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Unravelling the Oil Enigma
Past, Present
F irst, let me begin by insulting your
intelligence by assuming you know
nothing about the oil industry.
Now I’ve most certainly got your attention.
We are neighbours to the largest energy
consumers on the planet, and we're the
number-one supplier of crude oil and its
refined derivatives, gasoline and distillates
to that same consumer.
Of course we’re talking about our
friends in the USA.
There exists a misplaced belief that the
pricing of transportation fuels is unique to
this massive marketing island of Canada
and the USA, however, this could not be
further from the truth.
The equation that results in the ulti-
mate price to the consumer is in a constant
state of flux, and is based on certain factors
whose influence on the final price varies
almost on a daily, if not hourly, basis.
Some of the factors in the calculation
are not U.S./Canada parochial, but of a
global nature; a fact that in my experience
many people have a tough time under-
standing or believing. If we were asked to
prune down these factors today, we would
say that they are: supply and demand,
government policies, the stock markets
and geopolitics.
I’m going to begin by looking at the past,
discussing the situation today, and attempt
to look into the future.
In the past the weekly-to-long-term price
prediction was relatively straightforward.
Driving and Heating Seasons
Each Wednesday the U.S. EIA issues an
inventory report, which is a comprehen-
sive indication of the status of inventories
of both crude and all refined products on
a national and regional basis; this report
also includes refinery utilization numbers,
import/export figures for distillates and
gasoline, as well as year-over-year demand
levels for gasoline, distillates and jet fuel.
20 | The Roughneck Buy & Sell | November 2010 | www.northernstar.ab.ca
There are two seasons in the refining
calendar. The driving season, which runs
from the U.S. Memorial Day weekend and
which closely coincides with our affec-
tionately named May 2-4 weekend here
in Canada, to the Labour Day weekend,
which both countries share. During this
timeframe, gasoline inventories and
demand figures combined with crude
inventories determine the prices of each
other, while diesel prices merely slip-
stream with their increases or decreases
in prices.
The other season, of course, is the heat-
ing season, October to March, where the
opposite is true in terms of price drivers. In
this case inventory levels of distillates and
crude rule over gasoline. In both seasons,
however, we have the Mother Nature trump
card to be aware of: hurricanes from June
to November and the threat of a severe
winter from October to March.
Also during both of these seasons,
two other factors are watched, namely
demand and refinery utilization levels.
Demand figures have to be looked at with
a jaundiced eye as they compare the lat-
est four-week average with the previous
year's four-week average. As it stands
today, the gasoline demand levels may
be up, but we are comparing this year’s
recession with last year’s bigger recession
so the demand change is meaningless.
Refinery utilization is the indicator for
how close the industry is running to capac-
ity. The higher the utilization numbers, the
higher the theoretical demand, and there-
fore, the higher the short-term prices.
In keeping with an eye on the past, as
we have seen, for example, in the EIA
report in November 2009, distillate inven-
tories increased by three million barrels,
demand was level and refineries were run-
ning at 91%. Then the short-term forecast
would be for level or lower diesel prices as
well as gasoline.
If, on the other hand, there was a drop of
1 million barrels in inventory with demand
up 4% and refineries still at 91%, then our
call would be for increases in prices.
So, at this point, many ask, “Why
should we in Canada care about what
happens with all this in the United
States?” The short, if not blunt, answer
is that prices of all fuels in Canada just
aren’t made in Canada; the 49th parallel
does not exist when it comes to fuel pric-
ing. First of all, Canada is divided in half
as far as the fundamental pricing assump-
tion is concerned.
Pricing east of Thunder Bay tends to
follow the NYMEX-listed New York Harbor
futures prices while Thunder Bay and the
West tend to follow the gyrations of NYH
WTI crude prices.
This is all further complicated by the
import/export alternative available to all
Canadian refiners under NAFTA, which, in
my opinion, is strongly biased toward the
U.S., and is the key reason why transpor-
tation fuel prices in Canada are higher
than in the U.S. even though we are their
number-one source of crude oil.
In addition to crude oil, we supply them
with 192 million barrels per year of refined
products, with 121 million of those barrels
going to the U.S. Northeast.
Under NAFTA, refined products can
be exported to the U.S., but the domestic
Canadian price cannot be lower than the
landed export price in the U.S. That's my
short and sweet answer for price discrepan-
cies between Canada and our largest cus-
tomer, over and above the NAFTA proviso,
as Canadian rack prices tend to follow the
rack price changes at certain reference U.S.
rack locations.
What Exactly Is a Rack Price?
