Independence Day

Now that America's presidential race is decided, Canada's need to seek energy markets beyond the U.S. has never been more urgent.

 This article appears in the January, 2013 issue of Oilweek; photo from here

By Peter McKenzie-Brown

The day after America’s presidential election, the Calgary-based Canadian Defence and Foreign Affairs Institute (CDFAI) hosted a panel discussion on the political and economic significance of President Obama’s second term.

Some of the most interesting observations came from Jonathan Baron, an American lobbyist with a primarily Republican clientele. “What you need to know about Republicans and Democrats is that they hear different things when they hear the word energy. Say ‘energy’ to a Republican, and he will think about increasing energy production. Say ‘energy’ to a Democrat, and she will think about mitigating environmental impacts. It’s like another world.”

Now he was on a roll. “When a Republican thinks about Canada’s energy resources,” he added, “they really do think that these resources belong to America. There isn’t a strong sense that they are a sovereign asset for Canadians. For Republicans, the idea of North American energy security is a no-brainer.”

The irony is that the International Energy Agency issued its annual report a few days after this panel discussion – a report which seemed to put the cat among the pigeons. According to the IEA, “The global energy map is changing, with potentially far-reaching consequences for energy markets and trade. It is being redrawn by the resurgence in oil and gas production in the United States and could be further reshaped by a retreat from nuclear power in some countries, continued rapid growth in the use of wind and solar technologies and by the global spread of unconventional gas production.” According to this respected agency, the US will become the world’s top oil producer by 2017, and could be nearing energy self-sufficiency two decades later.

A bearish outlook for Canada’s oil producers, is this report worth long-term worry? Probably not. Since the 1972 publication of The Limits to Growth, a book which forecast shortages of virtually every commodity by the end of the 20^th Century, a good rule of thumb has been that long-term natural resource forecasts are always wrong.

To a large extent, this is because major forecasts are political. IEA member governments and some oil companies vet them before they go public. In the highly likely case that the United States reviewed the IEA forecast before it hit the streets, they would have wanted the agency’s report to justify fracking, Keystone, perhaps, and the West’s embargo of Iranian oil. As one commentator observed, “Forecasters test scenarios – they assess economic and energy trends to produce numbers. Among the enormous range of possibilities, one forecast is chosen for public purposes.” Also, of course, since Adam Smith published The Wealth of Nations in the 18^th century, economies have shown repeatedly that markets eventually equilibrate.

If you focus instead on the near-term implications of the recent US election, there is a lot of good news.

·         Before campaigning began, global warming environmentalists developed traction by opposing Keystone. Notwithstanding their public protests, sources Oilweek spoke to believe the project has a good likelihood of getting State Department approval. An okay would increase the integration of Canadian oil and bitumen production into US markets and provide tidewater access to overseas buyers.

·         On the gas side, this commodity will expand its market for power generation, and Canadians will perhaps gain an advantage in the export of this commodity overseas.

Keystone

President Obama’s re-election was a near-term good news story for Canada’s oil patch. If approved, he Keystone Pipeline will move bitumen to the 7.6 million barrel-per-day Gulf Coast market. It is worth remembering that the Department of State originally deferred its decision on the pipeline as a political gesture, so as not to alienate environmentalists during the election. The reason given was concern about a proposed segment of the pipeline route through environmentally sensitive sand hills in Nebraska.

According to Maryscot (“Scotty”) Greenwood, a left-leaning Democrat, “There is awareness in the United States about the importance of energy from Canada and I believe that awareness was heightened during the campaign. There is a renewed appreciation of the importance of North American energy independence.” She is reasonably confident the project will go ahead, using TCPL’s revised route. In a separate interview, AJM Deloitte’s geoscience director Dave Russum enumerated the reasons the State Department might stand behind Keystone: “Job creation, economy boost in the US, secure supply.”

For Canada, the benefits are different. Keystone would provide Canadian oil sands producers with direct access to America’s single biggest oil market. Thus that pipeline’s throughput would not be subject to the price differentials that have become chronic – especially for the oilsands sector. More importantly, the project would provide Canadian producers with access to tidewater. This would mean overseas markets and international prices. Meanwhile “we are in for a rocky time in the Canadian industry regardless of who is in the White House,” according to Russum. “When oil prices were more than $100, many projects looked pretty attractive, but current prices in the $85 range make the economics much less robust.”

