To be sure, Canada’s energy patch isn’t without its risks. Last winter, for example, the country’s oil and gas producers suffered from depressed price realizations. As we explained in Midwest Refinery Turnarounds Widen WCS-WTI Spread, temporary pipeline outages and refinery turnarounds in the Midwest exacerbated an existing shortage of local takeaway capacity and increased competition from the upsurge in US oil production. At one point, the prices that many Canadian producers fetched for their oil volumes was as much as $50.00 per barrel less than West Texas Intermediate (WTI), which itself was about $20.00 less than Brent, a benchmark that reflects global supply and demand.
In this challenging environment, a number of upstream operators with an oil-weighted production mix suffered a collapse in cash flow. For example, these harsh realities forced Penn West Petroleum (TSX: PWT, NYSE: PWE), one of Canada’s largest oil and gas producers, to slash its dividend by almost 50 percent this year. Fortunately, these troubles have melted away with the winter snow; second-quarter earnings benefited from a rally in the prices of WTI and Western Canadian Select (WCS) crude oil.
Source: Company Reports, Bloomberg, Energy & Income Advisor
“Diminishing Differentials” tracks the improving oil-price realizations for 11 Canadian producers, which have been a boon for these companies’ earnings and dividend coverage–if not necessarily their stock prices.
Why have key North American price differentials narrowed in recent months? Increased southbound pipeline capacity from Cushing, Okla., has helped to bolster the price of WTI relative to international benchmarks, while WCS has benefited from an uptick in pipeline capacity and a dramatic upsurge in crude-by-rail volumes headed to the US.
The upstream segment also received a boost after a normal winter and increased consumption of natural-gas among electric utilities helped this commodity to recover from ultra-depressed levels to merely depressed prices. For Peyto Exploration and Development Corp (TSX: PEY, OTC: PEYUF) and other low-cost producers, the improvement in natural-gas prices has been a welcome tailwind.
In short, upstream segment’s earnings crisis of only a few months ago appears to have passed.
Risks of Rail
Although midstream energy companies eventually will construct enough pipeline capacity to handle North America’s rapidly growing oil production, this pipe dream remains several years away–especially when you consider the regulatory obstacles facing cross-border pipelines. In the interim, delivering crude-oil volumes by rail remains the best way to circumvent this challenge.
Not only does this pipeline alternative entail higher transportation costs, but, as the tragic derailment in the Quebec town of Lac-Megantic last June demonstrated, there are significant safety concerns associated shipping crude oil via railcar. In the aftermath of this tragic accident, scrutiny of the increasing volumes of crude oil traveling on Canada’s railroads has increased. However, the Canadian government continues to support any solution to deliver Western Canada’s growing oil output to market. Although restrictive regulations appear unlikely, rail operators will likely be more cautious going forward.
As for the much-needed expansion in cross-border pipeline capacity, the US government appears as far away as ever from approving the controversial northern leg of TransCanada Corp’s (NYSE: TRP) Keystone XL pipeline. The US State Dept doesn’t expect to complete its investigation of an alleged conflict of interest by one of the contractors involved in the pipeline’s environment review until January 2014. That the State Dept is giving credence to charges that would undermine its own credibility raises the risk that the Obama administration has bowed to the environmental lobby.
In this hostile environment, we expect midstream operators to focus on building pipelines that will deliver oil volumes to Canada’s coasts. For example, TransCanada’s Energy East pipeline, which enjoys the backing of Prime Minister Stephen Harper, would deliver crude oil from Alberta to East Coast refineries. Meanwhile, Enbridge’s (TSX: ENB, NYSE: ENB) proposed Northern Gateway pipeline would take oil to the Pacific Coast for export to Asia.
Rest assured: Canada’s growing oil production will find its way to market–timing and destination are the sole question. In the meantime, investors should focus on low-cost producers that have the financial wherewithal and scope to weather higher transportation costs and volatile price realizations. Although the ruinous price differentials of last winter have disappeared, these challenges could reemerge in the event of temporary midstream capacity outages.
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Elliott and Roger on Dec. 21, 2017
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