Weighty oil

Are growing crude oil supplies in North America finally pushing down oil prices?
For the last year and a half we have been writing about the ongoing migration of the same technologies that caused a continentwide gas glut towards the oil side of the hydrocarbon spectrum, and how this is causing a renaissance in US onshore oil production. See here and here. At last we are starting to see evidence of this same renaissance emerge in Canada with publication of Statistics Canadas most recent non-oilsands production data. As chart 1 shows, Albertas light and medium crude oil production (the red line) bottomed in early 2010, dithered around for another year, and then exploded upwards in the last five months of 2011. (Compared to US oil production data published by the EIA, Canadian data comes out relatively infrequently December 2011 numbers are the latest we have). Prior to the last five months sudden jump, Albertas light and medium oil production had been in a long-term decline. The boom in oil sands production (synthetic and bitumen on our chart) more than compensated for the stagnation in conventional production so that Albertas overall crude production steadily increased over the last three decades. Most of the sudden rise in Albertas light and medium production comes from the re-exploitation of existing oil wells with the technological one-two punch of horizontal drilling and multiple-stage fracking. Note that in focusing only on Albertas production, the Saskatchewan side of the now famous Bakken shale formation has not been included in the first chart. This means that increased targeting of Albertas tight sandstone and carbonate formations like the Cardium, Viking, Beaverhill, and Montney, and not shale, have been responsible for this new production. That being said, Saskatchewans light and medium oil production has also been rising quite significantly, largely due to new wells in the Canadian side of the Bakken shale (see chart 2 we have also included BC). Barrels per day have shot up in the last three months of 2011 in particular, marking a doubling in Saskatchewans medium and light oil production in just six years. Alberta still produces far more light and medium oil than Saskatchewan, so the doubling of Saskatchewan's contribution hasnt had a huge effect on net Canadian results. In chart 3 we compare the renewal in production from the

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Western Canadian Sedimentary Basin (WCSB) with that of onshore Texas and the US Bakken (this includes the sum of North Dakota and Montana). Texas is at least 12-16 months ahead of Alberta in terms of technological adoption so, using the Lone Star state as a model for Western Canada, we expect production from the WCSB to keep growing strong for the remainder of 2012. How much has this jump in North American production influenced the recent selloff in oil? In general, all risky assets stocks, commodities, and non-USD currencies have been in a downtrend since spring. Breaking down what component of oils decline has been due to general market weakness and what component has been due to supplyside developments unique to oil markets is difficult. Well simplify by looking at just three assets: the S&P 500, copper, and West Texas Intermediate oil (WTI). All three registered major tops on April 30, 2012 (see chart 4). From that date to their absolute lows, the S&P fell 10.5%, copper fell 16.1%, and oil fell 26.8%. This is certainly an outsized fall for oil.

As chart 4 also shows, oil has not only fallen further but has required more time to carve out a bottom. Equities and copper flattened out on June 2, but crude didnt hit its bottom till June 27. Some factor, evidently, has been weighing on oil more than the other risky assets although its tough to determine whether that something is the tight/shale oil production boom, political events in the Middle East, or the China slowdown. The longer term oil-to-copper ratio (see chart 5) shows nothing abnormal although it has been weakening for the last six months, the ratio is still hovering around the midpoint of its three-year range. On the other hand, the oil-to-S&P500 ratio just hit its lowest point since early 2009. Should these ratios decouple further, and we think this is likely, it will be hard for the market to conclude that supply-side considerations have not been responsible for oils relatively poor performance.

John Paul Koning jpkoning@pollitt.com

Toronto, Ontario July 12, 2012

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