Natural-gas producers face lost market share

CIBC Energy's Scott Vali cites higher shipping costs, U.S. competition.

Michael Ryval 1 December, 2016 | 6:00PM
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The long-standing relationship between North American energy producers and consumers is changing as new supplies from shale deposits come on stream and regulators continue to open markets. That, argues Scott Vali, manager of the $92-million CIBC Energy, is bound to affect Canadian industry players and have consequences for investors as well.

"Historically, if you were an Ontario local distribution company (LDC) like Union Gas, you would contract with TransCanada Corp. to buy gas from Western Canada," says Vali. "You were responsible for the transport fee to get the gas to Ontario and serve your customers. Canadian producers simply had to pay to get the gas to the so-called AECO hub."

But LDCs are no longer compelled to buy transportation capacity. Instead, producers will be responsible for moving the gas to the end market. "The difference is that now LDCs will change the way they do business because they see alternative sources of gas, particularly the Marcellus shale in the U.S. northeast," says Vali, who has focused on the energy sector since 2005. "They no longer need to source gas from one place, Western Canada."

In the future, natural gas will be priced according to the so-called Dawn hub outside Sarnia, Ont. As well, new regulations will allow TransCanada the freedom to charge tolls it deems appropriate. "This is important to producers because they are responsible for paying those tolls to get gas to the Dawn hub," says Vali, noting that negotiations are under way to establish the tolls for the next decade. "That's a challenge for Western Canadian producers because they don't know what the price at Dawn will be. They could be locking themselves into an arrangement that could be uneconomic."

The game-changer in this scenario is that two proposed U.S. pipelines, called Nexus and Rover, will transfer gas from the Marcellus shale into Ontario via the Dawn hub. "If these pipelines are built, Ontario, which consumes about three billion cubic feet (bcf) of gas per day, will no longer have to buy gas from Western Canada. They will start to buy from the Marcellus shale, and Western Canadian producers will have to sell their gas elsewhere -- although other markets are already full and not growing."

Vali notes that the Ontario Energy Board (OEB) has ruled that LDCs can buy capacity from the two proposed pipelines and they have actually done so. "The OEB is looking at it from a long-term perspective. 'We want diversity of supply in our market.' This is going to be a challenge for Western Canadian gas producers. AECO prices will trade at a discount to those at Dawn."

Approvals are required for the two new pipelines. Vali believes that Nexus is most likely to be built, starting in the second half of 2017. Meanwhile, Vali expects Western Canadian producers that sell into the AECO hub will see the price of gas start to trade at increasing discounts. "All companies will feel some pain. But some have been forward thinking and getting contractual arrangements with other pipelines to get their gas out of the AECO hub or the Western Canadian basin."

The changes will force a re-think of the way business will be conducted. "Instead of a producer selling into the local market and having LDCs come to buy gas at that hub, it will be responsible for getting gas to the end market. That's a big difference. A lot of firms don't have the marketing expertise to do that. They are used to producing the gas and selling it locally."

Time is running out, adds Vali, and there is limited infrastructure to transport the gas out of Western Canada. The other challenge is that the price at the Dawn hub is unknown. "If the only buyers are the LDCs, unless you have a contract with an LDC to buy your gas, you may get your gas to the Dawn hub and find you have no buyer," says Vali. "At that point, your gas is stranded."

Western Canadian firms will continue to supply some natural gas, Vali believes, but not to the same extent as in the past. Currently, Ontario gets 2.5 bcf a day from Western Canada, and about 0.5 bcf from the U.S. Within five years, Western Canada will supply only one bcf, and the Northeastern U.S. two bcf, or four times its current volume. "Producers who have the foresight to contract on other pipelines will still have a market. Others who have not done that -- and should this other source become the main source for the province -- may find it difficult to sell their gas, or may sell it at a discount. That will only discourage production."

From a strategic viewpoint, about 25% of CIBC Energy is exposed to natural gas, plus 63% to oil, with the balance held in service providers and cash.

One company that Vali believes will thrive is Seven Generations Energy Ltd. (VII), which has contracted pipeline capacity out of the basin in order to get its gas to other markets. "They trade at about eight times cash flow, and are not super cheap, but they have a good growth profile and their balance sheet is in relatively decent shape," says Vali, adding that in 2017 the company is expected to produce about 175,000 barrels of oil equivalent (BOE) a day, versus 124,000 in 2016.

Another favourite is  ARC Resources Ltd. (ARX), which is active in gas production in the Montney, B.C. play and produces in total about 120,000 BOE a day. The stock trades at about nine times cash flow and pays a 2.5% dividend. "It has a good track record of creating value."

Vali notes that natural-gas prices are dependent on the weather. Although prices have hovered around US$3 per thousand cubic feet, a "normal" winter may push prices higher. "Demand for gas has increased, while supply has not, so the market is tightening," says Vali. "That could lead to a good gas price in 2017."

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
ARC Resources Ltd23.88 CAD-0.25

About Author

Michael Ryval

Michael Ryval  is regular contributor to Morningstar. He is a Toronto-based freelance writer who specializes in business and investing.

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