Crude Oil:Marching to a Different Drummer

By Tina Kremmidas

Crude oil prices typically spike whenever there is an escalation in geopolitical tensions involving oil-producing nations directly or indirectly, but this time around markets do not appear to be too concerned about the risk of disruption to oil supplies.

DESPITE THE TURMOIL in the Middle East and the Russia-Ukraine conflict, oil prices have been trending lower since June. The spot price for Brent crude, the global benchmark for oil, touched a 17 months low in the second week of September and was down 16% from its recent peak in June. West Texas Intermediate (WTI) — the North America benchmark — suffered a similar fate, falling 15% since its recent peak in June.

Canadian crude oil prices held up much better. Western Canada Select (WCS), the Canadian benchmark for heavy crude oil, fell by 8.5% over the same time period.

What in the World is Going On?

Tepid demand growth and rising supplies have driven prices lower. The International Energy Agency (IEA) called the recent slowdown in global oil demand growth “nothing short of remarkable.” It trimmed its projections for global oil demand growth for 2014 and 2015 citing weaker economic growth in Europe and China. Meanwhile, global supplies remain plentiful, in large part, a result of the surge in oil production in the U.S. and increasing output from Western Canada (the source 94% of total Canadian crude oil production).

These market fundamentals are trumping geopolitical concerns.

Canadian Crude Prices

Western Canada-based oil producers have avoided much of the pain wrought by falling prices. WCS always sells at a discount to WTI, but the price differential narrowed significantly in mid–September to US$13.50 per barrel from a high of US$42 per barrel in November 2013. Typically, WCS is discounted US$20-US$25 per barrel reflecting insufficient infrastructure capacity to bring it to market and because it is of lower quality — it is a blend of Canadian heavy crude oils, high in sulfur, and is harder to process than light, sweet (i.e. low in sulfur) crude.

An increase in oil-by-rail shipments, an expansion of existing pipeline networks and a rise in heavy oil conversion refining capacity in the U.S. Midwest have eased supply bottlenecks in the near term, supporting WCS prices.

The narrower discount on WCS and the lower value of the Canadian dollar mean Canadian heavy oil producers who who are essentially paid in U.S. dollars for their product are receiving much higher Canadian dollar denominated prices.

More Oil is Moving by Rail

With limited pipeline capacity to deliver oil to markets in the U.S. East Coast, Eastern and Western Canada, and the U.S. Gulf Coast., the industry has turned to rail.

According to the Canadian Association of Petroleum Producers (CAPP), total crude oil shipments by rail from Western Canada have increased from about 180,000 barrels per day in early 2013 to about 250,000 today. The CAPP estimates crude oil shipments by rail will reach 700,000 barrels per day by the end of 2016.

The CAPP estimates it costs between $15.60 and $21.50 per barrel to move oil by rail from Western Canada to the U.S. East Coast. It costs a similar amount to get the oil to the U.S. Gulf Coast (i.e. $15.30 to $22.45 per barrel). If oil companies own significant rail-related infrastructure (e.g. rail cars and/or terminals), costs drop to about $10 per barrel. This is competitive with transporting oil by pipeline which costs $7 to $11 per barrel if shippers have secured long-term contractual agreements with pipeline companies.

Several regulatory initiatives and prescriptive rules to improve rail safety, transparency and response are underway in both Canada and the U.S. that may add new costs to the equation.

While oil-by-rail has proven to be a flexible and relatively cost-effective option to move product to market, over the longer term, given the potential for strong growth in oil production in Western Canada, additional pipeline capacity will be required for the industry to maximize its full potential. Rail is expected to continue to play a role, particularly in niche markets.

Canada’s Crude Oil exports to the U.S. at a Record High

In the week ended September 12, 2014, total U.S. crude oil imports averaged 8.1 million barrels per day, according to the U.S. Energy Information Administration (EIA). The U.S. imported almost 3.0 million barrels per day from Canada.

