gas) has the potential to significantly impact the investment hypothesis. And with respect to oil and gas prices, we do find ourselves concerned with both the potential for oversupply and the inability of Canadian producers to get that supply to market. As such, at the margin we have been reducing our exposure to upstream oil and gas companies in Canada (those that are primarily involved in exploration and/or production) and tilting our portfolios towards North American manufacturing businesses that stand to benefit from lower energy input prices. In addition, we recognize a potential trend of increasing utilization of railroads to transport crude in response to shortages in pipeline capacity which would benefit existing portfolio holdings such as Canadian National Railway and Canadian Pacific Railway. Going forward we will continue to monitor the situation closely and will make adjustments to our portfolios as necessary. Ed Ylagan Report Writer Mawer Investment Management Ltd.

5 Volume 39 April END NOTES 1 What is Unconventional Oil and Gas? Energy Resources Conservation Board, Web. 2 What is Unconventional Oil and Gas? Energy Resources Conservation Board, Web. 3 What is Fracturing? Canadian Association of Petroleum Producers, 4 Canada s Energy Future: Energy Supply and Demand Projections to Energy Market Assessment. National Energy Board, Web. 5 Canada Analysis. U.S. Energy Information Administration, Web. 6 Tight Oil Developments in the Western Canada Sedimentary Basin Energy Briefing Note. National Energy Board, Web. 7 CEPA Library Factoids. Canadian Energy Pipeline Association, n.d. Web. 8 Observation Drilling Down on Crude Oil Price Differentials. TD Economics, Web. 9 Ungar, Rick. IEA Report: USA Set to Become Number One Oil Producer by Energy Independent by Forbes 12 nov. 10 Keystone XL Pipeline - About the Project. TransCanada, Web. 11 Mason, James. Bakken s Maximum Potential Oil Production Rate Explored. Oil and Gas Journal 02 Apr Web. 12 Vanderklippe, Nathan. Kinder Morgan Hikes Planned Capacity of TransMountain Pipeline. The Globe and Mail 10 Jan Web. 13 Northern Gateway Pipelines - Project Details. Enbridge, Web. 14 Canada Overview/Data U.S. Energy Information Administration, 15 World Bank Commodity Markets Data. The Washington Post, 01 Apr Web. Apr All information contained herein has been collected and compiled by Mawer Investment Management Ltd. All facts and statistical data have been obtained or ascertained from sources, which we believe to be reliable but are not warranted as accurate or complete. All projections and estimates are the expressed opinion of Mawer Investment Management Ltd. and are subject to change without notice. Mawer takes no responsibility for any errors or omissions contained herein, and accepts no legal responsibility from any losses resulting from investment decisions based on the content of this report. This report is provided for informational purposes only and does not constitute an official opinion as to investment merit. Based on their volatility, income structure or eligibility for sale, the securities mentioned herein may not be suitable for all investors.