Carbon emissions kept coming up during the CDFAI forum, and Greenwood stressed the political importance of the environmental constituency. “During the second term of the Obama administration (president Obama) has an imperative to deal with some new legislation which covers coal ash, soot and other environment-related questions. This will affect core constituencies. However, there is not necessarily a conflict between these two. You can look after these regulatory issues, and also do Keystone.”

Right-leaning Jonathon Baron disagreed. “The environmental community feels frustrated, so (their protests) have moved down to the state level. The president is going to have to do quite an interesting balancing act to deal with fracturing and Keystone.”

A master of Realpolitik, Baron offered hope for crude oil prices – but hope with a bitter taste. “There’s going to be more instability in the Middle East during an Obama presidency,” he said; after all, the president campaigned on having ended “a decade of war.” If the president is not willing to use American might in response to Iran’s apparent nuclear build-up, Baron argued, there will be mischief in the Middle East. “That volatility means high prices going forward. That has important implications in American markets for Canadian oil sands and natural gas.”

Gas Prices and Markets

Canada’s gas industry is likely to benefit from President Obama’s next term through the conversion of its power industry to natural gas. According to Scotty Greenwood, who served for two terms as a staffer in the Clinton White House, suggested that he “is looking for ways to regulate more stringently, to pivot to natural gas because it’s a cleaner burning fuel than coal. He does have a desire to build demand for natural gas and to clean up the coal industry.” Since it’s his second term, the president will find America’s powerful coal lobbies less daunting.

“During the election campaign Obama virtually did say ‘I hate coal!’” Baron told the CDFAI audience. “Cheap natural gas has given the president an opportunity that didn’t exist before. Because the United States knows that it is not going to be able to implement a carbon tax, it will instead increase the price of coal through regulation, making coal less competitive.”

North American gas markets are likely to expand at the expense of coal. In itself, this may not be cause for much celebration in Canada, since the United States is nearing self-sufficiency in this commodity, and its production and transportation costs are lower. However, Greenwood noted another area where the US political environment could unwittingly favour Canadian natural gas.

In the American political system, Congressional committees have plenty of muscle, and it matters who serves as the chair. The incoming chair of the Senate’s powerful Energy and Natural Resource Committee is Democrat Ron Wyden. Wyden believes large-scale LNG exports would raise natural gas prices in the US, harming the economy. In the past he has argued that Washington should impose a “timeout” on new LNG export facilities, pending review. “That could be the end politically for (additional) natural gas exports from United States,” said Greenwood.

“There is a gigantic and very legitimate debate about whether we should be exporting natural gas,” she added. “My observation is that in the United States it will be politically very difficult to export (gas to other countries).…This could be a big opportunity for Canada, since the same political challenges do not exist here.” Baron concurred. “There are already a number of LNG export projects in the United States. LNG exports along with hydraulic fracturing will be major issues during the president’s second term.”

While the Americans dither, Canada could approve and construct facilities for overseas markets. Eastern Canada already imports about two billion cubic feet per day of gas from the US, and “this is a cheaper source than Western Canada. We are of course a net exporter to the US, but that role is shrinking. We need alternative exports” said AJM Deloitte’s Russum. He observes that Canada is ‘way behind Australia and other countries in developing or expanding LNG facilities. While the US already has gas export facilities in operation, Canada’s first plant won’t be ready until 2019.

“To me the problem is that Canada can’t compete with gas supplies that are abundant, cheaper, and closer to market in the US – for example, Marcellus, Fayetteville, Barnett and Eagleford,” he added. “Gas is still a fossil fuel, so while it is cleaner and more environmentally friendly than coal, it still has the fossil fuel stigma and the fracking stigma. I’m unclear whether it is a problem or a solution in the US. In any case, if prices rise the US has shown it is able to drill and bring on new volumes of shale gas very quickly, which would in turn dampen prices.” Russum added that “prices for natural gas need to be considerably higher to make the industry profitable here.”

The US/Canada Alliance

Prime Minister Brian Mulroney once famously said that “the relationships (between prime ministers and presidents) are absolutely indispensable. If you don’t have a friendly and constructive personal relationship with the president of the United States, nothing is going to happen.”

According to Greenwood, the Canada/US relationship is “hugely important, writ large. It’s much bigger and more integrated than any personality. It matters who is in the White House, but in the end the relationship will do well because it has to, and because of all the history between the two countries.” She added that “the US government does not want to prevent Canadian development in any way. We have very close relationships, and those relationships are of great value on both sides of the border. I think the United States, as Canada’s most important commercial partner, wants Canada to be commercially successful in every possible way.”