The U.S. Midwest regional is a key export market for Canada due to its geographic proximity and established pipeline infrastructure. Additionally, many refineries in the region have been modernized and configured to process a large percentage of heavy, sour crude — the type of oil produced in Western Canada. The region sources virtually all of its imported crude oil (2.2million barrels per day) from Canada.

Western Canada producers have limited access to the U.S. Gulf Coast, one of the world’s largest and most sophisticated refinery centres, due to pipeline infrastructure constraints. Roughly 150,000 barrels per day of Western Canada crude is reaching this region.

Will the U.S. Still Need Canadian Oil?

The U.S. is experiencing an unprecedented boom in oil production. According to the U.S. Energy Information Administration (EIA), total U.S. crude oil production averaged 8.6 million barrels per day in August, the highest monthly average since July 1986. The EIA projects total crude production will ratchet up to 9.5 million barrels per day in 2015, the highest annual average since 1970.

U.S. output has increased by more than 3 million barrels per day since 2011. Thanks to hydraulic fracturing and advanced horizontal drilling techniques, enormous quantities of crude oil have been unlocked from shale and other tight rock formations. The vast majority of the new production (well over 90%) is light, sweet oil. Most of the growth is occurring in North Dakota’s Williston Basin (home of the Bakken formation) and Texas’ Eagle Ford Shale and Permian Basin.

Despite the rapid increase in production, the U.S. is still a major importer of oil, but its dependence on imports is declining. As recently as 2005, 60% of total U.S. petroleum consumption was met by net imports. In 2015, that number will drop to 21%, the lowest level since 1968.

To be sure, growing oil production in the U.S. is displacing imports, but it is largely imports of light crude oil that are being pushed out, reflecting the large increase in domestic production of light oil. Most negatively affected by this is West Africa. Nigeria has seen its shipments of crude oil to the U.S. totally displaced because it produces light, sweet crude oil of similar quality to that of the U.S. Nigeria was exporting about 1.0 million barrels per day to the U.S. over the 2004 to 2008 period.

Heavy crude oil is still in high demand because a number of U.S. refineries — primarily those located in the Midwest and Gulf Coast regions — invested tens of billions of dollars in more complex refinery configurations with high conversion capability to process heavy, high sulfur crude oil. The strategic decision do so was made before the shale boom that has made light, sweet crude so plentiful.

U.S. Gulf Coast refineries source their heavy crude primarily from Venezuela, Saudi Arabia and Mexico, but there is tremendous potential for Canada to play a greater role in this region. Indeed, Canada could displace some heavy crude oil imports from Mexico and Venezuela.

U.S. annual imports from Venezuela totalled 755,000 barrels per day in 2013, a 22-year low. Oil production in Venezuela has dropped significantly since peaking in the late 1990s to early 2000s, and an increasing share its exports are heading to China to pay off Venezuela’s loans, and to India.

U.S. annual imports from Mexico totalled 850,000 barrels per day in 2013, a 21-year low, reflecting a steady decline in production. Mexico’s state-owned petroleum company has made it difficult to attract money and technology needed to tap abundant oil reserves. The Mexican government recently proposed constitutional changes that would allow for risk- and profit-sharing partnerships between the state-owned monopoly and foreign firms. It remains to be seen if this will be enough to lure foreign companies with the expertise and the resources to moderize the nation’s oil industry.

Given the dynamics at play in the U.S. Gulf Coast, Canada is likely considered a preferred supplier and has the potential to gain market share.

In Summary

The U.S. will continue to be an important market for Canadian crude oil, and Canada its leading supplier. However, there appears to be a significant opportunity cost associated with not developing alternative markets — the industry is not benefitting from higher oil prices in Asia and Europe.

Price differentials will fluctuate based on supply and demand fundaments, but as long as prices elsewhere are high enough to compensate for the higher cost of transporting oil overseas rather than to the U.S., it will be advantageous for Canadian producers to make the most of opportunities abroad.

Clearly, development of alternative markets and the supply system to serve them is important for the Canadian oil industry and for the Canadian government. But it is also important for Canada’s economy in terms of stimulating job creation, capital investment, government revenues and shareholder returns.