October 28, 2020 12:22 AM

Small Canadian oil producers under pressure and COVID-19 is not their only problem

Oil and gas stocks have not weathered the COVID-19 crisis well. But with the Canadian industry now in the depth of a 6-year downturn, the health crisis is not the only problem it’s facing. With an ongoing price war squeezing margins and a slow shift towards alternative energies, even long term investors seeking value stocks should heed caution before committing to any energy stocks.

/ Published 1 month ago

An oil refinery
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While the global health crisis has dealt a nasty blow to oil and gas companies, the industry’s troubles were already well underway. With an all-out price war already underway before COVID-19 struck, all that has occurred since March is an exacerbation of the industry’s woes. 

Today, the reality for many small operators and companies with high levels of debt is that of a very challenging future. With the Canadian industry already in the throes of a 6-year downturn, the patience of banks and creditors is only getting shorter with the double shock delta by the crisis.

Small Canadian oil producers in danger of extinction

Adam Waterous, CEO of the Waterous Energy Fund, a private equity fund that has been buying up smaller producers in recent years, noted the troubles back in 2019, well before COVID-19 was on our radars. According to Waterous, “the 20,000-barrel-per-day producer in Western Canada is an endangered species. I don’t see that changing for some time.”

To provide some context for the size of the companies smaller producers are competing with, QP, the 15th largest producer churning out 1.74M barrels per day pales. Saudi Armaco, the largest, even manages to dwarve that, pumping just shy of 12M barrels per day.

Understandably, with oil prices low, margins are paper thin. This forces a situation where only producers selling mega-volumes are able to scrape anything resembling a profit. As a result, analysts now expect there to be a wave of M&As as the impact of the COVID-19 crisis further weakens the industry.

The transition away from oil is underway

Another movement adding woes to the already struggling industry is the slow transition away from fossil fuels that’s beginning to take place. This is causing some companies to diversify operations, whether that be to bring other energy products into their business, or to broaden the scope of what they produce.

In Armaco’s case, a move towards petrochemical production is underway. Last year, the oil producer announced a plan to invest over US$100B into turning the company into an integrated energy and chemical producer. With ambitious plans to become a leader on the global market for petrochemical products, Armaco is working towards turning 2-3 million barrels of crude oil per day directly into petrochemical products.

Alternative energies are in increasing demand

The hype around electric vehicle manufacturers, like Tesla and Nikola, would have you believe that the move to alternative energy is happening faster than it is. In 2019 electric cars only accounted for 2.6% of global car sales and 1% of global car stock. Even if this number increases tenfold, that’s barely enough to threaten oil as a whole. 

However, despite the tiny slice of the market that EVs hold, it does just deliver one more cut to an industry that’s already in crisis.

TSX30 top energy stock—it’s not oil and gas

The 2020 version of the TSX30 has just been released this week. As has already been reported, 10 stocks have managed to make it into the TSX30 group two years in a row. Amongst them, there was one energy player; alternative energy stock, Ballard Power Systems Inc. (TSX: BLDP).

As a manufacturer or proton exchange membrane fuel cells, their explosive growth only rubs salt into the wounds of the flailing Canadian oil and gas industry.

What should investors do now?

Without making any specific recommendations, caution should be exercised before jumping into any oil and gas stocks. The industry as a whole is far from being in its death throes, but only the toughest are going to survive.

It is also unlikely that there are many—if any—growth stocks to be found amongst them, but for the dividend investor there are opportunities.

For those looking for more price growth but still want to keep some energy stock exposure, alternative energy stocks are an option for those seeking exposure to energy. As demonstrated by Ballard’s two years run on the TSX30, this is a hot growth industry.

(Photo by Patrick Hendry on Unsplash)

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