Oil Markets: Their Impact on the Canadian Economy

BGEN. ANDRUNYK:

Distinguished guests, members and friends of The Empire Club of Canada: During the past few years the business environment for the oil industry in Canada has been one of unprecedented change. The provisions of the National Energy Program, energy conservation, fuel substitution and the current so-called oil glut have all had a significant effect on the oil industry.

Today The Empire Club of Canada is pleased to welcome as its guest speaker Mr. Ross A. Hennigar, President and Chief Executive Officer of Suncor Inc., who will speak on the subject of the oil glut and its significance to Canada.

A native of Halifax, Ross Hennigar received his schooling in Montreal, graduating from Mount Royal High School and later from McDonald College of McGill University where he received a Bachelor of Science degree. He also holds a certificate in personnel administration from McMaster University which he earned through attendance at evening classes, and he is a graduate of the advanced management course at Harvard University. Mr. Hennigar joined Sun Oil Company in 1967 as manager of the industrial relations department. In early 1972 he transferred to Sun Oil Company of Pennsylvania, where he was the manager of employee relations and one year later the manager of human resources. He returned to Canada in June 1974 to be the Senior Vice-President of Sun Oil Company of Canada and in December of the same year he was appointed President. He was elected deputy chairman of Great Canadian Oil Sands in May 1977. With the amalgamation of Sun Oil Company and Great Canadian Oil Sands in August 1979, Mr. Hennigar was named President and Chief Executive Officer of the new company, Suncor Inc.

In addition to his responsibilities at Suncor, Ross Hennigar is active in numerous non-profit organizations and community service groups. He is a director of the Ontario Chamber of Commerce, President of the greater Toronto region Boy Scouts of Canada, a director of Rosseau Lake Boys School and a past president of the Western and District Personnel Association. When he is not busy with his company or his community projects, he sails, swims or crosscountry skis. He is married and has three children.

Ladies and gentlemen, I am honoured at this time to present to you a leading Canadian businessman, the President and Chief Executive Officer of Suncor Inc., Mr. Ross A. Hennigar.

MR. HENNIGAR:

Mr. Chairman, Reverend Sir, honoured guests, ladies and gentlemen: It is with a measure of personal pride that I address The Empire Club of Canada today on the eve of a very important milestone in Canadian history. As the repatriation of our constitution draws near, I would be remiss if I did not acknowledge the importance of the Empire Club as a forum to discuss our nation's affairs. For almost eighty years this club has served as a Canadian institution, dedicated to the interests of Canada and the Commonwealth in partnership for peace and progress with our friends and allies throughout the world. In the next eighty years and beyond, although the face of the Canadian nation may undergo change, I am confident that this institution will continue to serve as a positive force in our society.

I would like to talk to you today about oil markets and their impact on Canadian economic policy.

This will not be another dissertation on the need to free our industry from government regulations so that we can pursue that elusive goal of self-sufficiency. Rather, I would like to look at some of the implications of making oil the crucial pivot for our national development and fiscal strategies.

There is no arguing that oil is closely linked to our way of life. It supplies the unprecedented personal mobility which draws the line between our society and the rest of human history. It governs our agricultural production and distribution as pesticides and as fuel. It is the base from which we have produced a revolution in plastics and chemicals. The economic developments of the past eighty years are, in large part, a commentary on our evolving use of oil.

As its usefulness has grown, so has its economic and political significance. The supply of oil has become a key geopolitical concern. Nations have directed increasing attention to securing it and committed a growing percentage of their resources to paying for it. Oil has become a crucial factor in foreign policy and in financial markets. It is also becoming an enormous source of public confusion and outright disbelief.

In the past several months, we have asked the Canadian people to accept some extraordinary shifts in thinking.

First, that there is a huge, world glut in this resource which governments have been pleading for us to use sparingly and even paying us to conserve or replace with other forms of fuel because shortages were to be expected.

Second, that oil prices are falling after a tenfold increase over the past nine years and assurances that they would continue to rise forever.

Third, that OPEC may now have lost control of its markets when, for the last nine years, we have been told that it is the world's most powerful and successful cartel.

Fourth, that our industry here in Canada is in need of a billion or more dollars annually in tax relief after Canadians had been persuaded by public officials and the media that we are outrageously profitable and that our earnings should be investigated and taxed away. Alberta's royalty revisions announced yesterday acknowledges the case that the oil industry has been making since last September.