Colin Robinson, a Canadian diplomat who helped broker the Canada-US Free Trade Agreement and NAFTA, stressed the importance of international cooperation to help prevent trade disputes. “The first lumber dispute between Canada and the United States goes back to the time of George Washington,” he reminded the CDFAI audience. “These kinds of things do lead to protectionism. In a lot of cases, we have to put competition aside and think of things as North American.”

“Whenever (a diplomat has) to do something in the United States you have to do it through the White House,” according to Baron. The State Department is critical for international affairs, but other parts of government are in play. Formerly Canada’s ambassador to the US, Frank McKenna once said that “The president can love you to death, but that doesn’t mean you don’t have constant harassment from Congress….The tone at the top helps, but it’s not conclusive.”

As this article went to press, there was optimism that the United States would not fall over the “fiscal cliff.” For the sake of talking about the near-term future, this article assumes a compromise that won’t suffocate North America’s economies. If America remains a house divided, though, Canada needs to declare greater independence from US commodity markets. That truth is self-evident.

The Desirable Barrel

Why conventional heavy oil is a sizzling commodity in Alberta and Saskatchewan

By Peter McKenzie-Brown

As an oil producer, Saskatchewan seems to have it all. The Bakken light oil trend is a play of frenzied activity. So is Cenovus Energy’s carbon injection oil operation at Weyburn (the world’s largest carbon capture and storage facility). But the province’s meat and potatoes – conventional heavy oil production in the Lloydminster and Kindersley areas – are hidden behind these high-profile developments.

The province’s first 2010 land sale tells the story, but it’s only clear if you dig deeply into the numbers.

Out of nearly $40 million in bonus bids, about $26 million went for land in the Weyburn-Estevan – a reflection of the importance of Bakken and Weyburn. Dig a bit deeper into the numbers, though, and you will find that the highest price paid for a single parcel was $2.1 million for a 1,552-hectare exploration licence in the Lloydminster area. One operator, Baytex Energy, paid $6,512 per hectare for a 16-hectare parcel near Maidstone, also in the Lloydminster area – by far the highest bid per hectare.

Between them, the two heavy oil producing regions in Saskatchewan brought in nearly $10 million in bids – not bad for the Cinderella sister of light oil. The message is clear. The resource has been on production since 1946, but despite its longevity is an increasingly valuable asset. This reality applies to conventional heavy in Alberta as much as it does to production in Saskatchewan. In today’s market the commodity is sizzling. Although there was a blip due to low oil prices a year ago, today’s barrel of conventional heavy is almost as profitable as ever before.

Major changes in transportation to the US and modifications to US refineries have made the Canadian commodity extremely desirable. As a result, the differential paid for Canadian light compared to Canadian heavy is holding firm near historic lows. The differential has averaged about C$8 per barrel for the last year. To put that in perspective, as recently as late 2008 conventional heavy sold briefly for 45% less than Edmonton Par. That wasn’t a profitable environment.

By contrast, the market today is a bit like a winery selling this year’s plonk for 14% less than a vintage wine. Like plonk compared to fine wine, heavy oil is intrinsically less valuable than Edmonton Par, the Canadian standard for light oil. In most refineries, after all, heavy feedstock results in less high-value-added gasoline and more low-value-added asphalt.

But the big US refining complexes are changing that. “It’s a matter of adding vessels to the refinery,” according to Steven Paget; he is vice president for energy infrastructure at First Energy Capital. “Those longer-chain hydrocarbons need more work to break up, but new pipelines from Canada are accessing the refineries at Wood River (Illinois) and Cushing (Oklahoma).” Those refining complexes have the capacity to break heavy oil into lighter feedstock. “Therefore the (narrow) differential becomes minimal or close to equivalent to actual operating cost.”

The good news is that the two heavy oil provinces have a lot of plonk left to sell. According to the Canadian Association of Petroleum Producers (see chart), between them the two provinces have more than a billion barrels of established reserves left to produce. More importantly, each has estimated heavy oil in place many times the volume of reserves.

CAPP estimates that initial volumes of heavy oil in place (this includes both conventional and non-conventional heavy) were about 15 billion barrels in Alberta, and 20 billion barrels in Saskatchewan. Established reserves will thus continue to grow, just as new in-place volumes will continue to be found.

