Why do Canada’s provinces gamble on the oil markets?

Provincial governments need to be sober, disciplined, realistic and do whatever they can to not lose money for their citizens

Ian MadsenWhile crude oil’s startling and unprecedented recent price plunge into negative territory was notable, it didn’t mean that producers were actually paying others to take oil off their hands.

It did point to major problems the industry faces, however. In the short term, the foremost issue is weak demand.

And it raised a significant problem with provincial budgeting across Canada.

The COVID-19 shutdown of most oil-consuming nations has drastically reduced the demand for oil. Fewer people commuting to work, less goods being trucked, lower global shipping volumes and a near-halt to airplane flights has meant that gasoline, diesel fuel and jet fuel are in surplus.

The oil refineries that produce such fuels need much less crude oil, making producers slash their prices to offload it. The pipelines and storage tanks of North America, and most of the world, are overflowing with crude oil.

The U.S. Energy Information Administration (EIA), forecasts that world demand for crude oil will shrink by about five per cent this year, or roughly five million barrels per day.

Saudi Arabia took this opportunity to boost supply even more, causing the price to plunge. It sought to damage other nations that weren’t co-operating in its attempts to forge an agreement to reduce production to more closely match demand.

Indirectly, this could work, as oil companies slash capital spending, allowing reserves and production to deplete and decline, respectively.

However, this takes time. Some reserves have decline rates of less than five per cent a year. Others, such as some shale formation wells, have much more rapid decline rates. Most of the new production that has made the United States the world’s largest oil producer over the past 10 years has been from shale.

Oil companies in Canada and around the world are hurting badly, and some are calling for government assistance to sustain them until oil prices recover. Some are already receiving aid, in the form of subsidies to help remediate closed or abandoned oil wells.

The provinces of Alberta, Saskatchewan and Newfoundland and Labrador are in fiscal trouble. They derive much of their revenues from oil royalties on provincial territory. They too are looking to Ottawa to help them through this year – and perhaps beyond.

But it doesn’t have to be this way.

Rational, competent oil and gas producers commonly hedge most – sometimes all – of their production by selling futures contracts on barrels of oil or gigajoules of natural gas. The ones that are trundling along reasonably well have at least hedged the estimated costs, including their capital budgets, that they will have over the next few quarters or even a year or two.

They lock in the sale of barrels of oil at US$30, for example, and forgo any gains they might have scored if the oil price recovered. But they’re assured of not losing money if the price goes below $30 – let alone turns negative.

Farmers do the same thing when they sell grain futures forward, locking in their price and not gambling on a windfall escalation.

So why have any oil companies not hedged their production costs, at least, for at least the next year or so?

And why should taxpayers have to pay for their shortsightedness and what is effectively a risky sort of gambling strategy?

Come to that, why don’t the governments of oil and gas producing regions, including Nova Scotia and British Columbia, also hedge the prices of the petroleum commodities they rely on for a good portion of their revenues?

The means are at hand.

While the standard contracts use West Texas Intermediate oil delivered at Cushing, Okla., and natural gas at Henry Hub in Louisiana, there are Canadian industry-tracking alternatives available: Western Canadian Select and AECO, respectively, for their energy equivalents.

If the provincial treasurers across the country don’t know how to go about it, there are commodity or investment dealers who can do it for them and customize it to their needs.

If they think this is gambling, what do they think blundering blithely along through volatile and dangerous energy markets and risking the hazards of other injurious economic forces without insuring against them is?

Prudent?

Not likely.

Provincial governments need to be sober, disciplined, realistic and do whatever they can to not lose money for their citizens.

They might recall that those citizens vote them in and out, and are having ever less faith in the dubious wisdom of their putative leaders, given what has transpired thus far this year.

Ian Madsen is a senior policy analyst with the Frontier Centre for Public Policy.

© Troy Media


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