And finally, that we may have to scrap the September 1 price agreement between Ottawa and Alberta just months after achieving it.

Canadians can be forgiven for shaking their heads in disbelief.

Some not easily answered questions begin to emerge. Is self-sufficiency still a realistic goal in a world now flooded with OPEC production? Will this glut last or is it a short term phenomenon? What is the future of a national industrial strategy based upon energy megaprojects? And will Canadians soon pay less for oil products as consumers now do in the US.?

These questions were not being asked last fall. Anyone who had asked them would have been sent somewhere for observation. We are asking them today and finding no firm answers because we can no longer pretend that government policy can set oil prices or nail down the supply. We are asking these questions today because Ottawa has tied its star to rapidly rising oil prices. Last fall, Ottawa stepped gingerly toward the world price in its agreement with the Alberta government. There was to be a new and higher price schedule for old oil, with most of the increase paid as taxes into government coffers. And there was to be a new oil price schedule with somewhat more attractive netbacks to producers. Both schedules were directly or indirectly related to the world price which was supposed to rise in real terms at the rate of two or three per cent per year. This increase was to generate significant new revenues for federal and provincial treasuries and somewhat more modest gains for our industry. Thus, Ottawa tied its fiscal future to OPEC. As long as OPEC could keep ahead of inflation, Ottawa could keep ahead of its deficits. And who doubted the power of OPEC?

Well, today, those doubts do exist. Not that OPEC is about to disappear. Personally, I don't have much faith in those experts who are projecting twenty dollar oil. Thanks to the self-discipline of Saudi Arabia, OPEC is alive and well and still a significant force in oil markets.

But, the cartel's share of world markets is declining. And consumption seems to be on a downward trend. The result is that OPEC may not now have the power to keep prices rising in real terms. In fact, we can probably expect some erosion of prices in real terms over the next several years.

This has some very serious consequences for Canadian energy policy. The federal/ provincial price schedule for new oil is now out of date. It has been overtaken by events just four months after it was announced, as Alberta has recognized.

It now appears that we may be entering into a new era for our oil markets, an era of better balance between supply and demand. If this is so, then price increases will be much more moderate than they have been in the past decade and, in fact, there will even be periods of decline. We are rediscovering that oil is a commodity. And like any commodity, the price, the supply and the demand interrelate.

The gap between the current situation and the events of last fall is seven months by the calendar but it spans several generations of economic thought. In the medieval world of last summer, governments were confidently setting prices. In the brave new world of the spring of 1982, the market prevails.

The oil market may be imperfect, to use an economic term. In other words, there is certainly not a state of perfect competition among a multitude of buyers and sellers free to negotiate a price. But the market works, nonetheless. The only way OPEC can maintain its official contract price of thirty-four dollars U.S. is to cut back production. That is what they have decided to do and so they are producing much less than they would like to. Some economists believe that at least eight of the thirteen OPEC countries are now running significant budgetary deficits as a result. Imperfect though it may be, the market is having its effect, turning high prices into lower demand and increased supplies of energy, including oil.

Saying this makes it sound like a simple matter. But in fact, the adjustments are enormous. OPEC's crude production last year declined by twenty-three per cent to approximately 22.5 million barrels per day. This was the sharpest drop ever recorded. Actual production levels were the lowest since 1969. In any industry I know of, that's a depression.

The full magnitude of what is happening can be assessed by going back to 1977. In that year, OPEC's exports reached a peak of thirty-one million barrels per day. Today, the cartel's stated ceiling is 17.5 million barrels and some analysts believe an even lower level may be needed if OPEC is to bring down supply sufficiently to maintain its official price. We can therefore conclude that the cartel's production has fallen by almost half in less than five years.

Some of the problems undoubtedly relate to a high level of oil inventories. Earlier this year, the western world held supplies equivalent to 110 days or more of consumption, about twenty per cent higher than usual. We have been drawing down these inventories and this has contributed to slackening demand for new production.

Economic recession is another important factor. The European economy has been seriously below par for two years while North American output has fallen at a precipitous rate since last summer.

Both of these factors have contributed to an oil surplus. But the current glut also reflects a more fundamental change.

