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How much for that heavy oil?

How much for that heavy oil?

Western Canadian Select made headlines in early December when prices hit the low US$20s a barrel, a full $15 lower than the US benchmark crude West Texas Intermediate. Of course, this isn't new information. Anyone that watches the six o'clock news is painfully aware that Canada sells almost 2.5 million bbl/day of heavy oil to the US at bargain basement prices.

But there's a lot of confusion over how crude oil streams are priced. Politicians would have you believe Canada's oil is cheap because it's a low grade, "raw" material. Perhaps we would be better served if every last drop of heavy oil were upgraded into light synthetic crude. Or maybe it's because we don't have a diversity of customers and lack access to tidewater. Whatever the reason, there's no doubt we need to do more to close that gap.

Here's a look at some common misconceptions surrounding Alberta's heavy oil and how it's priced.

MYTH #1:

Heavy diluted bitumen produced in Alberta is a "raw" material, but upgraded crude oil is a "value-added" final product.

By definition, crude oil is raw, unprocessed and unrefined. That includes all types of crude, regardless of whether the oil is heavy, medium or light. Upgrading a heavy crude into a lighter crude changes its classification and makes it less sour, but doesn't make it a final product. Only refineries produce final products, like gasoline, diesel and jet-fuel.

There are over 300 different streams of crude oil produced all over the world. Crudes are classified according to specific gravity (measured on the API scale) and impurity content, particularly sulfur. The two ends of the spectrum are as follows:

  • Light Sweet Crude: less viscous and less dense, with a higher fraction of simple hydrocarbon molecules; light sweet crudes have a high API reading and low sulfur content (less than 0.5%),
  • Heavy Sour Crude: more viscous and dense, containing a higher fraction of long-chain, complex hydrocarbons; heavy sour crudes have a low API reading and a high sulfur content.

Here's a look at some of the different crude oil streams processed through US refineries, classified by API density:

 
 

The US benchmark crude is West Texas Intermediate (WTI). WTI is very light and low in sulfur (sweet), and is actually lighter and sweeter than the international benchmark, North Sea Brent

Canada produces a wide variety of crude oils, but much of the growth in recent years has been heavy sour crude from the oil sands. Bitumen from the Athabasca region is very heavy and high in sulphur, comparable in quality to Venezuelan Boscan crude. About 50% of Alberta's bitumen is upgraded into synthetic sweet crude oil (ultra-low in sulphur and similar to Brent in quality). The remaining 50% is blended and sold to market (primarily the US) as heavy sour crude streams. 

MYTH #2:

Refineries prefer light sweet crude over heavy sour crude because processing lighter crude oil earns them more money.

That might have been true twenty years ago, but is no longer the case today, certainly not in North America. It sounds counter-intuitive but US refineries actually make more money by processing heavy sour crude.

Yes, you read that correctly. Refineries actually make more money processing heavy sour crude than the higher quality light, sweet stuff. But how, you ask?

Refineries profit by taking relatively inexpensive crude oil and making value-added consumer products, like diesel, gasoline, jet fuel and heating oil. The money is made on the "crack spread" - the difference between the input cost of the crude feedstock and the selling price for each final product.

The big money is made on the production of ultra-low sulfur diesel, gasoline and jet fuel. Everyone knows that the bottom of the barrel (like low-grade bunker fuel, paraffin wax and asphalt for paving roads) doesn't earn the refinery much revenue. But surprisingly, neither do the very light-ends. The very light end of the barrel, like propane and butane, has a limited market in the US and way too much supply. So light ends also don't earn the refinery a lot of money.

That's why light, sweet shale oil produced from the Eagle Ford, Bakken and Permian basins aren't desirable feedstock for US refineries. Although they are technically "higher grades" of crude, they don't maximize the production of good stuff (diesel and gasoline) and produce too much of the very light stuff, which nobody wants.

