America’s New Energy Boom Is Bust for Foreign Suppliers

Commentary, Energy, Frontier Centre

For the better part of a year, Canadian officials and executives watched from afar as a shale-oil boom exploded south of the border.

But it wasn't until last fall that the full impact of the U.S. energy boom hit the provincial government here in the heart of Canada's oil patch.

Around October, prices for Canadian bitumen—a heavy crude from the country's vast oil sands developments—tanked, walloping the economy of America's largest supplier of foreign oil, its biggest trading partner and one of its closest allies.

Amid a bottleneck of too few pipelines and too much new oil across the U.S. Midwest, Canadian producers had started agreeing to steeper and steeper discounts to get their oil to American refiners, their only foreign buyers.

The country's central bank estimated recently that lower Canadian oil prices helped shave 0.4 percentage point off the country's economic output in the second half of last year. That's a big chunk for an economy that grew just 1.8% in 2012.

Canada isn't alone. A handful of other traditional suppliers of America's crude are now scrambling to deal with the fallout of surging U.S. output. West Africa's light, low-sulfur crude is similar to that being pumped out of shale-oil hot spots like North Dakota and South Texas.

That's a big part of the reason Nigerian exports to the U.S. fell by almost half last year from 2011, according to the U.S. Energy Information Administration. Both Algeria and Angola saw their respective U.S. export volumes drop by about a third last year.

Latin American producers, meanwhile, are expected to double crude-oil exports to Asia by the end of the decade, seeking their own alternative buyers to the U.S., according to energy consultancy IHS CERA.

In the U.S., new extraction techniques have squeezed a bounty of new oil out of once-unpromising rock formations, creating jobs and raising hope in Washington that one day America may wean itself off foreign crude. Outside the U.S., the ramifications aren't so rosy.

The impact on Canada—which currently has no other oil-export options—has been especially painful. America's energy boom "is changing the order of global oil markets," says James Burkhard, head of oil-market research at IHS.

The problem for Canada isn't falling demand. The country's exports are actually rising in the U.S. Rather, a bottleneck of U.S. and Canadian crude has caused Canada's pricing to become extremely volatile, cutting into oil-company profits and government revenue forecasts.



Prices have rebounded since hitting lows earlier this year. But government officials, industry executives and analysts expect continued price swings and market pressure until more pipelines are built.

The situation poses a threat to the broader economy across Canada. "If we don't get certain oil pipeline expansions, if companies slow projects, this will impact employment," and other swaths of Alberta's economy, like the property market, says Ann-Marie Lurie, chief economist for the real-estate board of Calgary, the province's commercial hub.

While Canada is facing other economic headwinds, lower oil prices hit corporate tax receipts and reduce the payments shared between Canada's semiautonomous provinces.

In Canada's annual federal budget, released last month, the government estimated that lower Canadian energy prices could shave off some 28 billion Canadian dollars ($27.6 billion) a year in gross domestic product, translating into more than C$4 billion in lost government revenue.

Many experts say Canada's woes are likely to be temporary and that prices will stabilize once additional pipelines are built to the U.S. or to Canada's shores, allowing for exports to other destinations. Demand among refiners along the U.S. Gulf Coast remains strong for western Canada's heavy oil.

And Canadian producers and U.S. refiners are increasingly using rail to bypass the pipeline congestion. Canadian crude exports to the U.S. grew about 8% last year, to an average of about 2.4 million barrels a day, according to the EIA.

Heavy Canadian crude—which isn't suitable for many refineries—has often traded at a discount to U.S. and international blends. But that so-called differential widened significantly last year, as producers competed for congested capacity along the corridor of pipelines that bring Canadian oil south, mostly through the U.S. Midwest. Growing Canadian production competes with growing U.S. output for space.

In January and February, Canadian heavy crude at times traded as much as $40 cheaper than U.S. benchmark oil. Recently, that differential has fallen back down to less than $20 a barrel. Because of the Midwest glut, U.S. oil trades at its own discount to international blends.



The erratic Canadian discount has created a crude market largely out of whack with the rest of the world.

"Historically, [the discount to international markets] has been about 20%, not 50%," says Brian Ferguson, chief executive of one of Canada's biggest oil-sands producers, Cenovus Energy Inc. CVE.T +1.79%

While the big price differential has eased since earlier in the year, the pipeline constraints have made prices volatile, causing sometimes-sharp market reaction after even small pipeline or refinery disruptions. Despite recent price relief, Alberta isn't backtracking on its pledge to slash spending. Low prices have reduced expected revenue for the province this fiscal year by C$6.2 billion.

To cope, Alberta has scaled back or abandoned a number of spending priorities at a time when its population is still growing quickly. It will also borrow heavily this year to fund current infrastructure commitments.

Energy has been an economic mainstay since the mid-1900s in Alberta, which stretches across Canada's western prairies to the Rockies. Large-scale development of Alberta's oil-sands reserves—deposits of bitumen mixed with quartz sand found mostly in its northern boreal forests—came later.