The Background
To understand the economics of conventional heavy, cast your eyes back to the industry’s beginnings.

There are three historical reasons for the growing strength of conventional heavy oil. First, since the 1980s operating costs for conventional heavy production have been in relative decline because of improving technology, higher prices and a better understanding of the reservoirs. Second, policies established since 1990 have lowered royalties for the stuff. Third, the volumes of heavy oil in the Alberta/Saskatchewan heavy oil belt are simply huge. Although the reservoirs tend to be thin, the output is large, and production lasts for many years.

Defined as oil below 20° API which can flow from its reservoirs like lighter oils, conventional heavy oil goes back a long way in Western Canada’s economy. The heavy oil belt is a series of thin sand reservoirs straddling the border of the two provinces. The oil is lighter in density (11-18° API) and of much lower viscosity than the bitumen in the oil sands deposits.

The buckle of the heavy oil belt is Lloydminster, the border town. The first conventional heavy discovery occurred in 1938, and modest development began when Husky Oil (now Husky Energy) moved into the area after World War II. Husky began producing heavy oil from local fields in 1946, and by the 1960s was easily the biggest regional producer. In 1963 the company undertook another in a series of expansions to the refinery (to 12,000 barrels per day). To take advantage of expanding markets for Canadian oil, it also began delivering heavy oil to national and export markets. These developments made conventional heavy more than a marginal resource. Within five years, area production had increased five-fold to 11,000 barrels per day. However, production volumes remained small until the 1990s.

The first of two important developments was the completion of two upgraders – the Co-op facility in Regina and Husky’s in Lloydminster. These upgraders, which were subsidized by government to reduce risk during a period of lousy oil prices, created a large local market for heavy oil. In the early 1990s, production from the heavy oil belt had risen to 300,000 barrels per day – one third of that production being upgraded and refined for local markets. Today Husky produces about 75,000 barrels per day of heavy oil – more than 10% of Canada’s total.

More importantly, in 1993 the Alberta government redefined conventional heavy as “third tier” oil, with highly favourable royalty rates. Once Saskatchewan’s New Democrats were removed from power, new governments in that province matched and then exceeded the Alberta initiative – after all, heavy oil is Saskatchewan’s single most important long-term hydrocarbon resource, so the province had good reason to kick-start development. Indeed, in a modification to the royalty system in 2002, Saskatchewan defined “fourth-tier” heavy oil, with very low initial royalties. All these new tier royalties were great kick-starters. However, as the CAPP data show in the chart below, conventional heavy oil production is now in decline despite growing reserves.

OPEC or Infrastructure?
Especially in a market of declining production, the question of whether differentials will remain narrow is critical. And on this score there is debate. Is the differential likely to narrow or to widen?

According to AJM Petroleum Consulting operations vice president Ralph Glass, the basic reason differentials are so low “is an increased demand for the heavier crude oils from US refineries. Over the last few years there has been a movement by US refineries to enhance their ability to handle the heavier crudes. With the downturn in US demand, OPEC cut their volumes. (The volumes cut were the heavier crudes and done to maximize returns from light crudes which receive higher prices). As a consequence, the US refineries found themselves short of heavier crudes to process, and are now paying a premium for Canadian heavier crudes to reduce the shortfall in their systems.”

He suggests that the demand for heavy oil to fill for new pipelines to the US – TransCanada’s Keystone pipeline into Patoka, Illinois and Enbridge’s Alberta Clipper line to Superior Wisconsin – may narrow the differential even more in the short term. However, the return of competition from OPEC will widen the differential, thus making heavy oil production less profitable.

First Energy’s Steven Paget has a more sanguine view. “The reason the differential has gone down is that we have more transportation infrastructure out of western Canada,” he says. “This allows nearly 90,000 barrels per day of crude to access the Gulf Coast refining complex.” Demand for fill for new lines will increase demand over the short term (narrowing the differential), but the more important factor in his eyes is that those new pipelines will provide increased access to markets, making conventional heavy more competitive in US markets. “The narrow margin is likely to continue.”

Ralph Glass takes the more cautious view. In 2011 and 2012, he says, the industry will experience “widening on implied concerns of heavy OPEC production coming online and increased Canadian heavy production.” If he’s right, and if production continues to decline, expect the sector’s salad days to wilt.