In 1973, when the oil embargo occurred and prices increased four-fold, consumers went on with their lives as if nothing had happened. We still drove big cars and heated our homes the same as we always had. But in 1979, when prices doubled and shortages were expected as a result of the Iranian revolution, North Americans began to wake up. The United States quickly moved to decontrol its prices so that the full effects of OPEC policy were borne by the average consumer. This policy created a downward trend in oil consumption by stimulating conservation and the switch to other fuels, notably natural gas. North America has more than enough gas to meet its own needs for the foreseeable future.

Until the current recession ends, we cannot know exactly how much we have actually managed to curb our appetite for oil. But it is certain to be considerable, even here in Canada where prices have lagged behind the rest of the industrialized world. The National Energy Board has estimated that we consumed about 150,000 barrels of oil per day less in 1981 than we did in 1979.

In the United States, these trends have already led to a significant number of refinery closings, many of them permanent. Here in Canada, the downturn is not as pronounced but a number of the majors have cut back staff in their downstream operations and refinery closings are certainly a possibility.

It has taken the American consumer just three years to get even with OPEC. Faced with high oil prices, they have proved to be more flexible than anyone had thought they would be.

Now, if the U.S. had followed Canadian policy and subsidized its consumers, the story might well have been different. But the Americans had the courage to face their situation squarely.

In this country, we do not seem to have the same confidence in market forces. Even two years ago, responsible officials were saying that higher oil prices would not necessarily lead to reduced consumption. They argued that oil was so intrinsically a part of our life style that we would never manage to reduce its hold on us. However, now I think we can see quite clearly that prices do work.

At three dollars a barrel, it made no sense to cut consumption or search for alternatives. At thirty-four dollars per barrel, the alternatives looked pretty good and we have begun to take advantage of them.

OPEC has been slow to react to these developments and that is why a surplus has occurred. Last month, the spot market actually hit twenty-seven dollars and some experts were predicting the end of OPEC. Since then, production has been cut and prices have begun to firm up. Later this year, with inventories down substantially, I think we can expect to see the spot price move up over thirty dollars and perhaps beyond the current thirty-four dollar official marker. If economic growth resumes, prices could surge higher. At that point, I would expect the cartel to take the opportunity to produce more oil.

- Now the question is, what impact will oil markets have on Canadian economic policy? Should we abandon our search for self-sufficiency? Should we proceed with mega-projects like Alsands?

In my view, we need substantial revisions to the National Energy Program to readdress these questions. Premier Lougheed has already announced his government's royalty revisions. But we needn't go back to the beginning. In the agreement of last September, governments demonstrated an ability to compromise. And they managed to formulate a five-year agreement in response to the requirement for fiscal stability. These were important achievements. There are some other features of the NEP that are well worth keeping.

For example, I do not believe we should abandon the goal of self-sufficiency. Surely we have learned from the past decade that we do not want to be vulnerable to Middle East politics or OPEC policies. It would be just as much a mistake for Canadian policymakers to assume that oil prices will continue to fall as it was to think that they would sprint ahead forever. Prices will turn up again. Our national energy policy needs to be shaped around rational analysis of the long term rather than the spot price in Rotterdam. And our planning will have to assume price fluctuations.

The spot price is a leading indicator but it represents only a small amount of the oil flow. Therefore, its highs have tended in the past to be well beyond the reach of long term contracts. Similarly, spot market lows will not be realized for the bulk of OPEC's production. We need the maturity, in both business and government board rooms, to steer a middle course between these extremes.

I remember a stock broker friend of mine who described the behaviour of his clients as a balancing of fear and greed. When prices are going up, they forget experience and suddenly believe that everything is going up forever. And then, when the markets turn, they stampede to the exits fearful that their favourite stock is going through the basement floor. We have seen the same cycles in residential real estate here in Toronto, in gold and, most recently, in oil. Let us try to remember the events of the past few months when, in the future, oil prices start to move up again. And let us remember that they will go up, just as surely as the sun will rise tomorrow.

One need only look at the producers of base metals--of copper, lead and zinc--to see that there are businesses making long-term billion-dollar investments despite price swings that occasionally make their efforts uneconomic. We will need the courage to do the same.

