Falling costs and improved efficiency will save Alberta’s oil patch

Special to The Globe and Mail
Published Friday, Feb. 13 2015

“You’re an idiot!” the anonymous e-mail shouted at me. “Oil prices could never go that high. If they did, the entire global economy would collapse!”

The terse, crudely-worded note popped into my inbox about a decade ago. It was in response to comments I had made on the radio. The talk show host asked me: “Will oil ever hit $50 a barrel?” At the time, oil prices were marching higher... $40, $42, $45 ... to what seemed like dizzying heights. I had responded that yes, oil will probably reach $50 at some point.

My rude e-mail attacker probably wasn’t alone in his thoughts about oil prices. In 2004, $50 oil seemed spectacularly and unsustainably high. What motorist could possibly pay a dollar for a litre of gas?

Fast-forward to 2015, and now $50 oil seems tragically low – at least if you’re a producer in Alberta. Most producers in the province need oil somewhere north of $80 for a project to make economic sense (although the range in profitability is enormous).

So what has changed in 10 short years? The geology of Alberta hasn’t changed. Why was $50 enormously profitable for Alberta then, and now the province is teetering on recession? The answer: costs.

At the beginning of last year, all sorts of dire reports described how the biggest threat to Alberta’s petroleum sector was escalating costs. Labour, material, engineering, service contractors – prices were rising due to high demand and limited supply. When oil prices are close to $100 (U.S.), it’s easy to back up the money truck and pay whatever it takes to get the project moving.

The good news for Alberta in 2015 (and there is ALWAYS some good news) is that costs will now start ratcheting down. Consider labour costs. Between 2004 and 2014, average weekly earnings for all Canadian employees rose 31 per cent, while earnings in Alberta’s oil and gas sector shot up 67 per cent. At $2,234 a week (including overtime), these are the highest-paid employees in the country by a wide margin. The national all-industry average is only $941 a week.

I don’t begrudge the high wages commanded by workers in oil and gas. They perform tasks most of us could never do. It is simple economic supply and demand: Few workers and plenty of demand equals high wages. But the cost escalation over the past decade has grown unsustainable.

Consider also engineering costs. The price index for petroleum engineering services over the past 10 years has increased by 28 per cent, slightly greater than the rate of general price inflation in Canada (24 per cent). But unlike most other prices, costs for petroleum engineering services fell sharply in years when oil prices fell. In 2009, for example, the price index dropped 5 per cent. Petroleum service providers reacted and adjusted their prices in the face of weaker industry demand.

This is the silver lining to Alberta’s current oil industry downturn. While everyone is gloomily fixated on price – how low it will go and how long it will stay there – there is less general attention to cost. These will also be falling throughout 2015 as producers sharpen their pencils and improve efficiency.

Some of these will result in painful, unpleasant adjustments. Layoffs will occur. Bonuses for the white-collar workers will be chopped. Christmas and Stampede parties will be scaled back. Corporate in-house chefs and lavish expense accounts will be axed. And through all of it – as difficult as it will be for many individuals – the industry will improve efficiency and come out in much healthier shape. There’s no better time to control cost and increase efficiency than when commodity prices have dealt you a nasty blow.

If $50 used to be a fantastically high price for producers a decade ago, there is no reason why costs can’t be wrestled down to a point where $65 or $70 is once again an acceptable range. And with broad expectations among energy watchers that prices will edge higher by the end of the year, producers should end up in decent shape – or at least the ones that can lower costs and improve efficiency.

Todd Hirsch is the Calgary-based chief economist of ATB Financial, and author of The Boiling Frog Dilemma: Saving Canada from Economic Decline.