Cures for Distressed Barrels

North American refiners and pipeliners are working hard at near- and long-term solutions for the differential-mushrooming Midwest supply glut. 

An edited version of this article appears in the Oilsands Review 

By Peter McKenzie-Brown
After the financial crisis of 2008, the United States was flat on its back. Since that terrible period, Canada’s energy industry has been a considerable, though unwilling, contributor to its return to financial health. To a large degree because of the glut of bitumen in much of its heartland, the US is enjoying lower energy prices than other oil-importing countries. Because of the perverse economics of oilsands development, from many perspectives – not least that there are no alternative markets – it makes short-term sense to keep sending cheap bitumen into the growing glut.

Behind this debacle is a continental pipeline system that does not reflect the realities of contemporary oil supply. In a Globe and Mail report, Canadian Association of Petroleum Producers (CAPP) chairman Lowell Jackson described the industry as “taking the short end of the stick…simply because we can’t move product.” The solution? More pipelines to more markets.

A Manageable Glut
There are four reasons for the glut in much of the American oil market. First, the country is consuming less – a response to higher oil prices, lower economic activity and government policy. Second, the US is producing more oil for the first time in years – much of it coming from the Bakken play in North Dakota and Montana. Those growing supplies are a response to new production technologies – essentially the use of horizontal wells and hydraulic fracking to release tight oil from shale. Third, Western Canada exports its oil almost exclusively on the American Midwest. Finally, both bitumen and light oil production are growing rapidly in Western Canada despite the region’s limited markets.

After being in decline for decades, light oil production in Alberta is again at 2003 levels. In three years nearly 100,000 barrel-per-day of new production have taken the total to 400,000 barrel-per-day. Adding to the supply is Canadian synthetic oil and bitumen production, which increased by more than 100,000 barrels a day last year alone, to around 1.8 million barrels.

Those new volumes are fighting for market share in already tight segments of the American market, which is divided into five PADDs (Petroleum Administration for Defense Districts). Of the five districts, three – respectively encompassing the US East Coast, the Gulf Coast and the West Coast – are the largest oil consumers. However, according to Ralph Glass, economist and vice president of consultancy AJM Deloitte, “80 to 90% of the oil exports coming down from Canada are going into PADD 2 (the Midwestern states) or PADD 4 (the Rocky Mountain states). The other three PADDs are where the population is. So the problem is that you can’t get the oil from these relatively unpopulated places to the densely populated states that really need it – California and Florida, for example.”

He added that the other three PADDs are mostly fed by offshore oil, so they have to deal with offshore prices. “They are paying $15-$20 more per barrel for oil coming in from the offshore, even if it’s coming in from a Gulf of Mexico platform.”

Since Canadian export markets rely on a system of pipelines that feeds Midwestern markets from producing fields in Western Canada and the Western states, the competition for access to limited pipeline capacity is huge, and it is leading to huge differentials for Canadian oil. To cite one example, synthetic crude was recently selling for $10 per barrel less than West Texas Intermediate (WTI), although it is clearly higher-quality oil.

Pipeline capacity is relatively tight already. According to CAPP vice president Greg Stringham, “really small incidents that wouldn’t have had much impact in the past are now having a big impact on crude throughput.

The real disconnect is between WTI prices and world prices. In the next year a lot of market pressure is leading to a lot of infrastructure development with the idea of eliminating the differences between. A lot of that will be resolved within the next year and a half or so.”

Part of the solution will actually make things worse for the oilsands sector. At present, there is no major pipeline coming out of the Bakken; that oil is still mostly railed to market. The magnitude of the potential issue became clear when an American company recently proposed the 2,100-kilometre Bakken Crude Express Pipeline, a 200,000 barrel-per-day pipeline to deliver crude from North Dakota’s Bakken play to Cushing Oklahoma. When completed in 2015, the line will carry high-quality sweet oil into an already competitive market. That line could further reduce Canadian access to US markets by increasing the glut.

Winners and Losers
Alberta – which receives royalties in kind – receives lower royalty revenues because of the differentials. The differentials also affect the corporate bottom line, bringing down governmental tax revenues. In eastern Canada, refineries pay the much higher Brent prices. “The widening differential between Brent and WTI is an indication of the over-supplied North American market and limited access to the off-shore markets,” Glass added.

