Alberta’s Black Swan

...and the failure of our conservative leadership to manage risk.

By Jeff Gailus

The best evidence of our conservative government’s cluelessness before the economy tanked in 2020 is the provincial budget. It was passed in a rush on March 18, 2020, two months after the novel coronavirus, COVID-19, had arrived in Canada. Oil demand in China was already down 20 per cent. Oil storage tanks in the US were filling up. Saudi Arabia was growing frustrated with Russia’s reluctance to cut oil production to buoy up prices. The markets were in freefall; Western Canada Select (WCS) had dropped from almost US$40 to just under $10 per barrel over the previous three weeks.

Despite the turmoil and uncertainty, the United Conservative Party government, led by ideologue-in-chief Jason Kenney, passed a budget based on an anticipated oil price of $58 a barrel in 2020–21 and $62 in 2021–22. “This budget continues the responsible four-year fiscal plan that started with Budget 2019,” said Finance Minister Travis Toews. “We are on track to eliminate the deficit.”

Apparently the UCP had no idea this crisis was coming. Or perhaps they thought Alberta immune to the risks of outsized and unpredictable events.

“I am optimistic,” he told media, with the confidence of the Cheshire Cat. “I believe 2020 has the potential to be a turnaround year for the economy in this province…. We’re seeing signs at this point that our broad-based method of improving the Alberta economy is beginning to attract investment.”

University of Calgary economist Trevor Tombe saw the budget for what it was—a reckless bet on Alberta’s economic future. “Despite the massive drop in markets, oil prices and growth forecasts the world over, the government put forward projections in Budget 2020 that are a carbon copy of their outlook in Budget 2019,” he wrote in a column for CBC. “This is a very optimistic gamble, with huge implications for Alberta’s finances.”

A week later Russia rebuffed Saudi Arabia’s demand to cut oil production, and Saudi Arabia pledged to flood the market with oil. It immediately booked three Very Large Crude Carriers, each capable of carrying two million barrels of oil, for a last-minute junket to the US Gulf Coast. Russia was more than happy to reply in kind. By mid-March, WCS was trading for less than a pint of beer. In mid-April, to Kenney’s abject horror, the price went negative.

And apparently the UCP had no idea it was coming. Or perhaps they thought Alberta immune to the risks of outsized and unpredictable events.

Highly improbable, unanticipated events with extreme consequences are called “Black Swans.” Nassim Nicholas Taleb, a former derivatives trader and expert in quantitative risk and uncertainty, published his theory about such events in The Black Swan: The impact of the highly improbablejust before the Great Recession of 2008 ravaged the global economy. For many experts the 2008 stock market and credit crash qualified as a Black Swan, which made Taleb a modern-day fortuneteller.

The crash was caused by a depreciated subprime mortgage market that collapsed investment bank Lehman Brothers, creating the worst global financial crisis since the Great Depression. Taleb and his business partner, fellow investment guru Mark Spitznagel, saw it coming. Contrary to popular belief, they realized the financial system was fragile and unsustainable, so they hedged their investments on their clients’ behalf. Writing in the New York Times in 2015, Taleb and Spitznagel concluded that “…the effect from rare but monstrously consequential events … had been increasing, owing to increasing complexity and globalization. Given that almost nobody was paying attention to the risks, we set ourselves and our clients to be protected from an eventual collapse of the banking system, which subsequently happened to the benefit of those who were prepared.”

In 2020 the enormous risk to both human health and economic and political stability posed by the COVID-19 outbreak drew Taleb’s attention. On January 26, the day after Canada discovered its first case, in Toronto, and two months before Alberta’s 2020 budget was passed, Taleb and two colleagues from the New England Complex Systems Institute published a technical “note” that provides a theoretical rationale for taking a precautionary approach to what had not yet been designated a pandemic.

