Hello and welcome to The Download. I'm your host, Dave Richardson. I am joined for his regular visit by Scott Lysakowski, Head of Canadian Equities at Phillips, Hager & North Investments in rainy, rainy, rainy Vancouver. I hear it's a nice day out there today.
Yes, I think summer is officially over here in Vancouver. We're going to get more rain today than we got all summer. So, I couldn't think of a better thing to do on a rainy day than get my coffee in my hand and have a chat about the Canadian equity market.
And specifically, because you've been doing some work on the energy sector itself and looking at some of the concerns around the energy sector, some of the headwinds that they're facing, even though it's been a very strong performer this year, although mostly in the first quarter. What were you taking a look at and what were your findings?
Energy has been one of the best performing sectors so far this year. We often get the question of how sustainable this strength in the share prices is, and is this something that could expect to continue, or is this just more of a cyclical bounce? We come out in a number of ways and partly to set the stage is to think about some of the headwinds that the industry has faced over the last several years and see if those headwinds have been appropriately addressed. So, the big reasons why the energy sector has underperformed over the last several years has boiled down to three things. One is pipelines. We've heard lots and read lots about the lack of pipeline capacity to get the oil production out of Canada. The second piece would be profitability, and the third headwind would be emissions and ESG, and how that is taking hold and affecting the sector. Starting with pipelines, the cancellation of the Keystone XL pipeline at the beginning this year grabbed all the headlines. But quietly in the background, the industry has been progressing. Several other pipeline initiatives, one of which is a replacement of an old existing pipeline by Enbridge, and that's due to be in service by the end of this year, which would help alleviate some of the pipeline capacity deficiencies. Then, of course, the Trans Mountain pipeline, which is now owned by the Canadian government, is inching along. It's still probably several years away from being in service but if and when that does come into service, we'd see excess pipeline capacity. So, a lot of that news and headwinds around heavy oil pricing and pipeline price differentials, that will fall by the wayside when we have enough sufficient pipeline capacity in place. The second piece is on profitability, because commodity prices have been so weak over the last number of years— obviously much stronger today—, but had been quite weak over the last several years. The industry is really forced to work really hard at focusing on their cost structure, focusing on the efficiency in which they operate their business, the way that they spend money and really making sure that they can operate and sustain their levels of production in a low commodity price environment. So, they're really reaping the rewards of higher commodity prices in their lower cost structure and generating a lot of free cash flow. Secondly, they're being quite disciplined about what they're going to do with that free cash flow. They've learned that the market is not rewarding production growth right now. Production growth comes with emissions growth, which I'll talk about in a second. So, they're focused on repairing balance sheets, buying back stock, returning capital to shareholders. The final piece is emissions and the ESG framework. As we know, more and more investors are integrating ESG framework into their investment decisions, and that lands squarely in the face of the energy sector. As you can imagine, oil sands producers are very large emitters of carbon. And so that's a very focal point for applying an ESG framework. The Canadian energy industry has been very hard at work at this over the last several years, basically several decades. But specifically, over the last five to seven years, they've significantly reduced their carbon emissions. They're down to 25% to 30%. They're still pretty high from an absolute basis, but the industry is working very hard on a number of technologies and improvements in the way that they operate to help reduce emissions. They've reduced their water consumption by close to 50%. Water doesn't get talked about as much as carbon does but I think it's going to gain importance in the eyes of the investors in the ESG framework. If we stack it all up, when we're thinking about ESG scores from some of the third-party rating agencies, Canada stacks up really well compared to some of their global peers on an ESG score in front, on environmental, social and government issues. So, while there's lots of concerns about peaking oil demand at some point in the future and emissions, the energy sector in Canada is working very hard to earn the right to be a producer of oil in today's environment. It's very interesting to see.
You kind of touched on what my next question was going to be. I have to say something that a lot of people think is ultimately holding back this sector, which is the perception that at some point down the road, we’ll hit peak demand and we're just not going to need as much oil as we had. Or maybe we're not going to need any oil, and these are stranded assets. These companies will ultimately go away unless they evolve in some way. You've done some thinking about that as well?