According to Glass, if the price differentials of early spring this year were to hold until year end, the Canadian economy would forego about $18 billion in revenue, royalties and corporate taxes. What happens on the other side of this trade? North American refiners that can process bitumen – almost entirely located in the US – make high returns by buying bitumen feedstock when differentials are high and selling refined products at regular market prices. The beneficiaries of the oil glut are mostly American.

Perverse oilsands economics mean it makes sense to sell bitumen even when there is no profit in it. Some companies have suggested that, if you apply full-cost accounting to bitumen production, they are selling product to refiners at cost. Yet it makes sense to continue doing this once the capital investments have been made because the cost of is low – perhaps $20-$30 per barrel for SAGD production. According to one bitumen trader, “operating costs are partly subsidized by the gas price collapse. Even if we only get $60 a barrel (from the buyer), we want the income stream.”

Some companies, though, use hedging strategies to beat the differentials. Beginning in 2006, three Canadian companies – Cenovus, Husky and Suncor (through the Petro-Canada takeover) – have taken deliberate steps to average away these peaks and valleys by acquiring interests in bitumen-processing US refineries. They benefit from high bitumen prices when differentials are low (and bitumen prices therefore high.) Conversely, their refining operations benefit when differentials are high, since products manufactured from lower-cost feedstock yield better returns.

Relative to the rest of the world, the energy industry is subsidizing the American economy. “The Americans see the advantage of taking as much Canadian oil as they can because it is significantly cheaper,” according to Glass. “The push by American refineries to get their hands on Canadian oil (will increase summer demand). I think that over the summer the synthetic price will pick up again, too, as it did last year. The Americans are building up their storage reserve with cheaper oil from Canada.”

But “I see the immediate issue as a short-term problem,” he added. Large price differentials “happened last year about this time, but rectified themselves by the end of summer. There is some capacity to put new oil into the pipeline system to get it to the US. Last year Edmonton par actually received a premium over WTI.”

“Enbridge is reversing the Seaway pipeline and that should help. Also, President Obama has announced that he wants to push ahead with the southern leg of Keystone XL…” Access to the Gulf Coast would do more than give Canadian producers access to the vast refining markets in those areas. It would also mean surplus volumes – as crude or as refined products – could be exported to distant buyers.

Three Things
In 2009 Canada exported 1.1 million barrel-per-day into PADD 2. By the end of last year, that number had grown to 1.68 million barrel-per-day. That 580,000 barrel-per-day increase is likely to increase because of the new projects on the oilsands side that still haven’t gone on stream.

That is the bad news. The good news, according to CAPP vice president Greg Stringham, is that the markets are working hard to fix the problems. “The real key is to be ahead in building pipeline capacity, and not to be behind. Right now we’re behind, and we have seen what problems that can cause.”

“There are three things the industry is looking at,” according to Stringham. “The first is market expansion within Canada. At present we import about 800,000 barrels a day into Atlantic and Eastern Canada, even though we have a pipeline that was built in the 1970s to supply oil from Western Canada to that region.

That’s a good light oil opportunity, and there is also some potential for refining heavy oil and bitumen at the Irving refinery. In the past they did refine some oil from Venezuela. Can we get the pipeline reversed and get the oil to those markets in the medium term? The NEP is now looking at that issue.”

Would reversal of that pipeline mean lower energy costs for Canada? “The savings would be quite substantial in the short term, but that can’t last. What will happen eventually is that North American production will be priced at world oil prices.”

The biggest potential market for Canadian oil, “the 9 million barrel-per-day market,” is the Gulf coast. “We have to get into that. Right now there are many proposals to enable us to do that. The real bottleneck is the access between Cushing and the Gulf coast. That’s what’s causing the disconnect between the pricing structures in the United States compared to the rest of the world. The market is working to reverse that, by installing new pipeline capacity.”

Both Stringham and Glass are optimistic about the impact of Enbridge’s efforts to reverse the Seaway pipeline and the construction of the southern leg of the Keystone pipeline. According to Glass, “The only way we can really get our oil out is not by building refineries and trying to export product, because we simply don’t have (pipeline) access. But we can supply world markets with products by getting our oil to Gulf Coast refineries.”