My own definition is that it’s a price deter-
mined by a committee. Under the Competi-
tion Act, these committee members are
and Future
never allowed to speak, meet or communi-
cate directly in any way.
So, riddle me this, how do the rack
prices posted by five suppliers in Montreal
and Toronto and across the country all end
up at exactly the same levels at the end of
the business day?
It’s truly amazing.
Rack prices and eventual retail prices
across the country follow these U.S. rack
markers. The next day Canadian rack price
changes were – and are – set by 3:30 p.m.
EST Monday through Thursday, but around
noon on Fridays. This is one hour after the
NYMEX close of business.
So, in the past it was relatively easy to
predict price changes over the long-term
based on supply and demand information,
a stable foreign exchange rate and low
number of price influencers; in other words,
low volatility.
The Situation Today
You won’t be surprised that there aren’t
the same options today. This is due to
a multitude of optics some of which are
overexposed, while others are dangerously
underexposed. We now have high volatility
in a melting pot of ingredients with differ-
ent boiling points.
An obvious example of hyper-volatility
was the $110 per barrel drop in the price
of crude in the five-month period of July to
December 2008. This forced the oil compa-
nies into selling gasoline and diesel in some
parts of the country at negative "crack" –
below the cost of crude.
As most of you reading this know, the
term crack refers to the spread or refining
margin. The crack being the difference
between the acquisition cost of crude and
the rack price.
With crude falling from $147 to the
$30 level, it forced investments in some
oilsands mega-projects to be placed on the
back burner due to the fact that crude did
not meet the threshold number of $60/bbl,
which for all intents and purposes appears
to a moving target; some say that $80/bbl
is the real number to justify investments in
the oilsands.
At the other end of the scale, when
crude was rising up to, and it seemed it
was going to surpass the $150 mark, those
refiners like Irving, who are buyers of crude
with no exploration or production capabili-
ties, cancelled refinery expansion plans due
to projected poor ROIs. This was based
on a high cost of inputs and low return of
outputs (gasoline and diesel cracks), to
say nothing of the long-term forecast for
declining gasoline demand.
Pricing Today – Supply
and Demand
The weekly inventory report has been
the key reference data used by traders
and analysts to set or guess the futures
numbers for crude, gasoline and distillates.
Without this data, forecasting price move-
ments would be like playing darts with a
revolving dartboard.
I find it unfortunate to the point of
annoyance that the largest supplier of
crude oil and refined products to the U.S.
cannot provide similar inventory data. One
would think that the U.S. government
would like to have these stats from its key
supply source, not to mention the fact
that Canadians would also appreciate the
figures to justify to themselves, and their
customers, the moodiness of daily and
weekly price swings.
As it stands today, the inventory data
appears to be taking a back seat to other
factors in the pricing equation, some of
them objective but some very subjective.
Current inventories of crude, gasoline
and distillates are all above the upper limit
of the five-year average. As a matter of
fact, total petroleum product stocks are the
highest on record. Demand for gasoline,
The Roughneck Buy & Sell | November 2010 | www.northernstar.ab.ca |
By Roger McKnight
Senior Petroleum Analyst
En-Pro International Inc.
diesel and jet fuel are all positive, but we
are comparing red apples to green apples.
In view of the end of the driving sea-
son, refinery runs are down to below 90%,
which is understandable when bearing in
mind high stock levels. Imports of gaso-
line and distillates have been consistent
at about 1.0 and 0.25 million barrels per
day, respectively.
So, in terms of pure supply and demand,
the roller-coaster seems to be moving in
favour of an oversupply, which should lead
to lower prices for the transportation fuel
consumers. This would certainly be true
over the short term for the balance of 2010.
Beyond that, however, there could be
problems looming from the supply side on
both sides of the border. I am referring, of
course, specifically to the refining portion
of the supply chain rather than crude oil
supply per se.
In 1981 there were 324 refineries in the
U.S. This has diminished to fewer than 140
today. All the closures in the past year have
been from independent refiners – Valero,
Sunoco, Tesoro, Western Refining and
Flying J, with no upstream crude oil rev-
enue to fall back on like Exxon, Shell and
Chevron, so they’re at the mercy of daily
movements of crude oil and the recession-
influenced demand (or lack thereof) for
gasoline and diesel.
Add in the potential greenhouse gas
emissions costs, the threatened cap and
trade legislation, the increasing inclusion
of ethanol in gasoline and the unknown
10-year forward specifications for transpor-
tation fuels, and the refining sector has said
enough is enough!
It is no wonder that there has not been
a new refinery built in the U.S. since 1976.
