How Canada’s oilpatch is reacting to a generational price shock

What began as a disruption to shipping has become a structural shortage in global oil supplies. The closure of the Strait of Hormuz hasn’t just sent global oil prices skyrocketing, it’s begun a drawdown in the excess supply that oil markets had before the outbreak of the US-Israeli war with Iran. Going into the conflict, there were about 8.2 billion barrels of global inventory. Since then, about one billion barrels of that excess supply has been consumed. Major oil producers in the Arabian gulf have had to slow or halt production at key sites, and nobody exactly knows how long it would take to bring that production back to prewar levels if and when the straits open.

Michael Shaw, Director and Portfolio Manager at Clearbridge Investments, explains that global consumption is currently outpacing supply by 13 million barrels per day. If we want inventories to come back up to prewar levels, we’ll need an extended period of oil production outpacing demand by at least one million barrels per day. In the meanwhile, oil prices are likely to remain elevated for an extended period as well as subject to speculation about ships in the Gulf or negotiations in Islamabad. For Canadian energy producers, the price spikes are a boon, but not one that’s motivating them to massively ramp up production. Shaw explains that the largest names in Canadian energy are taking a steady approach to volatile times.

“In the past ten years the industry went through a few near death experiences. You think back all the way to 2015 and low prices leading up into Covid, then obviously the low prices in Covid. These companies have had to change their capital spending to ebbs and flows in energy prices. The moniker that the industry uses is something called capital discipline,” Shaw explains. “Broadly speaking it’s a recognition that they have a higher cost of capital, higher cost of equity, higher cost of debt than they had before. The way that it gets manifested is that you end up having higher thresholds to deploy capital on growth projects on a risk reward basis. They have to be de-risked and then the returns have to be higher and there’s a higher preference returning cash to shareholders. So that means that the elasticity to pricing is a lot lower than it was 10 years ago.”

The Canadian oilpatch is no longer being defined by large greenfield developments. Shaw explains that growth is now modular, using things like excess steam capacity to add an additional 50,000 barrels per day in production to a Suncor plant. That approach leaves Canadian energy companies with far less direct exposure to swings in energy prices, and it means that Canadian energy names are not going to respond to global supply shortages with massive capital expenditures to increase production. The preference is for steady growth and consistent returns. Upward spikes in energy prices are windfalls, but sudden drops don’t result in another ‘near-death experience.’

That capital discipline meant that Canadian energy names were already enjoying strong performance in the pre-war oversupplied market. The big swing upwards in energy prices brought on by this war, however, was lagged by Canadian energy names. Shaw explains that as normal, with investors in these equities focusing more on long-term price expectations, thereby lowering the beta to immediate energy prices.  

While that stability and relatively low beta may be what some investors want, Shaw notes that there are options in the Canadian space for those who want high beta to energy prices. Generally, going into smaller capitalization names will result in more exposure to energy prices. Companies with thinner margins and more leverage will offer that exposure. Shaw cautions, though, that in this space, “those who live by the sword, die by the sword.”

A renewed focus on hydrocarbons and highly restricted supply in the gulf makes the investment case for Canadian energy broadly more compelling. Shaw notes that investors of different risk tolerances and goals can find names that suit their particular needs. He highlights, in particular, those companies making investments in producing more from existing developments, or sites that are already partially developed. Those projects offer better returns, in his view, and still serve the broader appetite for global energy that’s shaping markets today.

“We’ve had some very good years and good years recently for sure,” Shaw says. “But looking forward, I think you can build a very strong energy portfolio or a portion of your portfolio in energy that benefits not only from these short term higher energy prices, but are also durable value creators through the cycle over the next five to 10 years.”