Rising oil prices won’t solve Canada’s oil and gas problems
Oil and natural gas prices have risen considerably over the past nine months. The price of Western Canadian Select crude oil (WCS, the benchmark price for Alberta oil) averaged US$45.13 per barrel in January 2021. By the first week of October, that price had increased to $64.78 per barrel. Other things being constant, the price increase should stimulate economic activity in Canada’s oil sector.
However, the price of West Texas Intermediate crude oil (WTI, the benchmark U.S. oil price) also increased over the same period from US$59.04 to US$75.65, so while higher oil prices should be a tailwind for Canadian oil and gas companies, absent policy change in Canada (see pipeline restrictions, corporate tax rates, etc.), oil and gas investors will likely continue to favour U.S.-based companies that are also beneficiaries of higher oil prices.
Why? Because investment decisions in the private sector are ultimately determined by the expected future profitability of alternative capital expenditure projects appropriately adjusted for risk, and corporate and private investors in the energy sector will invest in projects located where expected risk-adjusted returns are highest. In this regard, investing in the U.S. has been and will continue to be an alternative to investing in Canada for energy companies and institutional investors, and the price of WCS (relative to WTI) remains only one factor influencing the expected profitability of investing in either location.
While investor expectations about the future profitability of alternative investments cannot be directly identified, they can be inferred from financial valuation metrics including a company’s “price-to-earnings” ratio or its “price-to-sales” ratio. If investors are willing to pay more for a share of Company A’s stock than for a share of Company B’s stock per dollar of current earnings or current sales, it’s presumably because investors expect the future earnings and sales of Company A to grow faster than those of Company B.
A new study by the Fraser Institute compares several financial valuation metrics (price-to-earnings, price-to-sales and price-to-book value) for a portfolio of publicly-traded Canadian oil and gas companies to a portfolio of U.S. oil and gas companies. From 2011 to 2020, each of the ratios for the portfolio of Canadian oil and gas companies decreased relative to the U.S. portfolio. This result is consistent with expressions of concern by executives of Canadian oil and gas companies that Canada is an increasingly less profitable location for capital investment compared to jurisdictions in the U.S. (notwithstanding the WCS price increase relative to the WTI price from 2017 to 2019).
However, the most recent valuation metrics for 2021 provide a more mixed picture. While the price-to-sales and price-to-book value ratios for Canadian-headquartered oil and gas companies increased relative to their U.S.-headquartered counterparts, the opposite was true for the price-to-earnings ratio. Perhaps the outlook for a less favourable regulatory and corporate tax environment under the Biden administration (compared to the reduced regulation and lower corporate tax rates implemented by the Trump administration) has diminished the expected future profitability of U.S. oil and gas companies.
Due to the rising price of gasoline and natural gas, there’s growing public concern in the U.S. surrounding the Biden administration’s ambitious plans to replace fossil fuels with so-called green energy alternatives. It’s possible, but far from certain, that Biden will get some portion of his green energy program passed into legislation, notwithstanding opposition from key Democrat senators, most notably Joe Manchin of West Virginia. Nevertheless, given the potential for a future Republican administration to reverse Biden’s policies, it remains risky to tie the financial sustainability of Canada’s oil and gas sector to the vagaries of U.S. political developments. If Canadians believe that a competitive oil and gas sector is in the national interest, Canadian government policies affecting the industry should be consistent with this public perspective.