Here’s a novel — and somewhat controversial — idea to fix the steep discount squeezing Canadian oil prices today: cut output.
A new report by analysts at RBC Capital Markets suggests the Notley government could bolster distressed oil prices in Alberta by taking steps to offer a “royalty holiday,” effectively using its own royalty barrels to temporarily curb production from the province.
They’re not the only ones supporting the idea of throttling back output.
Veteran oilman Hal Kvisle, the former CEO of TransCanada Corp. and Talisman Energy, believes the province should examine returning to an allotment system for producers used during the Lougheed era.
The government would curtail a small amount of output from all petroleum producers to lift discounted crude prices for the entire Canadian sector and improve government royalties, he said.
Both suggestions are contentious and would face opposition from several quarters, including producers.
But the fact the concept has the support of Canada’s largest bank and one of its most prominent executives highlights the magnitude of the dilemma facing the industry: too much crude and not enough ways to transport it to market efficiently.
“If we reduce production of oil by seven or eight per cent, that differential would go away,” Kvisle, a member of the Canadian Petroleum Hall of Fame, said in an interview.
“But we are giving it away right now. If we are giving it away, you have to stop and think.”
In a report issued Monday, RBC analysts Greg Pardy and Robert Kwan took the idea in a slightly different direction, arguing “partial drainage of Western Canadian’s oil storage” appears to be necessary for bringing Canadian oil price differentials back into equilibrium.
There’s little doubt the pendulum has swung wildly off-kilter.
On Friday, prices for benchmark West Texas Intermediate crude closed at US$67.33 a barrel, while the light oil blend Edmonton Par closed at $37.59.
Western Canadian Select (WCS), a heavy oil-oilsands blend that has seen record discounts this month, was selling for only $24.34 a barrel.
Recent refinery maintenance in the U.S. Midwest and Canada’s ongoing pipeline constraints have pushed the oil price differentials into unprecedented territory.
The market is oversupplied by about 160,000 to 185,000 barrels of oil per day (bpd), once existing pipeline capacity and oil-by-rail transportation options are accounted for, according to RBC.
As owner of the resource, Alberta has the option of taking its royalty payments in cash or production remitted in-kind by companies.
RBC says Alberta could offer a “royalty holiday solution,” by instructing companies not to produce their royalty barrels for government for several months.
Royalty payments would be deferred into the future and paid back once prices improved.
Over the span of three-and-a-half months, the strategy would take about 200,000 barrels per day (bpd) of oil production offline, reducing bloated Western Canadian storage levels by up to 7.4 million barrels, the bank estimates.
Some oilpatch investors who’ve watched the price differential blow out in recent weeks say the idea is worthy of examination.
“It makes a lot of sense,” says Eric Nuttall, a partner and senior portfolio manager at Ninepoint Partners.
“Whatever you lose short term on royalties on the shut-in production, you should more than make up for in the increased royalties on the much higher price.”
Such action would require government intervention, something that would unsettle many producers.
While OPEC has tried to manage pricing through quotas, Alberta and other producing economies allow the invisible hand of the market to solve such issues.
In this case, a market response would mean unprofitable oil being shut in, although that usually takes time.
Mike Walls, a crude markets analyst with research firm Genscape Inc., said if current oil-price discounts are sustained, some Western Canadian producers will naturally reduce their output.
Large integrated producers that use oil in their refineries benefit from lower feedstock costs in their downstream operations, and many already have committed pipeline space or rail capacity that avoids the steep price discounts. These are the least likely to reduce output.
However, smaller heavy oil producers with higher operating costs are most at risk of shutting in or letting output decline, Walls noted.
Jackie Forrest, senior director of research at ARC Energy Research Institute, said the idea of reducing production in Alberta would have its own challenges.
If the province used an allotment system, it’s unclear which producers would be cut back and at what levels.
And the idea of a royalty holiday means “the Alberta taxpayer ends up taking all of the lost revenue” pain over the short term, Forrest said.
Producers themselves are wary of the idea.
It’s not so simple to curtail production from large oilsands facilities meant to run at high levels to maximize output and efficiency.
Alberta isn’t an island and if it cut the flow of oil heading south, it would serve as “a gift” to operators closer to market to fill the gap, said Gary Leach, president of the Explorers and Producers Association of Canada.
“It’s difficult to see industry, especially when the impact of these commodity price discounts are so varied, uniting behind a single solution,” he said.
The Notley government is studying the idea of ramping up oil-by-rail shipments and pressing the federal government to buy additional locomotives to make it happen, but that will also take time.
Energy Minister Marg McCuaig-Boyd said today’s price discount is “absurd,” but was firm the idea of a royalty holiday to reduce output is a non-starter.
“These are resources owned by Alberta. We need to keep the value here,” she told reporters.
All of these solutions are complex, and getting collective buy-in from industry and governments won’t be easy.
At this stage, however, Albertans are searching for answers to a intricate problem that needs to be resolved, sooner rather than later.
Chris Varcoe is a Calgary Herald columnist.
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