On the matter of the proposed Northern Gateway pipeline, both men are effusive. “We have really strong opportunities to develop markets from Canada’s West Coast,” according to Stringham. “We aren’t only talking here about selling oil to China, but also delivering oil to other markets like California, which is currently feeding off a diet of Alaska oil, which is in decline.” A relatively new issue with this development is related to the industry’s growing need to export light and medium oil. It is no longer just a bitumen pipeline. “We need to find new markets for light oil, also. We have to find the right balance between the exports of light oil and bitumen.”

Part of finding the right balance may involve expanding the TransMountain pipeline to BC’s lower mainland – a three/four year project. That longer-term timeframe is where the biggest risks lie. How fast can Keystone XL be approved, and then how long will it take to bring it to completion? What about Northern Gateway? Reversing the TransCanada pipeline to Eastern and Atlantic Canada could also be done in the medium term, and in that timeframe it may be possible to turn part of the TransCanada gas pipeline into an oil line to Quebec.

“But looking five to 10 years out there is going to be a lot more bitumen production. We will need new markets, and those are going to require more options from (Kitimat) to California, to the East and to the farther east. Western Canada is going to need new markets. Over the next 10 to 15 years we will need to increase pipeline capacity by 1.5 to 2 million barrels a day.”

The message that Canada needs market diversification is getting a lot of traction. In a widely reported speech, Prime Minister Stephen Harper told a group in Washington that delays in the Keystone XL pipeline have greatly increased Canada’s interest in export pipelines. “We cannot be in a situation where really our one and only energy partner can say no to our energy products….The very fact that a no can be said underscores to our country that we must diversify our energy export markets.”

Where to Go?

Some say transportation should be a market grail for natural gas, while others aren't so sure

This article appears in the second volume of CSUG's Energy Evolution Guidebook & Directory

By Peter McKenzie Brown
In his best-selling 1958 book The Affluent Society, Canadian-born economist John Kenneth Galbraith popularized the concept of conventional wisdom. “It will be convenient to have a name for the ideas which are esteemed at any time for their acceptability, and it should be a term that emphasizes this predictability,” he wrote. “I shall refer to these ideas henceforth as the conventional wisdom.” The problem with conventional wisdom is that it isn’t always true. Contrarians are often right.

Price Bull
It’s worth keeping that truism in mind as we develop the case for building new natural gas markets in North America. In a recent comment, author and analyst Peter Tertzakian argued that the rapid decline in drilling for natural gas across North America raises the question of whether natural gas is likely to continue to be in a serious state of oversupply. Tertzakian notes that for the first time in 15 years half of the US drilling fleet is drilling for oil, compared to less than 20% of rigs for the last decade. Such a dramatic decline in drilling almost certainly suggests that production levels will decline, he suggests.

He then moves on to the killer argument: “Let’s say (gas) production starts retreating in earnest this year and natural gas prices rise back to some fictional level like six dollars per MCF. Notionally, the (conventional) wisdom goes that producers will dispatch more rigs to ramp up production and thus clobber prices again. There is a problem with this line of thinking: why would producers do that when more money is to be made elsewhere?” He suggests that as long as oil is valued at more than four times the value of gas (energy equivalency basis), there is little motivation for the industry to shift toward more gas drilling. The result? Declining supply and still higher gas prices until a cost-reward rebalance restores aggressive natural gas drilling.

Supply Bull
Since Tertzakian is such an unusual voice in the wilderness, the balance of this article assumes that the conventional wisdom is true. Gas supplies are likely to continue to be plentiful, and there will continue to be a need to develop new markets. One of the most interesting advocates of greater markets is the legendary oilman T. Boone Pickens, who says he has invested $70 million in developing and promoting The Pickens Plan.

An 83-year-old geologist who received his degree in geology in 1951, as a young man the Texas-born Pickens spent a decade in Calgary. In a broadcast interview, he said he opened an office in Calgary in 1959, and lived in the province with his family in the 1960s. After moving back to the United States, he made a multibillion-dollar fortune in exploration and development and, much more publicly, as a corporate raider. His current passion is to promote the Pickens Plan.

