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Think $100-a-barrel oil is too
darn expensive? Want to buy a barrel of oil for $65 instead? Well, you can.
In fact, it's just north of the border.
The price for a barrel of Western Canada Select
– the benchmark blend for crude produced from the Canadian oil sands
– fell below $63 last week. It then recovered slightly but even now
remains at a 33% discount to West Texas Intermediate, the North American
benchmark that is currently trading at almost $100 a barrel, and a 44% discount
to Brent North Sea crude, the European benchmark that is sitting near $118 a
barrel.
Why is Canadian crude so cheap, you ask? For two
reasons: one that is permanent and the other, we hope, transient. The
permanent reason is that heavy crudes are harder to refine than light crudes,
so refiners are able to buy heavy blends at a discount in recognition of the
higher costs incurred in transforming them into finished petroleum products.
That discount has run at about 20% for the last few years. The other force
currently at play, pushing the discount to almost double its usual level, is
a lack of infrastructure.
The situation in its entirety involves many factors,
ranging from North Dakota's shale-oil boom to the billions spent on refinery
upgrades in Texas. The fallout from a failure to fix the problem is not
pretty. New oil-sands projects are uneconomic at $65 a barrel, but the oil
sands represent one of America's only friendly, increasing sources of crude
oil – without continued ramp-up in Canadian supplies, the US will
remain locked into dependency on suppliers like Nigeria, Iraq, Angola,
Algeria, and Venezuela.
The solution, however, is pretty straightforward:
build more pipelines. But build them quickly, because Canada will not wait
forever for a commitment from the US. Another buyer is waiting in the wings,
armed with billions of dollars and a mandate to lock in energy supplies to
feed its huge, oil-hungry population.
The Problem
The problem is very basic: demand is exceeding
supply. But that balance doesn't refer to oil – it describes North
America's pipeline capacity. There are already more than a million kilometers
of oil and gas pipelines crisscrossing the United States alone, and they
count among the safest in the world. But the geographic distribution of oil
production on the continent is shifting, creating the need for specific new
pipelines to connect booming oil hot spots with refineries thirsty for crude.
The top three oil states in the US have long been
Texas, Alaska, and California. Texas has produced a roughly a million barrels
of oil per day (bpd) for a decade (it produced more before that); Alaska used
to pump a million bpd but now kicks out about 600,000; and California's
production has dwindled from 900,000 bpd ten years ago to 550,000 bpd today.However, while production in the top three states
stagnates or dwindles, there's a new player on the team.
That player is North Dakota, where oil production
increased 42% during 2011 to surpass half a million barrels a day near the
end of the year. Put another way, oil production in the state has increased
anywhere from 8,000 to 40,000 barrels a day every month since June. Over
the last two years,
output has doubled.
North Dakota's oil boom is great news for the US.
Half a million barrels a day is equivalent to America's imports from Algeria
and is more than top-fifteen suppliers Iraq, Angola, Ecuador, and Brazil. It
is almost as much oil as the US currently imports from Russia. The point of
these comparisons is that North Dakota's oil boom is enabling the US to move
away from some of its riskier, less-reliable suppliers in favor of good old
domestic production.
The only downside is that North Dakota's oil is now
in direct competition with crude from the Canadian oil sands for pipeline
space. Crude oil is not particularly useful until it is refined, and the
center of North America's refining universe is the Gulf Coast. The 45
refineries along the Coast process more than eight million barrels of oil per
day, accounting for almost half of America's refining capacity.
Those refineries have lots of capacity available to
process all this new, North American crude. The issue is getting it there.
As North Dakota's oil production climbed, so did
production in western Canada, growing by 7% last year. Both markets now feed
into the refineries and oil storage tanks in the US Midwest, a processing
district centered on the city of Cushing, Oklahoma. Pipelines running from
Canada and North Dakota into Cushing are already jammed, so much so that many
producers are using rail to move their product to market. Moving oil by rail
is always significantly more expensive than moving it through a pipeline, so
the fact that producers are relying on rail is a sure sign that pipeline
capacity is maxed out.
The problem doesn't end with getting the oil to
Oklahoma. There are some refineries in the Cushing area – in fact,
there was once so much oil production in Texas that,
combined with imports from Mexico and South America, Gulf Coast refineries
were overwhelmed. To help out, Cushing-area refineries used to take some of
the excess. Now those few Cushing refineries have nowhere near the capacity
to deal with current output from Canada and North Dakota, so instead of
flowing north the oil needs to flow south.
The southern leg of Keystone XL would alleviate a
lot of this pressure. Running from Cushing to Houston and Port Arthur, Texas,
it would move roughly half a million barrels of oil a day from the
overflowing storage tanks at Cushing to refineries. We're hopeful that
Keystone XL in its entirety will receive approval once the presidential
election is over; if it looks like it is going to take longer to re-route the
contentious Nebraska portion, TransCanada has mentioned trying to fast-track
the southern leg to start alleviating the Cushing glut as soon as possible.
