As global oil prices rose this fall, Western Canadian Select moved in the opposite direction, hurting Canadian producers forced to sell at a discount.
“We’re at a level right now where differentials are extremely wide for producers,” said Brian See, vice-president of equities, energy, at CIBC Asset Management, during a late-October interview.
While Brent crude and West Texas Intermediate (WTI) hit 2018 highs of approximately US$86 and US$76, respectively, in early October, Western Canadian Select (WCS) dropped from around US$40 in September to below US$30.
That $40 to $50 differential “is so wide that the realized price is making it extremely difficult to earn an acceptable rate of return for [energy] projects,” See said. The result has been a headache for Canadian producers, which produce about four million barrels per day of oil—approximately 60% of which is heavy oil exposed to the WCS-to-WTI differential, he said.
Analysts say the steep oil price discounts and excess production were costing Alberta producers and the provincial government millions of dollars each day, due to lack of pipeline space and little storage capacity for excess oil that couldn’t be moved.
In the past there, was “ample capacity” to deal with excess production, See said. “If supply exceeded demand, you could put it into storage and therefore buffer price movements.”
Now, a lack of storage space is bringing the price of WCS down, he said. As of Nov. 6, Brent crude was trading around US$73, WTI around US$63 and WCS around US$15.
How did this happen? Oil production in Canada has grown at a pace that’s exceeded the capacity to move it by pipeline or rail, See said. Pipelines that would move Canadian oil to the coast for shipping, such as the Trans Mountain pipeline, are facing regulatory delay.
Until those issues are solved, producers are looking at other transportation means. Crude-by-rail exports increased to 229,544 barrels per day in August, from 119,936 barrels a year earlier, according to the latest monthly data from the National Energy Board.
Another challenge, See said, is that downstream participants, including U.S. refineries, actually benefit from wide price differentials. They can take “a lower feedstock cost to process gasoline and distillates in their refineries,” he said.
BP plc has seen the upside in its refining division, reporting an adjusted profit of US$2.11 billion in its third quarter downstream operations, up from US$1.46 billion in the second quarter, attributing most of the increase to higher North American heavy crude oil discounts.
Outlook for price differential
The heavy oil differential will likely narrow heading into 2019, said See, who forecasts a WSC-to-WTI price gap of between US$30 and US$35 by the end of this year or early next.
One reason is several midwestern U.S. oil refineries that are undergoing maintenance are expected to restart operations, he said. “There’s a million barrels of oil offline currently, and that’s expected to ramp up over the next month.”
Another is oilsands production continues to grow. “Even with the wide differentials today, there are still some projects that are offline and [they’re] going to be coming back on,” he said.
See also expects crude-by-rail shipments to increase, which will further narrow the differential by late 2019 or early 2020 to under US$30, he said.
Further, with the introduction of Enbridge’s Line 3 pipeline to Minnesota, which could start operating in Q4 2019, approximately 400,000 barrels per day of extra capacity will be added, See said.
Though his outlook on differentials is improving, it’s still wider than the market expectation, said See, who co-manages the CIBC Energy Fund. Still, he’s constructive on oil producers and thinks it’s a good time to buy quality companies.
“What we see is a structural improvement on a go-forward basis, particularly as we get into 2019 and 2020,” he said.
One company he likes is Calgary-based Cenovus, mainly due to its asset sales and its improving balance sheet.
The company is looking to expand how much crude it moves by rail, Reuters reported at the end of October, signing contracts with Canadian National Railway Co. and Canadian Pacific Railway to ship approximately 100,000 barrels of oil per day from northern Alberta to the U.S. Gulf Coast beginning in the fourth quarter.
See is also watching Canadian Natural Resources (CNR), a Calgary-based heavy oil producer that reported a profit of $1.8 billion in the third quarter, up from $684 million a year ago. CNR said at that time that it plans to reduce its oil output by up to 55,000 barrels per day in November and December due to wide price differentials—after already cutting its output by 10,000-to-15,000 barrels per day in October.
Despite its focus on heavy oil, See said CNR also produces light oil, which helps buffer the big heavy oil discounts. “This is a company that continues to grow free cash flow and deliver [its] balance sheet,” he said.
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