Outside of the US, the world's oil supply is becoming increasingly heavy and sour while transportation fuels are becoming increasingly light, high-quality and ultra-low in sulfur. So how have refineries responded? They've added expensive secondary upgrading units such as catalytic crackers, hydrocrackers and fluid cokers. These units crack and coke the heavy crude "bottoms" into high-value products, removing all traces of sulfur to produce expensive low-sulfur gasoline and diesel that meet the tightest environmental standards. These highly complex facilities are known as "high-conversion" refineries and are specifically designed to process heavy sour feedstock. 

 
 

But what about those low-value light-ends? The lower-value light-ends can't easily be converted into heavier consumer fuels (not without adding more pots and pans, such as distillation towers, conversion units and furnaces). Highly complex refineries do have the ability to process greater volumes of lighter crudes, but they would actually get a lower yield and make less money.

  CANADIAN REFINERIES AT A GLANCE:
  • In Western Canada and Ontario, about 75% of the crude oil processed by refiners is medium to light, sweet crude; the remaining 25% is heavy sour.
  • Refineries in Atlantic Canada and Quebec rely on imported crudes and have the flexibility of processing a more diverse feedstock. They currently process about 1/3 light sweet crude and 2/3 is medium to very heavy crude, with a medium-to-high sulfur content.

Over the past 10 years, refineries in the Gulf Coast and US Midwest have been modified from simple into high-conversion facilities. US refineries are actually some of the most complex in the world. The newest mega-refineries being built in Asia and the Middle-East are also highly complex, designed specifically for the export of refined products. That gives them the flexibility to take the heaviest sour crude oil streams available and convert them into whatever the customer wants. Since older, simpler refineries are being shutdown, complex refineries now represent the vast majority of the world’s refining capacity. And each one of those refineries is designed for heavy sour crude.

MYTH #3:

Alberta's heavy oil sells at a discount because there's too much heavy oil in the world and not enough demand.

Nothing could be further from the truth. Demand for heavy oil in the US and around the world, has never been higher. In fact, since the shale oil boom began in 2008, US imports of light oil have dwindled to almost zero. 

 
 
MYTH #4:

The selling price of any crude oil stream is purely a function of quality. Western Canadian Select sells at a discount to West Texas Intermediate because it's heavy and sour.

You would think that lighter, sweeter crudes fetch a higher selling price versus a heavier sour feedstock. That would make sense because light sweet crude oil requires less energy to refine. Sounds perfectly intuitive. But it ain't true.

Here's a snapshot of the average selling price for several types of crudes purchased by US refineries during the month of September, plotted as a function of API gravity and sulfur content:

 
 

Four take-aways from the above plot:

  • The heaviest crude produced in the US (Kern River blend from California) sells at almost the same price as WTI, despite being very heavy and sour. Kern River crude is actually much heavier than WCS. 
  • The least expensive crudes were WCS and Bow River, sold at $30/bbl. Both are heavy sour blends from Alberta.
  • The most expensive crude was actually Basrah Light, a sour crude from Iraq.
  • Maya crude from Mexico, which is almost identical in quality to Canadian heavy crude, sells at a $10 premium to WCS. In fact, Mexico's "Heavy Oil Discount" to WTI is only $3/bbl.

And that actually makes perfect sense. US refineries are complex and have the flexibility of taking in almost any type of crude oil, so quality shouldn't have a huge impact on price. 

So if quality doesn't affect the price, what does? It's the cost of transportation, best summed up in the following graphic:

 
 

Shipping crude oil from Mexico or the Middle-East to the US by tanker is only a few dollars a barrel. Shipping oil from Alberta to the Gulf Coast by rail or pipeline ranges from $10 to $20/bbl. Guess who eats that transport cost? It's the oil producer, not the refinery. That's because the refinery located in Houston or Philadelphia has over 350 types of crude streams to choose from, and they'll always pick the cheaper one. And that means Canadian heavy oil producers need to sell their oil at a discount in order to be competitively priced with oil coming from Mexico or Iraq.

