EXPECTATION vs REALITY

EXPECTATION AND REALITY
by maryline vuillerod and jeff kralowetz
It may seem intuitive that Canada could gain more benefit from its crude oil resources by refining them in Canada and exporting refined products. But this theory fails to account for the structure of global markets, constraints in infrastructure and geography, and trends in global demand for refined products.

THE STRUCTURE OF GLOBAL MARKETS
 Any company considering investing $10 to $15 billion dollars in export refineries must take into account significant Asian growth that has been matched by rapid building and even over-building of refining capacity in China, India and the Middle East. Even there, refinery utilization has fallen.
Any new Canadian refinery would enter a market in which capacity has been over-built and refinery utilization has been falling since 2006, particularly in the Organization for Economic Cooperation and Development (OECD) member countries.
 Source: IEA, June 2014 Medium Term Market Report: Market Analysis and Forecasts to 2019

 
Oceania Constraints in infrastructure

 Furthermore, the world is cutting back on refinery construction projects and closing existing capacity. Since 2008, 4.5 million barrels per day (b/d) of OECD refining capacity has been shut down. Source: IEA, June 2014 Medium Term Market Report: Market Analysis and Forecasts to 2019



The Goldilocks principle states that reasonable argument falls within certain margins rather than occupying extremes. Consider the argument over how much refining is right for Canada. One extreme holds that we should refine all Canadian crude in Canada; the other that we should refine no crude in Canada.
The former suggests markets for refined products are unlimited and there is more value in refining crude than selling it as a critical Canadian commodity. The latter proposes reliance on imported transportation fuels, exposing Canada to supply insecurity and foregoing the associated economic and social benefits of refining.
The reasonable position is the middle ground, where market forces dictate the wisdom of selling and refining crude.
Refining is a complex business and an integral component of Canada’s oil and gas value chain. The industry provides jobs for nearly 18,000 workers and contributed over $5 billion to GDP in 2014. The industry operates 15 refineries in seven provinces for a total capacity of nearly two million barrels per day—enough to meet Canadian demand and ensure we are a net exporter of products.
 It is an industry that has been shaped by the market, if sometimes harshly. Since 1970, 20 refineries have closed; others have increased efficiency and expanded their capacity to remain competitive and satisfy Canada’s current demand. Production and demand in Canada are in positive balance, with Canada a modest net exporter of refined products.
The outlook for demand is flat, which explains why, to date, investors are skeptical of new refinery proposals such as BC-based Kitimat Clean and Pacific Future Energy. Kitimat Clean is projected to cost $21 billion—with requests for government loan guarantees in the vicinity of $10 billion.
 How will local declining demand impact the business case? Where are the markets?
Canada’s export refiners must compete on a continental and global stage to survive and thrive. We currently export refined products where geography— specifically tidewater locations— makes us competitive. For example, the northeastern U.S. is a strong and reliable export market served by refineries in Newfoundland and New Brunswick.
In effect, we have struck a marketbased balance between selling and refining crude. According to the Goldilocks principle, we likely have got it just right.

Even in non-OECD countries, refinery expansion and construction is being scaled back in the face of over-building.
Source: IEA, June 2014 Medium Term Market Report: Market Analysis and Forecasts to 2019



SHELTERED BUT NOT IMMUNE
 The U.S. has been the exception to refinery construction cutbacks. Why? Cheap natural gas for fuel, the U.S. ban on crude exports that keeps feedstocks cheap, and easy access to Latin American and other export markets for refined products from the Gulf Coast. But this experience is regional. Over on the U.S. east coast, there has been 800,000 b/d in refinery closures in last 10 years.
 Canadian refiners are similarly affected, as evidenced by recent refinery closures in Montreal and Dartmouth. While refinery expansions have occurred, no new refineries have been built in Canada since the 1980s (a new 50,000 b/d bitumen refinery is now under construction in Alberta; see next page).
TRENDS IN GLOBAL PRODUCTS DEMAND AND SUPPLY
To complicate matters, North American products consumption is declining as a result of vehicle fuel efficiency standards, ethanol/ biofuels mandates, a more urbanized population and the growth of online shopping. This situation exists in all OECD countries. The sole markets where demand for refined products is growing are non-OECD countries. As a result, North America is oversupplied with refined products, and the glut is growing—and will continue to grow at least through 2019.


GLOBAL MARKET COMPETITION FOR CANADIAN REFINING INVESTMENT
What prevents Canada from competing globally in refined products markets as the U.S. Gulf Coast refiners have? The answer is that Canada is constrained by geography. We are located further from Latin American or Asian markets where refined product demand is growing.
And today there is no way to cost-effectively move crude to a coast, refine it and compete with a Chinese or Indian refiner running Russian or Middle Eastern crude that arrived at a lower cost.
Canadian crude availability is located offshore in Newfoundland and land-locked in the West—away from high-demand areas. We can’t move closer to clearing markets where the wholesale commodity price is determined.
North America is oversupplied with refined products, and the glut is growing – and will continue to grow at least through 2019.

CONSTRAINED BY CONFIGURATION
Not all refineries are alike. East coast Canadian refineries were built to run light crude. American Bakken and Eagle Ford feedstocks are good options, but most domestic Canadian crude production is heavy. Therefore, these refineries are not well placed to monetize Canadian domestic crude resources.
Currently, east coast refineries are refining less than 50 percent of the east coast offshore Canadian grades. And locking into one feedstock source threatens the profitability of refiners. Building a refinery solely to monetize one type of crude is perilous, as the light/heavy spread can change, and margins can contract or even disappear.

Mandating processing in Canada would almost inevitably raise prices for Canadian consumers. In the end, the best way to achieve optimal natural resource utilization and fair prices for consumers is to allow markets to function rationally, allowing market forces to allocate supply where it is needed. The constraints of inflexible infrastructure and the geographical challenges of stranded supply pools and scattered demand centers no doubt complicate the efficiencies that markets could bring. But intervention along the supply chain will only stop the flow and distort prices in ways we simply cannot predict.

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