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For The Western Canadian Select Differential, Rail Reigns

The ripple effects caused by ongoing challenges to pending pipeline expansion projects continue to reverberate through the Canadian oil and gas industry. As the completion dates for Enbridge Inc.'s Line 3 Replacement, the TransMountain Expansion, and TC Energy's Keystone XL are not expected before 2022, S&P Global Ratings expects the Western Canadian Select (WCS) differential will remain elevated during its 2020-2022 forecast period, at US$20 per barrel. In contrast, the International Maritime Organization's (IMO) requirement for reduced sulfur in marine fuel, which went into effect on Jan. 1, 2020, has had no collateral effect on the WCS differential. Despite the Canadian energy industry's heavy oil-dominant crude oil product mix, Canada's limited participation in the residual and bunker fuel markets effectively insulates Canadian crude oil prices from any adverse price effects of the IMO 2020 regulation.

Egress Capacity Still Influences The WCS Differential

Protracted delays in the completion of three proposed pipelines, expected to add about 1.8 million barrels per day of takeaway capacity from western Canada, have contributed to heightened heavy oil price volatility, stalling resource development and production growth. Canada's long-term crude oil production growth hinges on transportation capacity expanding in tandem with growing crude oil production. Canadian producers have responded to the continued obstacles to pipeline development in both Canada and the U.S. by suspending growth projects and largely focusing capital spending on sustaining existing operations. In 2018, Canadian crude oil production totaled 4.59 million barrels per day, with 3.1 million barrels per day (78% heavy oil and 22% light oil) exported by pipeline, and an additional 230,000 barrels per day exported by rail. As total pipeline export capacity remains below total crude oil production, the use of rail transportation is likely to keep increasing. The consensus estimate of crude oil volumes moving by rail is projected at 400,000-500,000 barrels per day in 2020.

Increasing use of rail transportation is fueling some production growth in Alberta, as producers are granted exemptions from the Alberta government's mandated production curtailment for crude oil volumes transported by rail. The increasing use of rail transportation to move crude oil out of Alberta has spurred some production growth in the province, with Alberta's daily average crude oil production reaching 3.74 million barrels per day in December 2019, an increase of 162,000 barrels per day from November 2019 production levels.

Although the Canadian Association of Petroleum Producers (CAPP) has reduced its long-term crude oil forecasts, it is projecting Canadian crude oil production will rise to 4.94 million barrels per day in 2020 (a 7.6% increase from 2018 production). As CAPP expects ongoing growth, projecting Canada's total crude oil production should increase to 5.49 million barrels per day by 2025, additional takeaway capacity remains vital to support this.

Pending Canadian Pipeline Projects
Capacity (Mb/d) Previous expected completion date Current expected completion date
Enbridge Line 3 Replacement 370 2019 2022*
TMX 590 2020 2022
Keystone XL 830 2021 2022-2023
*Market consensus estimate.

With none of the three proposed pipeline projects expected to be in service before 2022, S&P Global Ratings believes the WCS differential will remained linked to the marginal cost of rail transportation from western Canada to the U.S. Gulf Coast. The high proportion of heavy oil in Canada's crude oil product mix makes the U.S. Gulf Coast the ideal market for Canada's heavy oil exports, given the large deep conversion refining capacity in this region.

Are Canadian Oil Producers Vulnerable Under IMO 2020?

Prior to the implementation of the IMO's Jan. 1, 2020 requirement for reduced sulfur content in marine fuel, there was significant speculation that IMO 2020's effect on bunker fuel pricing (bunker fuel is the generic term given to any fuel used in marine shipping) would extend to the WCS differential.

Heavy fuel oil (HFO) is the most widely used marine fuel. Virtually all medium- and low-speed marine diesel engines are designed for HFO. Bunker fuel oil, a subset of residual fuel oil, is one of the lowest-value petroleum products from a refinery. In addition to being the primary fuel used on ocean-going ships, residual fuel oil is also used in simple furnaces such as power plants and industrial boilers.

Chart 1

image

In 2018, total global residual fuel oil demand was about 7 million barrels per day, with bunker fuel oil demand accounting for about 3.5 million barrels per day (or half of total residual fuel oil demand). Relative to 2018 global residual fuel demand, North America accounted for about 9.6% of global production of residual fuel oil, or about 673,000 barrels per day (see chart 1).

North America's limited exposure to the residual and bunker fuel markets is directly linked to the relatively high deep conversion capability of the continent's refineries. The U.S. and Canada are among the least exposed to the high sulfur fuel oil (HSFO) market, with residual fuel oil representing a small portion (about 2%) of total refined product demand. In 2018, U.S. production totaled 425,000 barrels per day, with approximately 80% of total U.S. residual fuel demand used as marine bunker fuel (about 340,000 barrels per day). Canada has historically produced only about 2% of global residual fuel oil, estimated at about 94,000 barrels per day in 2018, with HFO accounting for about 60% (or 3% of total petroleum products), whereby the country's total HFO production is about 57,000 barrels per day.

North America's relatively low exposure to residual fuel is due to the deep conversion ability of a significant portion of U.S. and Canadian refining capacity. The U.S. and Canada, with coking and hydrocracking at 20% and 9%, respectively, of crude distillation unit (CDU) capacity have very low residual yield, so they are not major suppliers in the residual markets. In addition, U.S. diesel desulfurization and residual desulfurization capacity is among the highest in the world at approximately 40% of CDU capacity (Canada's is 23%).

In contrast, countries with lower coking and hydrocracking capacity will produce more bottom-of-the-barrel products (see chart 2). Historically, the Middle East has produced about 18% of global residual fuel. Given no de-sulfurization capacity there, a high percentage of the output is geared toward the bunker market. Russia has historically had the highest exposure to the residual fuel market, producing almost 1.5 million barrels per day in 2014, which was approximately 16% of global production of residual fuel oil. With de-sulfurization just over 5% of CDU capacity, almost all of this residual fuel oil production is bunker fuel.

Chart 2

image

With high sulfur bitumen accounting for the majority of Canada's crude oil production, market watchers widely speculated that IMO 2020's implementation would put additional pressure on Canadian heavy oil pricing, and contribute to wider WCS differentials. This anticipated negative price response has not been evident in WCS differential trends since Jan. 1, 2020 (see chart 3). Given Canada's negligible participation in the residual fuel market, we believe that IMO 2020 should not contribute to WCS volatility in 2020 and beyond.

S&P Global Ratings' WCS Differential Assumptions Are Unchanged

With current and projected Canadian crude oil production expected to remain above export pipeline capacity during our 2020-2022 forecast period, we believe the cost of rail transportation will continue to influence the WCS differential. As Alberta accounts for the majority of Canada's crude oil production, with its product mix skewed toward heavy oil, its production levels relative to available transportation and storage levels are the key factor underpinning the WCS differential. The Alberta government's 2019 unprecedented production curtailment policy reduced the deep heavy oil price discounts that began in 2018. As the province works to maintain crude oil production within the limits of available transportation and storage levels, with incremental rail transportation capacity serving as a swing factor, we believe rail transportation costs will continue to determine the WCS differential. As a result, S&P Global Ratings is maintaining its WCS differential assumption at US$20 per barrel for 2020, 2021, and 2022.

Chart 3

image

This report does not constitute a rating action.

Primary Credit Analyst:Michelle S Dathorne, Toronto (1) 416-507-2563;
michelle.dathorne@spglobal.com
Research Assistants:Laura Collins, Toronto
Andrea Sigurdson, Toronto

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