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Where is Alberta? Why should you care?

A barrel of crude oil supplies far more than energy.

Can it really be true that the Canadian petroleum industry is almost in crisis with oil at $90 per barrel?

It is true, and you should care. Traditionally ignorant about things Canadian, Americans in particular should understand the critical economic issues now facing Canada’s petroleum industry.

A kahuna is a priest, sorcerer, magician, wizard, minister or expert in any profession, and Canada is the energy kahuna on America’s doorstep. If we do not perform our production magic well, the energy world should worry. Canada is by far the largest source of imported oil for America, and one of the few large oil producers with the potential to keep increasing oil production well into the future. The US Energy Information Administration has identified Canadian reserves as being second only to those of Saudi Arabia. So if you worry about peak oil and the world’s energy future, you would be foolish to ignore the geopolitics and energy economics that are racking Canada today.

The Canadian petroleum industry is facing a perfect storm of ill effects. These are five in number: First, the Canadian dollar is at its highest level against the dollar in 30 years. Second, the natural gas industry is in the tank. Third, environmental issues are getting critical. Fourth, industrial inflation is rocketing out of site. And finally, governments have become greedy. Let’s look at these points one at a time.

1. Exchange Rates: Since 2001, the Canadian dollar has risen from 66 cents per US dollar to $1.04. During the same period, oil (priced in US dollars) has tripled in value.

These parallel movements have had some curious effects. Oil prices for Americans have more than tripled, while in Canada they have slightly more than doubled - a big increase in Canada, but much more modest than in the rest of the world.

As a result of the twists and turns of foreign exchange, consumers have been hit much harder in the United States than have those in Canada. On the other hand, American oil companies have benefitted far more from oil price increases than have those in Canada. And since Canadian oil companies have profited much less, they have less capital for exploration and development than you might expect. Exchange rates have made conventional crude oil less profitable, and the industry consequently has less incentive to develop it.

2. The Natural Gas Industry: Forecasters now commonly suggest that western Canada's conventional gas production has peaked and will continue to decline. Part of the reason is that Canadian can’t sell their gas at the prices Americans can command. The $7 futures contract for gas on the NYMEX is not the reality Canadian producers know. They get $5 per thousand cubic feet for their gas, while the cost of finding and developing the stuff is in the $7-$9 range. Once again, this means less capital for investment in domestic reserves.

3. Environmental Issues: Global concern about climate change is leading to higher taxes on crude oil, most of it imposed at the retail level. In Canada, this includes new transit taxes in the cities of Vancouver and Montreal, and – effective this month – a carbon tax in Québec.

Retail taxes are not a concern for the oil producers, except to the extent they are inflationary. However, tough environmental rules at the downstream end of the industry are creating a lot of real problems for producers. They increase costs and they delay project development. No one disagrees about the importance of good environmental regulation, but it comes with costs in time and money. Environmental regulation is adding to inflation.

4. The Boom: So is the general industrial boom in Alberta, the province that hosts most of Canada’s petroleum production and the North American jurisdiction with the lowest unemployment rate. In this province the sector faces rapidly escalating costs in almost every area: Office space in Calgary, the industry’s geographic centre, has quintupled in five years. Labour in the oil sands is astronomical. Productivity is declining.

How can there be an economic boom when the basic economics of conventional oil and gas production are in decline? The main reason is that conventional reserves, which were drilled in an era of lower costs, are getting produced and sold as quickly and profitably as possible. High prices for oil are accelerating the resource’s depletion.

Costs for drilling and mineral rights have declined in the last year, but that is not a cause for celebration. It has happened because the industry is less inclined to drill. That is something to worry about: If you don’t drill, you don’t find oil.

5. Greedy Government: The final piece of this puzzle is the matter of royalties and taxes. In Canada, oil and gas reserves are mostly owned by government, and governments get revenue from producers in a variety of ways – primarily economic rent (royalties), sales of mineral rights, and a variety of taxes. In response to voters who are convinced high oil prices mean high profits for oil producers, Canadian governments are finding ways to increase their take from the sector. This is their right and privilege, of course. However, the more the industry has to pay, the less oil it is going to produce.

In a world anticipating peak oil, these are serious issues. Love ‘em or hate ‘em, under the rules of capitalism oil companies have to be able to make money by producing oil or else they will put their money somewhere else. And Canada, which has a strategically vital place in the world petroleum industry, is now increasingly finding it cheaper to import oil from overseas – paying for it with our strong currency – than to invest that currency in the costly processes required to find, develop and produce the stuff conventionally.

We should worry about this, and worry a lot.

What do you think? Leave a comment below.

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