Do high energy prices have a silver lining?

Over the past 10 months, oil prices have skyrocketed to record levels on both a nominal and inflation-adjusted basis. According to the U.S. Energy Information Administration, the prices are expected to remain above $140 per barrel to the end of 2009, and possibly even longer.

So what do higher oil and gas prices mean for Atlantic Canadians? Just like with the rest of the country, it translates into outrageous numbers at the pump and higher heating costs.  In fact, the negative impact from higher fuel prices is compounded for us on the East Coast because Atlantic Canadians often depend more on our vehicles, given the low population density relative to other regions within Canada.

The good news is that there may be a silver lining to this story. The higher prices have stimulated a recovery in the Canadian oil and gas exploration sector, which had softened due to Ottawa’s announcement in October of 2006 to tax income trusts, soaring field services costs, and Alberta’s new royalty regime. While Alberta has historically been the main beneficiary of oil and gas exploration within Canada, exploration and production firms are now looking beyond that province for new discoveries, as global oil and gas reserves are becoming depleted and demand continues to soar.

We believe that interest in Atlantic Canada onshore and offshore hydrocarbon exploration will accelerate because of higher energy prices and as a result of the continual evolution of hydrocarbon-recovery methods, which make unconventional hydrocarbon recovery economically viable. Discoveries in neighbouring areas such as the Utica shale in the St. Lawrence Lowlands will also likely draw interest. When we consider the attractive royalty regimes of the Atlantic Canadian provinces (about 10%, on average), our region carries a lot more sex appeal than most.

Oil and gas exploration in Atlantic Canada isn’t new—in fact, Contact Exploration’s (CEX-TSX.V) Stoney Creek field in New Brunswick is one of the oldest producing oil fields in North America—but we have only scratched the surface in terms of exploration. Exploration costs in a frontier area such as Atlantic Canada are considerably higher because there is a lack of infrastructure and field services are often imported. Higher oil and gas prices offset these costs and improve the overall risk/reward profile of an exploration play. In the past when oil prices were considerably lower, some Atlantic Canadian prospects evaluated may not have looked attractive, but now that oil is trading at over $120 per barrel, and Henry Hub gas prices are in the $9 per thousand cubic feet (mcf) range, the potential gains from exploring these prospects, as well as the economic viability of development, offset the higher costs. It’s like gambling a quarter with the hope of winning fifty cents versus winning $3.

For example, the offshore leases now owned by NWest Energy (NWN-TSX.V) in western Newfoundland were previously considered by Hunt Oil and Mobil Oil (now Exxon Mobil Corp). These companies shot 2-D seismic data that suggests those properties have the potential to contain hydrocarbons. When the prospects were evaluated in the 1990s, crude oil was trading in the $20-per-barrel range, and larger targets off the east coast of Newfoundland were deemed more attractive. At current oil prices, this prospect is about six times more appealing. NWest plans to shoot a 3-D seismic program later this year and to drill its first offshore-exploration well in 2009.

What does this mean to Atlantic Canadians? While an increase in oil and gas exploration is unlikely to help us at the pumps, it could give our region the means of providing higher standards in education, better health care, and safer highways. For example, Newfoundland and Labrador is the first Atlantic Canadian province to cross the threshold from a have not to a have province on the back of offshore oil and gas royalties. In addition to royalty payments, oil and gas exploration and production translates into investment in infrastructure.

Aside from initial construction expenditures, maintenance costs can be substantial for smaller communities. For instance, Corridor Resources (CDH-TSX) estimates that it will spend $2 million annually within Sussex, N.B., to run its natural gas plant. Then there’s the possibility of good-paying jobs in the field-service sector and spin-off sectors, which all add to our tax base. Look at Alberta, whose economy has largely been impacted by the oil and gas industry; its GDP has increased by a compounded annual growth rate of 4.7% over the past five years, compared to Canada’s growth of 2.7% over the same period.  

So as we watch the numbers rise as we pump gas into our vehicles, we can take some comfort in knowing that perhaps someday we may feel the same way that our Western Canadian cousins do when oil prices rise: wealthy.

Ken Chernin is an equity research analyst with Acadian Securities Inc. in Halifax. He can be reached at ken.chernin@acadiansec.com

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