And, given the restrictions just mentioned,
we cannot see any chance of one being built
in the near future. Why bother if it will take
10 years and $7 billion to build a 400,000
bpd greenfield refinery? When, after those
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ten years, the emission, GHG and spec
requirements may have changed since the
initial design.
The same myriad of legislation does not
exist in China or India, two areas where
refining capacity has increased during this
recession to the point where the excess
refined product capacity has meant that
California, with the toughest fuel specs
known, now imports gasoline from China.
Needless to say, due to the less strin-
gent, or dare we say, non-stringent environ-
mental controls in China and India, where
it does not take 10 years to build a new
refinery, it does not make economic sense
to attempt to increase domestic North
American refinery capacity when you are
playing against a stacked deck that happens
to be the powerhouses behind any potential
recovery from this recession.
And so I find it disturbing that if and
when these so-called “green shoots” of a
recovery turn into something other than
tumbleweed, the U.S. will be at the mercy
of crude oil imports as well as heading
down the dangerous path of dependence of
imported gasoline.
Irving or Husky Stepping Up?
For the same reasons here in Canada, the
refining situation is not much better. The
announced closure of the 130,000 bpd
Shell refinery in Montreal leaves us with 15
facilities, excluding upgraders and asphalt
plants, and only one in Montreal, which is
Suncor’s 130,000 bpd unit.
Shell plans to turn the former refinery
into a storage terminal, but this begs the
question: Where will they get supply?
As we understand it, Irving picks
up product from Shell to service the
Montreal market and from Ultramar for
the Quebec orbit. Esso also uses Ultramar
in exchange for the same courtesy being
provided to Ultramar in the Toronto and
22 | The Roughneck Buy & Sell | November 2010 | www.northernstar.ab.ca
Southwestern Ontario markets. When
the Shell plant closes in Montreal, we can
only foresee the potential for tighter sup-
ply and higher prices.
Tighter supply options because Irving
may have to withdraw, and higher prices
due to the fact that the refining capacity
in Montreal has now been reduced from
260,000 to 130,000 bpd. If Shell’s intent is
to use the Suncor refinery as its Montreal
source then this will place the facility under
serious stress.
In 2005 Petro-Canada closed its
80,000 bpd refinery in Oakville, citing the
inability to justify an investment of close to
$300 million in order to comply with the
reduced sulphur specs required for gasoline
and diesel. To continue supply for the
Toronto market they reversed the Toronto
to Montreal pipeline to allow gasoline and
diesel to be sent to their storage terminals
in Oakville from Montreal.
So, as I see it, until such time as the
proposed $300-million pipeline linking the
Ultramar refinery in Quebec City to storage
facilities in Montreal, supply and pricing
in the Montreal, Ottawa and Kingston
marketing orbits will be tense, to say the
least, and pricing forecasts should include
this scenario as a proviso.
And add to that this ultimate cautionary
note: do not assume that the Suncor refin-
ery in Montreal is untouchable. The Suncor
buyout of Petrocan has not transformed
as smoothly as expected, with duplication
rampant throughout the new company.
Suncor was, and is, an upstream company,
more interested in the exploration and
development of the oilsands than the down-
stream, refining and marketing side of the
new business venture.
Although we must assume that a key
condition of the sale of Petrocan to Suncor
would have been the retention of the Petro-
can image of national supplier of commer-
cial and retail fuels, that perceived image
could be maintained even if the Montreal
refinery were at best, sold, and at worst,
closed. The logical buyer would be Irving
or Husky.
If Irving were to buy it then this would
allow them to stay in the Montreal, Ottawa
Kingston markets while freeing up the St.
John refinery for more exports to the U.S.
It would also give Esso the opportunity to
close the antiquated Dartmouth refinery
and set up an exchange agreement with
Irving for the southern Ontario market as
well, which would allow Irving to pick up in
Sarnia or Nanticoke in return for Esso pick-
ing up in Montreal. So everybody’s happy.
Supply problems will not be limited to
Quebec and the Maritimes. Those refineries
in the Sarnia hub may also be looking over
their shoulders, and so should consumers.
Crude supply for these refineries is Alberta-
based, mainly through the Enbridge lines
that also spur off to the key U.S. Midwest
refinery system. Over the last month or so,
two leaks, one in Michigan, the other in
Illinois, have resulted in a severe cutback in
crude supply, driving the price of crude up.
Although Enbridge has reacted with
relative lightning speed when compared to
the BP debacle, the image is still there as
are the politicians and regulatory entities
that must approve any restart.