SEPT AVERAGE SELLING PRICE, USD/bbl:
→ Canadian Heavy Sour: $30.40
→ Western Canadian Select: $31.85
→ Canadian Light Sour: $41.10
→ OPEC Basket: $44.80
→ West Texas Intermediate: $45.50
→ Brent Crude: $48.65
SOURCE: NATIONAL ENERGY BOARD OF CANADA, US ENERGY INFORMATION AGENCY, OPEC

So what's the message here? Shipping crude by tanker is by far the cheapest method of transportation. About 60 million barrels of crude oil is safely and reliability shipped every day into harbours around the world. And pipelines can be cheap too, provided they aren't constrained. Shipping oil by rail, which may have made sense at $100 oil, is inefficient and expensive. And that's what drives up Alberta's heavy oil discount.

MYTH #5:

Canada should upgrade 100% of its heavy sour oil into light sweet crude in order to get a better price on world markets.

Actually, Canada should figure out who their customer is and what the customer wants. If the customer is the US (which makes perfect sense since they are the world's largest oil consumer and located just next door), then producing 100% light sweet oil would be a mistake.

Plotted below is the average US refinery feedstock purchase price by API gravity over the past 10 years:

 
 

Prior to the last decade, US refiners did in fact pay more for lighter oil. But now that these same refineries have been retrofitted to take in heavy sour feed, that light oil premium has disappeared. Post 2011, refiners actually pay the most for crude streams with an API density of 20° to 25° (heavy to medium crudes). And that's exactly the kind of oil produced by the Alberta oil sands. 

Note that these numbers include the cost of transport, whatever that method of transport may be. Although Alberta sells its heavy oil at a low price, it has a high cost of transport, so the US refineries are actually paying more to get Canadian heavy crude delivered to their door. Surprised? We thought you'd be.

MYTH #6:

US refineries profit the most from cheap Canadian heavy oil. Alberta's heavy oil is cheap because we lack port access and only have one customer.

Not exactly. Pipeline bottlenecks and lack of port access in Canada drive up the transport costs, since Canadian and US producers are competing for space on pipelines that are already full and resorting to the insanity that is crude-by-rail. But remember, refiners need to factor in the cost of transport. So the refinery in the Gulf Coast doesn't profit. But the refinery in Vancouver does, because his cost of transport is much cheaper.

Who profits from infrastructure bottlenecks? It's the rail companies and pipeline operators. If getting Alberta's oil to its customer was cheaper (i.e., more pipeline capacity and better port access), then the price discount they would have to offer to the refinery would be much less. Better infrastructure would drop the cost of transport and hugely benefits the oil producer.

THE 30 SECOND TAKE-AWAY:
  • Complex high-conversion refineries can make more money from heavy sour crude than light sweet crude since they can crack the heavy bottoms into the good stuff (diesel and gasoline).
  • The world's refineries are becoming increasingly complex, particularly in the US and Asia. These complex facilities are specifically designed for a heavier feedstock. That drives up demand for heavy sour crude, just like the oil produced in Alberta.
  • The exploding supply of light shale oil and declining output of heavy oil from Mexico and Venezuela means US refineries are becoming increasingly more reliant on Canadian heavy oil and have no need to import light oil from anywhere.
  • Canadian heavy oil sells at a discount to other heavy crudes because of the high cost of delivering Alberta's heavy oil to the big US refining hubs. Therefore, the best way to increase the price of Alberta's heavy oil is to build more pipeline capacity, particularly to the US Gulf Coast (enter Keystone XL) and reduce reliance on rail transport, which is expensive and inefficient. That would reduce the cost of transport to our biggest customer and narrow the dreaded Canadian Heavy Oil Discount.

SOURCES:
American Petroleum Institute | Understanding Crude Oil and Product Markets
Canadian Fuels Association | The Economics of Petroleum Refining
CAPP | 2015 Crude Oil Forecast, Markets and Transportation
KBR | In Favour of Hydrogen Addition

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