Last year, Canada produced 3.2 million barrels a day of crude, according to government statistics. The Canadian Associations of Petroleum Producers, an industry trade group, estimates that could top 5 million barrels a day in 10 years. Just over half of current output comes from oil-sands development.

Today, bitumen is extracted in a number of ways. Companies dig it out in a process more akin to strip mining than conventional drilling. They can also steam it out of the ground. The bitumen can then either be upgraded into a low-sulfur oil; or it can be diluted and shipped to market as a heavy crude.

The upgraded oil now competes directly with U.S. shale oil. Suncor Energy Inc., SU.T +0.27%Canada's biggest oil-sands producer, said last month that it and partner Total SA FP.FR +0.94%won't go ahead with a multibillion-dollar plan to build a new upgrading facility. Suncor Chief Executive Steve Williams blamed the plant's uncertain economics, caused by soaring U.S. production in North Dakota.

"We have too much light, effectively sweet, crude," he told analysts earlier this year.

There's still strong demand for Canada's heavy crude, which many U.S. Gulf Coast refiners prize. But getting it to those buyers has become extremely difficult as U.S. output increasingly fills up the pipelines and storage facilities in between. That's resulted in a market where refiners, not producers, are calling the shots.

"At the very core of it [Canadian producers] are competing to sell into refiners, and the refiners will just drop their prices," said Don Moe, vice president for supply and marketing at MEG Energy Corp., MEG.T +0.70%a Calgary-based oil-sands producer.

There's no sign yet that producers have shut down production, with many executives saying that even at today's volatile prices, operations are profitable. But a number of players, both large and small, are shopping oil-sands assets amid the uncertain economics and still-high operating and development costs.

Producers are scrambling for alternatives. MEG Energy, a smaller player, saw cash flow and operating income fall sharply in the fourth quarter of last year, largely because of the lower prices it fetched for its bitumen.

MEG realized an average of about $46 a barrel for its bitumen in the period, down from about $68 a barrel in the year-ago quarter. The U.S. benchmark, meanwhile, fetched $88 a barrel in the fourth quarter of 2012.

MEG produces its oil by essentially heating water with natural gas to make steam. It then injects the steam into the ground to soften the bitumen and get it flowing to the surface.

As MEG and other oil-sands producers ramped up production in recent years, analysts started to warn of a looming glut—maybe as soon as 2020—if new pipes weren't built out of Alberta. When U.S. output started to soar more recently, the bottleneck came early.

Immediately after Mr. Moe started at MEG early last year, he set to work to figure out how to get around it. One answer was railroads.

Last year, MEG joined forces with Canexus Corp., CUS.T +1.00%a Canadian chemicals producer with a small railroad terminal near MEG's oil-storage facilities north of Edmonton. Today, MEG sends a few trucks a day to the terminal.

They pump their haul of diluted bitumen into tanker cars in the terminal's loading yard, thick with the smell of petroleum. Each night, the cars are whisked away and connected to bigger trains headed south.

Giant earth movers and bulldozers are now leveling a site next to Canexus' yard to make way for a new, 3-mile-long circular rail track that can accommodate 118 tanker cars. When the $125-million expansion is finished later this year, the terminal will be able to ship 70,000 barrels a day, about 10 times its initial capacity.

Mr. Moe has also started looking at using barges to ship oil down America's water ways.

"You can get to literally every refinery that is in the U.S. south from the water," he says. MEG has now contracted out enough space on rail and barges to be able to ship all of its bitumen output—currently about 32,000 barrels a day—directly to refiners later this year, boosting its pricing power.

Canadian officials, meanwhile, have set off on a frenetic, two-prong plan of attack of their own: clear the bottleneck into the U.S. and open new markets for Canada's crude.

Officials have ratcheted up lobbying to win U.S. approval for the long-stalled Keystone XL project, a pipeline expansion plan by TransCanada Corp. TRP.T +0.61%that would dramatically boost Canadian export capacity to the U.S. Gulf Coast. After initially rejecting the project early last year, U.S. President Barack Obama is set to rule on it again sometime later this year.

A State Department official said the U.S. meets regularly with Canadian officials and "are aware of their views on the proposed Keystone XL pipeline project."

The line has divided Washington. The oil industry and Republicans generally support the project as a way to bolster North American energy independence and create jobs. Environmentalists and many prominent Democrats oppose it, arguing approval would increase American dependence on Canadian oil-sands crude, which is more carbon intensive to produce than many other types.

For Alberta and the federal government, the project isn't so much a political football as an economic lifeline. Alberta's Ms. Redford has traveled more than a half dozen times to Washington or Chicago in the last year to push for approval of the line, she says.

"As a North American energy economy," she says she tells U.S. counterparts, "we need to be accountable to each other."