REAL ECONOMY BLOG | November 15, 2022

In this week’s energy industry analysis, we take a look at a proposed U.S. rule for methane emissions, the oil demand outlook and the Canadian government’s plan to introduce a tax on share buybacks.

Proposed methane emission regulation should spur technology investment

In pursuit of a “relentless focus” on reducing emissions, the Biden administration is set to further regulate oil and gas industry methane leaks.  

A new rule proposed by the administration would expand upon an existing methane rule by narrowing the size of leaks that oil and gas drillers are required to monitor and fix. The U.S. Environmental Protection Agency’s original rule in 2021 required monitoring of the largest well sites, around 300,000 well sites in total, in order to detect and fix leaks. The new rule requires monitoring and remediation of leaks of almost all sizes (includes wells that emit less than three tons of methane per year), which expands the well population to nearly 1 million well sites in the United States. In order to detect methane emissions on this scale, operators will have to up their game in terms of monitoring and collecting data for methane emissions, and ensure they have an adequate response plan for leaks.  

This additional regulation during a time of tight supply adds a layer of difficulty for small operators who may not have the technology in place to detect smaller sources of emissions. Notably, “multiple studies have found that smaller wells produce just 6% of the nation’s oil and gas but account for up to half the methane emissions from well sites,” according to an Associated Press story.

It will be important for upstream and midstream players of all sizes to understand the requirements and make the appropriate investment in technology to comply with this new layer of regulation. Tools that allow for predictive maintenance in the field will also be a key investment area for operators, as proactive equipment maintenance is foundational to reducing leaks and other operational issues. 

The new rule was a topic of discussion on Friday at COP27, an annual conference of the nations that signed the United Nations Framework Convention on Climate Change over 30 years ago. Tightening regulation around emissions is part of the United States’ commitment to the Global Methane Pledge, which, among many other reduction goals, aims to reduce methane emissions by at least 30% by 2030 from 2020 levels.  

According to the International Energy Agency, cutting the world’s methane emissions by 30% over the next decade would have the same effect on global warming by mid-century as immediately shifting the global transport sector to net-zero carbon emissions. Increasing participation in the pledge is imperative to the success of methane reduction efforts. Challenges remain, though, given that the top two methane emitters—China and India—are not currently participating in the pledge. 

Oil demand recovery expected to be prolonged

Organizations and governments continue to make downward revisions to oil demand forecasts amid ongoing concerns of a coming recession, high inflation and geopolitical disruption to global markets. The Organization of the Petroleum Exporting Countries (OPEC) cut its 2022 oil demand forecast for the fifth time in the last seven months on Nov. 14, although year-over-year demand is still expected to grow. Global oil demand is projected to grow by 2.55 million barrels per day (bpd) in 2022, which is 100,000 bpd lower than OPEC’s previous forecast. OPEC similarly revised oil demand growth for 2023 down by 100,000 bpd to 2.24 million bpd.

This is in line with the U.S. Energy Information Administration cutting its 2023 crude production forecast on Nov. 8. U.S. crude production is now expected to reach 12.31 million bpd next year, which is an increase of 480,000 bpd from 2022, but lower than the previous forecast of 610,000 bpd.

Crude production of 12.31 million bpd in 2023 would still, however, exceed the record volume of 12.29 million bpd set in 2019, prior to the global pandemic. And indeed, there are some signs of growth; there were nine more U.S. oil rigs added in the week ending Nov. 11, bringing the national total to 622, which is the highest amount since March 2020. An increase in oil rigs signals that producers are investing capital in drilling again, after limiting expenditures over the past two years.

Lowered revisions to oil demand and production forecasts are outcomes of an economic recovery that has continued longer than initially anticipated. Uncertainty and fear surrounding the ongoing potential for major global economies to plunge into recession have tempered growth expectations from earlier in the year, and hopes for industrial powers like China, the world’s largest crude importer, to reopen its economy and fuel global oil demand have been dampened as coronavirus cases continue to surge.

Middle-market energy companies will need to tread cautiously and update internal forecasts and budgets throughout the year accordingly, but recognize that oil demand, and consequently prices, are expected to remain high despite the many unknown variables affecting global markets.

Canada plans to tax share buybacks

Energy companies have collected windfall profits this year due to sky-high energy prices, and Canada’s federal government announced plans this month to introduce a tax on share buybacks in the hopes that the money will be redirected to green investments.

Oil and gas producers had been reluctant to use excess cash for reinvestment in drilling programs, instead preferring to practice capital discipline under investor pressure and return value to shareholders through share buybacks. The federal government is hopeful that the new tax will discourage the practice and force energy companies to direct proceeds to capital projects, such as climate change mitigation measures.

Share buybacks reward current shareholders by boosting the stock value and lowering the number of outstanding shares, and energy companies have been the main participants in Canada over the past year. Canadian companies are not the only ones increasing share buybacks; U.S. companies across all industries on the S&P 500 set a new record with $881.7 billion spent on buying back stock in 2021, which was up from $519.8 billion the previous year.

The Canadian federal government has proposed a 2% tax on share buybacks to take effect on Jan. 1, 2024, and expects the tax to generate approximately CA$2.1 billion over five years. This is following the U.S. federal government’s announcement in the Inflation Reduction Act of a 1% tax on share buybacks, which can potentially create a competitive disadvantage for Canada if the higher tax is effective in discouraging more stock repurchases in the country, thereby redirecting investors to the U.S.

We expect that the new tax may not have the intended results that the Canadian federal government aims for. Imposing the stick approach with a punitive tax to increase green investments is not as effective as the carrot approach with investment tax credits, such as the carbon capture incentives we discussed in our previous post, and the timing of the tax to take effect in 2024 does not encourage any immediate investments in clean initiatives. Companies are likely to opt to reward shareholders by increasing dividend payouts instead, and the tax may not deter companies from continuing to repurchase shares if it is believed that the stock price is undervalued.

The tax may simply result in additional government tax revenue, without any notable increases in green investment. Regardless, companies will need to be mindful of the new share buyback tax when planning their capital allocations for 2023 and beyond, and expect that the federal government will continue to introduce regulatory measures to influence investment in clean energy.

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