Thankfully, there is also help coming in the shorter
term. Enbridge (T.ENB, NYSE.ENB) and its partner Enterprise Products Partners
(NYSE.EPD) are working to reverse the flow of crude oil in the Seaway
pipeline, which connects Cushing with Freeport, Texas. It was one of the
lines that used to move oil north. Since all they need to do is build a few
new pump stations, the partners expect to have the pipe moving 150,000
barrels per day southward by mid-2012, rising to 400,000 bpd by 2013.
The Irony
Irony can be painful… and right now Gulf Coast
refiners know just how painful.
In the last decade, US refiners invested billions
into upgrading their facilities to accommodate heavier, sourer crude oils.
There were two drivers behind the shift. One is that the world is slowly but
surely running out of light, sweet oil deposits, which means production is
generally shifting to heavier, sourer crudes. The other is that heavy, sour
crudes are cheaper than light, sweet ones, so once their facilities are upgraded
to handle heavy oil, refiners can save money on their crude purchases.
The catch is that refineries can only process
specific crude grades. Once a refinery has been upgraded to process heavy
oil, the facility can no longer work light crudes; it has to be fed with
heavy oil. As such, all the sophisticated refineries on the Gulf Coast need
heavy oil, not only to save money but because it's the only kind of oil they
can run.
The cruel irony now is that they can't get their
hands on that cheap, heavy crude. Canadian crude is exactly the kind of oil
these sophisticated refineries need but it's all piling up in Cushing, 700 km
to the north. Without a way to pump it down south, Gulf Coast refiners with
sophisticated facilities are instead being forced to pay a premium for heavy
oil from Venezuela.
Only a few years after spending billions of dollars
on upgrades in preparation for an influx of heavy oil, these proactive
refiners are now being forced to pay extra for the heavy oil they were
supposed to be able to buy at a discount. For them, the Seaway reversal and
the southern leg of Keystone XL can't come soon enough.
The
Fallout
As nice as $65-per-barrel oil sounds, that is
actually too cheap. With each passing year the average cost to produce a
barrel of crude oil creeps upward, as the easy deposits of light, sweet oil
start to run out and producers are forced to use more complicated, expensive
means to access new oil: They have to go deeper, use fracturing technology,
work underneath kilometers of water, or work in countries where fiscal and
social risks run high.
The oil sands are a prime example. If the price for
Western Canadian Select crude oil remains in the $60 to $70 range for very
long, new projects will start getting cancelled. Producing a barrel of oil-sands
crude from an existing operation – one where the capital costs have
already been repaid – costs between $36 and $45 a barrel. For
established operations, therefore, $65 oil is just manageable.
For new projects, however, the bar is higher. Every
cost involved in building and manning an oil-sands operation has increased
notably over the last decade, from the cost of tires to the costs of employee
health-insurance programs. A new oil sands operation, even an in-situ project
where the size and therefore cost can be ramped up gradually, needs a crude
price of at least $80 a barrel before the project's economics turn from red
to black.
If new pipelines running south fail to materialize
and the lack of capacity keeps Western Canadian
Select below $75 a barrel, oil-sands development will slow. Environmentalists
might cheer at that notion, but without Canadian supplies the US will be
forced to continue relying on places like Nigeria for crude oil. If pictures
of oil-sands operations make your green heart tremble, photos of the huge oil
spills and daily natural gas flare-offs in Nigeria might stop it dead in its
tracks. Oil extraction is never pretty, but at least environmental
regulations in North America limit the damage substantially. Nigerians are
not so lucky – and by buying Nigerian oil, the US supports that
country's dirty oil industry.
The other fallout of a failure to build up North
America's pipeline capacity is that China will benefit. Canada knows it has a
very valuable resource in its oil sands; and if pipelines heading south can't
happen, then the US's northern neighbor will figure out a way to get its oil
to the Pacific, an effort that is already being encouraged and funded by
energy-hungry China. Pipeline capacity from the oil sands to the west coast
is currently very limited, but there are several proposed lines that would
boost westbound volumes dramatically, if approved. That is a big
"if," because Native groups across British Columbia are opposed to
the current proposals. Still, oil-sands crude needs new outlets and, with
enough time and negotiation, it seems likely that at least one of those
outlets will be on the west coast.
China would probably sign on to building a pipeline
to the coast tomorrow. The Canadian prime minister just completed a weeklong
trip to China wherein one of the main foci was energy; the CEO of pipeline
major Enbridge (T.ENB) was part of Prime Minister Harper's entourage. Chinese
energy companies have invested no less than C$10 billion in Canada's oil and
gas sector in expectation of a growing energy connection between the
countries.
If the United States wants to build a more secure
energy future, Americans (and Canadians) need to let the oil flow. By all
means, avoid the Ogallala aquifer and do everything possible to protect the
sensitive Sandhills region. But build a couple
pipelines, and build them now.
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