“For 40 years the United States has had no energy plan,” he explained. “We’ve just been drifting. Just drifting means you are just importing more oil from the Middle East, countries that the state department recommends we not visit.”

Pickens is adamant that the United States should reduce its dependency on overseas oil, and he believes that renewables like wind and solar aren’t viable anymore because of cheap gas.

“Natural gas is the only thing we have that can replace non-North American foreign oil. We import 5 million barrels from the Mid East. That’s the oil I want to replace with gas. If you had 8 million 18-wheelers (in the US trucking fleet fuelled with natural gas), that would cut OPEC imports in half.” He added, “If the US administration announced that from now on all new government vehicles would use domestic fuel that would be a powerful message to send to the world.”

“This is a security issue for me. I don’t want to be dependent on the enemy for energy,” he said. Until gas prices cratered, Pickens was a strong advocate of wind energy, and he was leading an effort to finance a multi-billion dollar wind farm in the Texas Panhandle. He uses this fact to support his green credentials. “Natural gas is 30% cleaner than diesel. We have the cleaner, cheaper, abundant fuel here, and it will replace the dirty fuel from the Mid-East.”

Pickens is also an advocate of continental fuel switching – in particular, substituting natural gas for coal in power generation facilities.

For many years most commentators have believed that the United States could never become self-sufficient in energy, Pickens said, but “things have changed. We have so much natural gas – the US has a 100 years supply, and the Canadians have a lot up in Horn River, for example, and the Canadians have a lot of oilsands (oil). Let’s use that to make North America energy self-sufficient.” He added, “When people say to me, ‘Hey, Pickens, I don’t like your plan!’ I say ‘Fine, what’s your plan? If you don’t have a plan your plan is to import more oil from the Middle East.’”

Not many oilmen are as colourful as T. Boone Pickens or as motivated by worries about enemies in the Middle East. However, there are a lot of other natural gas supply bulls.

Exxon-Mobil, for example, demonstrated its belief by plunking down $31 billion for gas-focused XTO Energy a year and a half ago. A company vice president, William Colton, recently told the New York Times that “If there is any kind of major trend, we think it’s going to be a shift toward more natural gas.” He added that “Natural gas is available. It’s the most efficient way to generate massive power. It’s affordable. We already have gas infrastructure in place. From a CO2 emissions standpoint, it’s 60 per cent cleaner than coal, and (the U.S. has) 100 years of supply.”

Agency Bull
America’s Energy Information Agency, whose job is to forecast supply and demand based on best-guess current trends, doesn’t appear to see much of a plan to promote greater use of natural gas anywhere in the future. According to the early-bird version of the 2011 forecast, “Non-hydro renewables and natural gas are the fastest growing fuels used to generate electricity, but coal remains the dominant energy source for electricity generation because of continued reliance on existing coal-fired plants” well into the foreseeable future.

According to the EIA, the agency has revised its methodology for gas prices “to better reflect a lessening of the influence of oil prices on natural gas prices, in part because of the increase in shale gas supply and improvements in natural gas extraction technologies.”

Of course, as Peter Tertzakian argues at the beginning of this article, it might be a mug’s game to discount energy equivalency too deeply when you are calculating the relative values of oil and gas.

Whatever methodology the organization uses, the EIA does forecast an increase in North America’s natural gas demand, but its estimates seem paltry compared to the aggressive development that T Boone Pickens, for example, is promoting.

The agency forecasts a strong near-term increasing demand because of a “strong recovery in near-term industrial production, growth in combined heat and power, and relatively low natural gas prices.” Look farther out into the future, however, and the agency’s forecasters are more circumspect than the gas supply bulls. “U.S. natural gas consumption rises 16 percent from 22.7 trillion cubic feet in 2009,” they intone, “to 26.5 trillion cubic feet in 2035.”

Such a small increase in forecast demand – 16% over 25 years – suggests that the EIA’s gas supply bulls aren’t as optimistic as Pickens; he might complain that they “don’t have a plan.” You could equally argue that there are contrarians among them.