They described it as an “extreme fat-tailed process.” This meant the likelihood of a catastrophic outcome was much greater than what could be predicted using a normal distribution of probability, which understates these kinds of risks. Because the virus was highly contagious and often deadly, and could be spread by infected people without symptoms, Taleb and his colleagues warned against relying on what we knew about historical infection and mortality rates. The fact that COVID-19 had already spread to North America, Europe and Australasia prompted them to remind policymakers and the public that “traditional cost–benefit analyses must not be used,” because of the very real risk of disastrous consequences.

The solution they proposed, as we now know, was to invoke the precautionary principle and hedge for the worst. This included mandated lockdowns, extensive testing and contact tracing. Taleb and his colleagues acknowledged that the economic and social costs of reducing mobility would be substantial, but “to fail to do so will eventually cost everything—if not from this event, then one in the future…. Policy- and decision-makers must act swiftly and avoid the fallacy that to have an appropriate respect for uncertainty in the face of possible irreversible catastrophe amounts to ‘paranoia,’ or the converse, a belief that nothing can be done.”

This, Taleb argued, is one of the essential roles of government. “While risk-taking is a business that is left to individuals, collective safety and systemic risk are the business of the state. Failing that mandate of prudence by gambling with the lives of citizens is a professional wrongdoing that extends beyond academic mistake; it is a violation of the ethics of governing.”

One can argue that both the Saudi–Russia oil price war and the eruption of yet another novel virus were predictable. Saudi Arabia has a history of increasing oil production to achieve desired political and economic outcomes. Viral epidemics are no longer rare; it was just a matter of time before one went global. But the simultaneity of both another oil price crisis and the demand-side contractions of the first global pandemic in more than century qualifies as a Black Swan. Our current predicament—Alberta’s benchmark crude has recently for less than $0, and our oil and gas industry is on life support—exposes the considerable risks associated with our reliance on petroleum as our primary economic engine. Black Swan theory can show us a way forward.

Jason Kenney’s newfound enthusiasm for public investment in corporate oil and gas projects has prompted him to compare his own tactics to former premier Peter Lougheed’s. But if Kenney bears any relationship to Lougheed at all, it’s as his antithesis.

In the 1970s Lougheed was a maverick who pushed back against the established wisdom of the oil industry—and even Alberta’s Energy Resources Conservation Board, which was rejecting new oil sands projects to protect the conventional oil industry—to invest in Alberta’s future rather than double down on what had worked in the past. He raised royalty rates and presciently invested public money generated from Alberta’s waning conventional crude industry into what he hoped would be the province’s next cash cow: the oil sands. As the industry grew and the millions and then billions rolled into provincial coffers, he set up the Heritage Trust Fund to squirrel away some capital that could be used the next time Alberta’s economy needed a reboot. In short, he was preparing Alberta for an uncertain future.

Our predicament exposes the considerable risks associated with our reliance on petroleum as our primary economic benefactor. Kenney’s economic recovery advisory panel is the very people whose beliefs got us into this mess in the first place. “They should never be given a new bus.”

The oil sands industry today, struggling as it is, is akin to conventional oil in the 1970s. Though there is no shortage of bitumen, the long, peripatetic fight to reduce global carbon emissions, together with the explosion of cheap American and Chinese shale oil, had weakened prospects for Alberta’s relatively expensive and carbon-intensive bitumen crude long before COVID-19 mutated itself around the world. An increasing litany of banks and investors—including HSBC, the world’s seventh-largest bank, and BlackRock, the world’s largest asset manager—had already sworn off the oil sands for its increasing, inherent risk, and most multinationals had already sold their Alberta assets and fled to other parts of the world, protecting themselves, perhaps, from the hazard of a Black Swan.

If this weren’t enough of a warning, Teck Resources’ cancellation of its Frontier mine, just days after disclosing a billion-dollar loss of value in its stake in the Fort Hills mine, was perhaps even more telling. Kenney, oblivious to the evidence everywhere around him, lobbied on the project’s behalf until the last minute, even while industry insiders made the call before Teck did. “I don’t think [Teck will] build it,” Brian Madden, senior vice-president and portfolio manager at Goodreid Investment Counsel, told BNN Bloomberg two days before Teck made its “surprise” announcement. “It’s not economic and I don’t think shareholders or the market will sanction them to splash out $10-billion, or whatever it’s going to cost.”

