What do higher natural gas prices mean to thermal oil producers?

MEG Energy is an example of the trade-offs

MEG Energy is one of the most efficient thermal oil producers with a steam to oil ratio (SOR) in the range of 2.5 barrels of water (as steam) per barrel of Access Western Blend (AWB) produced. As a result, MEG discloses the sensitivity of its financial results to the cost of natural gas and estimates that a $0.50 per gigajoule increase in the price of gas will add $6 million annually to its expenses.

That seems innocuous enough. Presumably, with natural gas costs of CDN$3 a gigajoule, MEG’s annual natural gas budget is around CDN$36 million. MEG produces 105,000 barrels a day of AWB or ~38 million barrels a year, so its natural gas cost at CDN$3 a gigajoule is about $36/38 = $0.95 per barrel. Does it matter?

Maybe.

Natural gas and oil are both just mechanisms to deliver BTU’s of energy and one barrel of oil provides 6.1 million BTU’s equivalent to 1,000 cubic feet of natural gas. If both were global markets with ready conversion as feedstocks for electricity generation or heating uses, natural gas prices would approximate the price of oil per barrel divided by 6.1 which, at the current CDN$100 per barrel for oil purchases amounts to roughly $16 per gigajoule. At that price, the increased costs to MEG for its natural gas would be about CDN$130 million a year if MEG could buy gas at the wellhead price and substantially more if it had to pay the price of delivered gas from a gas utility.

Sensitivity to AEC is disclosed by MEG since it buys its gas on the open market and typically at AECO prices (although the company often hedges its gas bill). AECO gas jumped to CDN$14 a gigajoule over the weekend as freezing temperatures hit Alberta, as low as 50 below deg. C. The cold snap is unlikely to last but it demonstrates the risks to a gas consumer of a shortage of gas when there are few alternatives. For MEG, if natural gas prices rise to a level higher than oil on a BTU basis, MEG could likely switch its boilers to oil fuel (for some capital) but could not avoid the higher costs.

In the United Kingdom, just a little less than 2 years ago, natural gas prices hit the equivalent of US$500 a barrel for oil when the Ukraine war and the foolish reliance on imported natural gas exposed the U.K. to extreme shortages in a cold winter. The same can happen in Canada if Ottawa keeps suppressing the industry’s ability to expand by forestalling pipelines and imposing needless carbon taxes and other barriers.

MEG has great assets but still carries too much debt (in my opinion) and is using free cash flow to buy back stock rather than eliminate the debt in its entirety. That may work out well for investors if oil prices remain firm but is a dangerous path if AWB prices fall sharply while natural gas prices increase.

Place your bets but keep the competing risks in focus. I am long the gas stocks and hold no MEG and even short it from time to time. The returns on my short book have been satisfactory (don’t be mesmerized by the high numbers since the trades are short term and even small gains translate into high annualized returns). Here is a clip from TD Waterhouse’s calculations of the returns on my short account.

I am long other oil producers like $RBY.TO $BNE.TO and $WCP.TO and have large positions in gas producers like $BIR.TO $PEY.TO $PNE.TO and $SDE.TO. We will see how this plays out for the rest of this winter and the next few years.