Governments must also have courage--courage to allow our industry to have the peaks as well as the valleys. For two decades, the oil industry in this country did not make very much money. In fact our return on capital lagged behind other key industries. Suddenly, as oil became more valuable, we were faced with new taxes which siphoned off the income that rewarded us for the years of big investments and low returns. It was a case of "Heads I win, tails you lose." Rather than waiting for the cycle to turn, governments stepped in and took what they considered to be our excess profits.

If governments do not have the forbearance to allow us to keep the profits that we make, then we might as well build tar sands plants on the utility model with a guaranteed rate of return--a failsafe method which also protects the inefficient. If we are asked to continue the present model--of taking risks but losing the advantage of upswings in the market--no more projects like ours will be built.

Our oil sands project was conceived and built during the sixties when our view was that world oil prices would ultimately increase substantially. Our timing was out by several years, during which the plant piled up operating losses of almost a hundred million dollars, or about half its cost, trying to make the new technology work.

When world crude prices rose dramatically in 1973, the Canadian government decided to hold domestic crude prices down and hence our production was denied the world market revenues for several years. I am pleased to say that today, through a series of policy reviews, the plant is once again receiving the equivalent of international prices. But the point remains. Owners and developers of most long-term projects cannot justify the risks in an atmosphere of limited rewards. It takes a level of confidence and the possibility of enjoying substantial rewards to justify such major risks. It takes returns of thirty and forty per cent on some projects to balance all the dry holes and the new ideas that died. Recently, public opinion has been so assured of our industry's profitability that everyone thought it was the way it had always been and always would be. The media spread the impression we were reincarnations of King Midas. Now everyone can see the other side of the equation.

Every business has risk. And nothing is golden forever. The bigger the profit, the greater the risk required to produce it and the more certain that the market will eventually offset it in the future.

Will this lesson now be learned? Perhaps the implications are great enough to drive it home.

Certainly, oil is not going to do as much for our government's budgetary problems as some people had expected. Ottawa had expected to raise about fiftyfour billion dollars in oil revenues over the five years ending in 1986. Estimates of the shortfall now range from ten billion on up. The revenue-collectors in the federal government must have a little of the OPEC feeling today.

Taxation will need to be redistributed. Both federal and provincial governments are now actively engaged in the search for new revenue opportunities. I leave you with the uncomfortable question of who may be next?

But perhaps governments have learned that too many eggs from one basket may bring on the exhaustion of the favourite hen. Last year, our cash flows were already plummeting under the weight of fiscal requirements. This year, exploration and production expenditures will drop substantially.

There are other unresolved issues, like the Alsands project. Personally, I hope it will be built ... someday . by private enterprise, when the price and profit forecasts are right.

And I think it should be built for the impact it will have on our self-sufficiency. Perhaps, for a project of this magnitude, we should consider the utility concept of a guaranteed return, although I would be concerned about whether or not there would be enough incentive to control cost escalations--especially for this type of project which is so vulnerable to inflationary factors. I hope Alsands will not be built entirely by governments as a make-work project to revive our economy. That would only introduce further subsidies, requiring yet more distortion of our tax and pricing systems.

To sum up, a national economic strategy based upon energy-related mega-projects is probably not realistic today. Nor should we plan our future around a single commodity.

Where are we and where are we headed?

I think it is fairly clear that we need to revise our national energy program. Self-sufficiency should remain our goal but the timetable for achieving it should reflect lower OPEC pricing over the next several years.

I think we should seize the opportunity offered by a downturn in international prices to move all Canadian production to the international price and reapportion the revenue. One good, stiff dose of reality, ending consumption subsidies, will get us on track with our major trading partners.

We should lower energy taxes. The strike of gasoline retailers in Quebec is a clear signal that taxes are out of line. Here in Ontario, until Tuesday's Alberta announcement, sixty-eight cents of your gasoline dollar was going to governments. The burden needs to be redistributed. And whatever new policies are developed, our industry needs to be given an assurance that the deal will apply equally to good times as well as to bad.

With these changes, I believe the oil industry will offer opportunities. It will be a tough, low margin business, especially in the refining and marketing areas. It will be very competitive. But there will be a good return for the people who do it well. That's my perspective on oil markets and their implications on April 15, 1982. But stay tuned to this station. It may all change tomorrow and likely will. That's what makes the oil business exciting.

The thanks of the club were expressed to Mr. Hennigar by Colonel R. H. Hilborn, a Past President of The Empire Club of Canada.