“Global capital markets are changing rapidly and investors and customers are increasingly looking for jurisdictions to have a framework in place that reconciles resource development and climate change,” Teck president and CEO Don Lindsay wrote in a letter to federal Minister of Environment and Climate Change Jonathan Wilkinson, while also announcing that his company would write down the project’s $1.1-billion value.

Kenney responded with obstinacy and aggrievement. He blamed the federal government, environmentalists and anyone else within earshot, then promised “to do whatever it takes to ensure our economic future, including a future of responsible resource development.” He promptly introduced Bill 1, the Critical Infrastructure Defence Act, a likely unconstitutional attempt to criminalize legitimate public protest and dissent against energy policy and projects that might not be in the public interest.

Then, in a move that must have shaken the libertarians and free-marketeers over at the Fraser Institute with the force of a 6.5 magnitude earthquake, Kenney mused about “direct investment” in oil and gas companies. Five weeks later, Kenney, with WCS hovering around $5/barrel and energy companies shelving billions in capital spending, announced that the province would invest $7.5-billion in TC Energy’s Keystone XL pipeline as a “bet” on near-term jobs and long-term royalty and tax revenues.

Kenney rationalized his decision with the belief that the pipeline wouldn’t get built without public money, and that “every projection for the Canadian energy sector [is] that we need a significant increase in pipelines to ship our energy. Inevitably prices will come back to something like normal and there will be a growing global demand for energy for decades to come.”

“The current crisis calls for dramatic action now,” he added, to reporters. “[This project] will rescue the future of our energy industry and power our country out of the COVID economic crash.” Within two weeks, a Montana judge shut the project down by revoking a water-crossing permit needed to complete it.

Even the oil bandwagoneers at the Fraser Institute have written the project off as an “impossible” saviour for Alberta’s oil and gas sector. While some economists, including Tombe, believe public investment in Keystone XL may be warranted, the obvious question is Why wouldn’t the private sector support it? The answer, of course, is the risk that comes with uncertainty: either pipelines won’t get built, or if they do, low oil prices and low demand will turn them into stranded assets. Moody’s Investors Service, which depends on its ability to accurately assess companies’ risks, wasn’t convinced by Kenney’s bullishness. Despite Alberta’s investment, it changed the credit outlook of TC Energy and its subsidiaries from stable to negative over concerns about the costs of getting the controversial pipeline built.

Few experts appear to believe in Kenney’s backward-looking economic plan. “It’s no longer realistic to believe that a 60-year-old game, based on old assumptions, can be played for any longer than it takes to get past the worst of the COVID-19 crisis,” wrote Calgary-based energy analyst Peter Tertzakian after the Saudis flooded the market with oil. He is one in a legion of economists declaring that the oil market will never be the same. “I have a sense of who will win a year out. It won’t be… western producers who think that countries on the other side of the world will continue to carry them to the finish line, only to see the ingratitude of having their market share taken away. No, the winners in this game will be as in any other business: producers that have a low-cost, diversified suite of energy offerings with access to multiple markets.”

Should the Alberta government be gambling the future of Alberta’s economy on the unsupported assumption that oil prices will “inevitably” return to “normal”? Kenney’s faith that the past will look much like the future reminds me of an interview I conducted on the use of game theory to plan a better future for Alberta’s then-booming oil sands industry. The project was commissioned by the Canadian arm of Deloitte Consulting, because the rapid expansion of Alberta’s oil sands was creating labour shortages, rising costs, construction delays and public concern about social and environmental impacts. All of these problems can lower return on investment.

