5 things the oilpatch is watching for in 2016

There's no question that 2015 was a bad year in Canada's oilpatch, but optimism dies hard in the energy sector and as a new year dawns, executives and investors are scanning the horizon for signs of light. Here's what they're looking for.

Supply 'rolling over'

For nearly a year now, analysts have been calling for U.S. oil supply to roll over, collapse, fall off a cliff. It hasn't exactly happened yet, no matter how quickly rig counts have fallen south of the border.

The U.S. produced 9.2 million barrels per day the week ending Dec. 25. That's more than the country was producing in late 2014 when OPEC decided that enough was enough and that it wasn't going to cut its production to offset more oil coming from the U.S.

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Energy analyst Stephen Schork said he thinks OPEC would like to see U.S. oil supply drop below nine million barrels a day, something he's not expecting soon.

"Supply has been extremely sticky," said Schork. "We did not see the turndown in 2015 to the extent that we were expecting. We came off 9.5 million and are holding at 9.1 or 9.2 million."

Oil producers are caught in a cycle in which no matter how low oil prices go, they need to continue to produce to generate cash. As a result, there's a growing sense that U.S. production won't roll over until companies run out of cash. 

"This could be the year," said Martin Pelletier, a portfolio manager with Trivest Wealth Counsel.

"What's delayed the production response has been access to debt markets. That has closed, the regular bank lines are being clawed back, they can't go to capital markets, you're relying on cash flow and that cash flow is being used to service debt.

"Many are underestimating the supply response," said Pelletier."

Geopolitics

The recent conflict between Saudi Arabia and Iran had a short-lived effect on the price of oil.

'You're looking at a region of the world that is always on a short fuse.- Stephen Schork, energy analyst on Middle East

"If that had happened a year or a year and a half ago, oil would have responded a lot more to what just happened in Saudi Arabia than what it did recently," said Pelletier.

Iran is increasing its oil production after the removal of sanctions related to its nuclear program. It has called for OPEC members to cut production to support prices. Saudi Arabia declined to do so at the most recent OPEC meeting in December, adding to the tension in the region.

"You're looking at a region of the world that is always on a short fuse," said Schork. "But that fuse is getting shorter and shorter."

China

The main reason oil prices haven't reacted to conflict in the Middle East is because the news from China continues to be bad.

On Monday, manufacturing numbers from China showed demand was still falling. China has cut its interest rates six times in the past year, and is cutting the value of its currency to spark exports, all signs of an economy under pressure.

"A lot of growth in oil demand came from emerging markets," said Pelletier. "And demand is still growing for oil, but at a much slower pace. Unfortunately, it looks like it's going to get worse before it gets better."

More mergers

It is a bit of a puzzle why there hasn't been more merger and acquisition activity in the energy sector. A report from the Toronto firm Crosbie & Company showed that oilpatch merger activity over the spring and summer was down by more than 50 per cent, compared to the summer of 2014.

It's hard to do consolidation in this kind of market because people don't want to lose their jobs.'- Martin Pelletier, Trivest Wealth Counsel

The slow pace of deals may simply be because it's hard to price a deal when you don't know where oil prices are going. But Pelletier thinks that something else is at play, specifically the self-interest of junior oil executives, who have risked everything and don't have other jobs to go to if they sell their companies.

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"It's hard to do consolidation in this kind of market because people don't want to lose their jobs. You're living off that $200,000 you're making. Where are you going to find that anywhere else?" 

The biggest deal to surface in the past year has been Suncor's offer for Canadian Oil Sands, which has a deadline of Friday and is too close to call at the moment. That shows that investors are not universally keen to do deals at any price.

Regardless, there's a broad expectation that more takeovers will happen as banks tighten up their lending.

Royalties

This month, the Alberta government will release its review of the oil and gas royalty system in the province. 

In a speech late last year, Peter Tertzakian, a respected economist and member of the royalty review panel, said that the current system is too complicated and doesn't reward the highest value products. When asked if Alberta producers would remain competitive, he said that segments of the industry would remain competitive.

That may not be cheering to marginal oil and gas producers, but is part and parcel of what often happens during a downturn in any industry.

Schork thinks that the price rout sparked by OPEC more than a year ago will end up as a sort of gift for the North American energy sector.

"It's forcing North American production to become more efficient, as painful as it is," he said.