Yes, it's a question we get often. I don't think anyone disagrees that oil demand will peak at some point, probably in our lifetimes or in the near future, in fact, and that there's a risk that these assets will be stranded. We try to answer that in a couple of different ways. One would just be thinking about the cost structure and how fully burdening the cost structure are the cost of carbon and the cost to reduce emissions. I talked about the Canadian energy industry fighting really hard and working really hard to earn the right to produce those last barrels, even as demand peaks and then subsequently declines. They've made very bold commitments to get to net-zero even. You see a lot in the press about some of these global super majors or multinational energy companies where the courts or activist investors are forcing them to reduce their emissions. The Canadian producers are doing that on their own, and they're making very bold statements about how they want to run their business—, like an oil sands company reducing emissions to net zero is quite the claim. They don't claim to get there in the next five to ten years, but they claim to get there over time. When we think about adding that to the cost structure, right now, on a per-barrel basis, the Canadian producers, on average, need about $35 to $40 a barrel to cover their operating costs, their overhead costs to run their business interest costs, and then also the cost to maintain that level of production. It's about the $35 to $40 per-barrel range. We start adding to that some of these costs. You have a progressive carbon tax in Canada; that adds a couple of dollars to the per-barrel cost, so we factor that in. I mentioned, the companies have goals to get to net zero. To get to net zero carbon emissions for an oil sands producer is going to take a significant amount of capital investment to capture the carbon, to sequester it or make alterations to their business process. It's still early days, but that could be upwards to 20 to $50 billion over the course of twenty or thirty years. We add that to the cost structure, and that adds another couple of dollars. The other thing is thinking about, are these assets going to be stranded? If oil demand peaks, are shareholders and debtholder going to be left holding the bag? So the other piece that we added to the cost structure is the burden of, can they generate enough free cash flow on a per-barrel basis to pay back all of the debt and buy back all the shares— so basically return all of the debt and equity holders value to the respective holders, and can they do that over the next ten years? A fairly aggressive assumption that companies aren't likely to do that, but just for mathematical exercise. So that adds another $15 per barrel. So, when you stack it all up, you take the current cost structure of $35 to $40 a barrel, and we get to something that's in the $55 to $60 a barrel, which is lower than what we're seeing today, but if you think about even in a peaking demand environment, oil prices, if you think they're going to be over $55 or $60 a barrel, the Canadian producers will be able to produce, reduce their carbon emissions, pay a carbon tax, and pay back all of their capital to debt and equity shareholders. That's a pretty impressive feat to do at $55 to $60. So, I don't believe that these assets will be stranded unless we see oil prices significantly lower than that.
And Scott, is it fair to say that, along with recognizing what the future brings, Canadian producers have focused on reducing emissions, reducing their carbon footprint. Kind of doing things the right way within this industry? Let's say it's controversial in today's world -- with a focus on climate change and such. But it's also been investors who have stayed invested in these companies and who hold seats of power— like an asset manager who's invested in these companies— that can have a healthy influence on the direction that these companies are taking in terms of managing their business. Is that not fair to say?
Yes, that's really the direction that the integration of ESG is taking things, which is quite nice to see. In the past, there was a decision to divest from the sector. A number of pools of capital and asset owners did make that decision. But what I think would lead to better outcomes is to take the approach that us and other institutional investors are taking. Integrate ESG into your investment framework and really hold these companies accountable for the commitments that they've made in terms of emission reductions and board representation, diversity, inclusion, and safety which is a huge aspect for these businesses. So, I think that as institutional investors, we can really play an important role in holding these companies accountable. If you divest your shares, you're not too sure whose hands they're going to go into, and those new shareholders may not have the same requirements and may not hold these companies to the same standard that we would. We believe that by integrating the ESG framework into our investment decisions, holding these companies accountable through engagement and dialogue with management teams and boards, we can help make sure that they follow through on the commitments they've made, whether it's net zero or emission reductions or diversity inclusion policy on their board, and even push them and extend or reach even further in terms of some of these policies. So, I think we can actually lead to better outcomes by staying invested and staying engaged with these companies and really holding them to a higher standard.
I guess what's nice for Canadian investors in today's world, with just a proliferation of different choice and options around investing, is you can choose to approach this industry the way we just talked about. Which is through engagement, ownership and influence. Or you've got lots of options to invest in fossil-fuel free. You can push this sector to the sideline in your investment strategy, if that's what you choose to do. There's different approaches that work for everyone in their own objectives.
Yes, that's right, Dave.
So, Scott, I know you're an expert in Canadian investing and the energy sector is a big part of the Canadian economy and the Canadian market. It's something that we certainly pay attention to, and we're always happy to have you come in and update us on some of your thinking, because there may not be a better voice in Canada around investing in the Canadian market. So always great to talk to you.
Thanks, Dave. Thanks for having me.