I duly set up an interview with Dick Cooper, Deloitte’s national leader for energy and resources in Canada and the architect of Deloitte’s fun-sounding game theory project. He explained that the game had two main players, industry and government. Industry could choose to expand oil sands production, delay investment or invest in Alberta-based “value adds” such as upgraders and refineries. The major options for both levels of government were to increase or maintain regulatory oversight, increase royalties and/or introduce incentives to encourage certain kinds of development.

After 33 million simulations, Cooper and his team saw only two viable options. The first is what Cooper called the “natural” outcome, where lightly regulated oil sands producers continue their “gold rush mentality” to invest in projects at a pace the model suggested will make the industry economically unsustainable. The other option they saw was what the report called the “most stable” or “best achievable” outcome, whereby the industry as a whole agrees to slow the pace of oil sands production in return for “incentives” from provincial and federal governments to encourage the construction of upgrading and refining facilities in Alberta. Cooper dismissed this as impossible. “Co-operation on strategic issues is difficult to achieve, because, well, there are penalties for delay of game. There is an expectation that you will operate in the best interests of the shareholders. You’re not rewarded for delaying strategic investments that could yield return on investment.”

When I suggested that there seemed to be at least one other possibility—namely, for the government to increase royalties and taxes to maximize public revenue and slow the pace of development—Cooper glared at me. His back stiffened and he rested his palms on the table, elevating himself out of his chair toward me. “In some parts of the world there’s a government-driven economy, where they make choices for the industry around who does what and first. That is not the economy we live in nor do we want to live in.”

This, in short, has been the economic philosophy of successive conservative govern-ments in Alberta since at least 1992, when Ralph “We Have No Plan” Klein got the government out of the business of business and let the oil industry have its way with the province. While it’s true that Albertans benefited economically from the oil patch when the price of oil was high, we’ve suffered greatly when it was low. And the environmental and social costs of our low-royalty, high-output business model are staggering. Not the least of these is the province’s estimated $260-billion in environmental liabilities alone. This is five times Alberta’s entire annual budget, and most of it isn’t covered by security deposits from industry (because our government didn’t require this). In mid-April 2020 the federal government stepped in to “invest” $1.7-billion to clean up thousands of oil and gas wells orphaned by bankrupt companies.

It’s hard to fathom why Kenney and Team UCP can’t even acknowledge the possibility that the future will be different than the past. Even the International Energy Agency and the World Bank understand that oil demand is going to decrease.

It’s as if our premier believes he can simply will the world to give Alberta’s expensive oil preferential treatment. As cleaner forms of energy become cheaper and the world endures the worsening impacts of climate change, the use of oil will decline everywhere. And as supply outstrips demand and prices decline, the last oil we use will not be expensive bitumen oil, but the cheap crude that virtually bubbles out of the ground in Saudi Arabia and Kuwait. To ignore this is almost pathological in its intransigence.

Albertans, it seems, might finally have had it with the delusional petrostate fantasies of the province’s conservatives. A recent CBC poll indicates that even before the economic implications of the pandemic became obvious, more than half of Albertans thought the province should transition away from oil and gas and 79 per cent believed the province should move toward renewable energy. If we are serious about our desire to avoid the risks of catastrophic failure, Nassim Taleb has some advice on how to build a more resilient economy.

For the second edition of The Black Swan, published in 2010, Taleb included an addendum. “Ten Principles of a Black Swan-proof world” serves as both a warning and a way forward. Alberta has already failed at number one—“What is fragile should break early while it is still small. Nothing should become too big to fail”—and number two—“No socialization of losses and privatization of gains.”

Number three speaks to the composition of Kenney’s so-called economic recovery advisory panel, which includes the likes of Jack Mintz and Stephen Harper, the very people whose beliefs got us into this mess in the first place: “[The] people who were driving a school bus blindfolded (and crashed it) should never be given a new bus.”

Originally from Calgary, Jeff Gailus now lives in Montana. He is the author of Little Black Lies: Corporate and political spin in the global war for oil.



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