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Crude sneezes, the economy catches cold

The benefits of diversification have long been preached by financiers and economists. Those countries too reliant on one industry naturally feel the pain of a limited portfolio. Canada is learning a stern lesson in overdependence

As if falling oil prices weren’t bad enough, a new fear is gripping Canada’s oil patch - contagion. Fallout from the faltering upstream is beginning to trickle down through other sectors of the economy, touching everything from manufacturing to oilfield services to finance and banking. Few have escaped the downturn.

For the moment at least, the effects are most keenly felt in the oil-producing province of Alberta, where more than 100,000 directly related jobs have been lost in the petroleum sector alone. Cash-strapped oil companies have slashed as much as C$50bn ($37.44bn) in capital spending, and delayed more than C$100bn in new projects.

But as the malaise drags on, the damage could spread to other sectors of the economy and stretch from seaboard to seaboard. A number of analysts expect Canadian GDP to shrink by as much as 1% in 2016 because of falling oil prices, tipping the economy into recession.

It’s a complicated chain that starts in the oilfields, infects the service sector, then the banks and associated investors. Ultimately the government itself will be hit hard, in the form of lost revenues and taxes from declining business activity and the many thousands of workers who have lost reasonably well-paid oil jobs.

Spreading risk

The phenomenon is bringing a new concern to the oil patch, right across the supply chain. It’s a term all too familiar to the financial industry that gained prominence during the darkest days of the Great Recession and which still sends shivers through the banking sector: “counter-party credit risk”.

As producers face a wall of mounting debt, credit defaults and outright bankruptcies, the failures start to be felt across the various critical supports of the industry - from financiers to service companies. Like a virus entering an ecosystem, each of the components is a liable to a similar fate.

One of the largest risks at the minute is Calgary-based PennWest Exploration, a mainstay oil and gas producer with extensive landholdings across three provinces. It produces about 77,000 barrels a day - down from almost 170,000 b/d in 2010 - in almost every facet of the industry, from conventional and tight oil to oil sands partnerships with Chinese firms.

But the company fell on hard times even before the downturn and the low oil price has compounded PennWest’s problems. It has been forced to sell a number of assets at bargain prices and slash its workforce from 2,500 in 2013 to just about 1,000 today. On 10 March, the company tried to convince investors that it would be able to meet credit terms on its C$2bn debt, despite dwindling cash flows. But most observers expect a default by the end of the first half of the year.

If PennWest and others like it go down, it will have a ripple effect on suppliers contracted to build long-lead items such as pipelines. Many of those third parties have already used the contracts as collateral to secure funding to meet their commitments. Should the unprofitable barrels fail to materialise, the house of cards could well start to tumble.

Another example - of many - is Pembina Pipeline, an Albertan midstream operator contracted to build some C$5bn of oil sands pipelines to support new production growth. Typically, midstreamers are considered to be insulated from low oil prices as they’re paid a fixed rate to ship oil regardless of the selling price. That makes them very attractive investments, especially in a difficult market. As such Pembina has held up farily well in this slump, boosting profits from C$383m in 2014 to C$406m in 2015, even as its customers have struggled.

But that’s where the problem lies. Concerns surround cash-strapped customers’ ability to pay, both short and long-term. The company’s chief executive Mike Dilger recently admitted to as much, indicating that it now monitors the credit worthiness of its customers on a monthly basis.

Dilger and other midstream executives might well be alarmed by a case in the US in which a judge ruled that producer Sabine Oil & Gas could break its pipeline contracts through the bankruptcy process. The decision leaves pipeline builders much more exposed to the financial health of their counterparties than they might have been. Dilger said his company would be willing to modify and adjust contract terms for its customers on a case-by-case basis to mitigate the risk.

And PennWest isn’t alone by any account. A number of estimates suggest that more than two-thirds of all Canadian upstream producers are in some state of financial distress. That presents a threat to expected 5% growth in oil production in 2016.

More than 0.5m b/d are coming on line in 2017 from planned oil sands expansions, most of which started construction two or more years ago when oil prices were much higher. Every one of those barrels is underwater at present prices.

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