Clear and Present Danger – the
Oilsands Image
If ever there was a clear and present danger
supply message to our largest trading part-
ner and ourselves, the current leak scenario
could not paint a clearer picture.
I am referring, of course, to the intermi-
nable discussions in the media concerning
the oilsands and its “dirty oil” image.
I’d like to ask a simple question of
the U.S. government who is an employee
of the U.S. public: If you don’t want the
oilsands crude oil then what are your
preferred alternatives?
• Venezuela? Good pick. All heavy, sour,
high-sulphur crude from a country headed
up by Hugo “Huggy Bear” Chavez,
who has in reality kicked out or national-
ized all foreign oil company projects.
• Mexico? Another good pick since that
nation’s oil company, Pemex, will not
allow foreign oil companies to assist them
in deep-sea exploration. As a result, Mex-
ico’s Gulf resources are drying up, forcing
that country now to import 460,000 bpd
of gasoline and diesel from you guessed it,
the USA!
• Then there’s Saudi Arabia: it used to be
the number-one supplier to the U.S. but
now it has slipped to #2 or #3. Although
it claims to have spare capacity, it is
somewhat secretive on the quality. The
consensus is that it is heavy and sour just
like the Canadian and Venezuelan offer-
ings. But the Saudis are gradually turning
their attention to China as a customer, as
the economic prospects seem more prom-
ising than that of the U.S.
• How about Russia? A dubious choice
given that the true leader of the largest
supplier of crude on the planet is the
former head of the KGB. Just ask how the
natural gas supply agreements went with
Belarus and Ukraine.
• What about the North Sea Brent crude?
Sorry, again, the supply, just like the
Pemex situation in the Gulf of Mexico, is
rapidly drying up.
• Then there’s Iran/Iraq: two of the key
traits required in a supplier profile are
reliability of supply and stability of the
governing powers. Sorry this doesn’t work
for these two.
• What about expanding offshore drilling on
the East Coast? The BP mess has placed a
presidential moratorium on this idea, and
even if it is approved, it will take ten years
to bring a drop of extremely expensive
crude onshore.
Given the options, I do not see where
the oilsands are a problem. Looks to me
more like a long-term solution.
Subjective Pricing Factors
The supply and demand situation is simple
when compared to the more mysterious,
subjective, non-measurable factors that
include the financial markets and geopoliti-
cal influences on potential price changes.
As it stands today, the geopolitical forces
are relatively comatose. When OPEC sees
the Western economies in full-blown
recession it is not in their best interest to
threaten cutbacks in crude oil production.
In times like these the co-operation of
the cartel members loses cohesion as crude
oil revenue becomes more important than
teamwork. By this I mean that quotas, as
announced following the regular OPEC
meetings, are rarely adhered to thus defeat-
ing the purpose of OPEC, which is basically
price fixing.
By far the most important factor in
today’s pricing theory is the involvement
of the speculators and traders in both the
financial and equity markets. The daily
movements of crude oil and its refined
derivatives have virtually no relation to
inventory levels, refinery runs or demand
levels. However misdirected, the price of
crude is following emotion and intuition
rather than fact.
Crude oil pricing has become a “wan-
nabe” equity.
If, on a given day, a government
statistic such as the nebulous Consumer
Confidence Level shows a decrease, funds
fly out of equities and into treasuries,
increasing the value of the dollar and
lowering crude prices.
The Roughneck Buy & Sell | November 2010 | www.northernstar.ab.ca |
If, on the other hand, we see an uptick
in employment levels then money goes the
other way into equities and out of treasur-
ies, thereby lowering the dollar and increas-
ing the cost of crude.
Add to this the weather forecasts in
either the hurricane or winter seasons and
forecasting short- or long-term price move-
ments becomes smoke and mirrors.
Until such time as the U.S. economy
shows solid recovery symptoms then short-,
medium- and long-term price projections
will be difficult.
The best advice we can give those laden
with the task of setting budget require-
ments would be a hybrid of the past and
present pricing methods. Watch the weekly
U.S. inventory reports, and watch for sud-
den movements in the U.S. dollar.
General rule of thumb: U.S. dollar up,
crude down, diesel down; U.S. dollar down,
crude up, diesel up.
It’s certainly a lot to keep up on for
major consumers of petroleum at times
when resources are already stretched to the
max. That’s what we do in my business –
help navigate and guide consumers through
the oil enigma because it’s not getting any
easier, it’s getting more complicated.
Contact Roger McKnight at:
rmcknight@en-pro.com and/or
1-800-686-6449.
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