We weren’t surprised to see Cenovus step up to buy high quality heavy oil assets or strategic investors take control of Northern Blizzard given that the fundamentals driving narrower than expected Cdn heavy oil differentials in 2017 are likely to continue in 2018 and beyond. Cdn heavy oil is trapped and has no option but to sell to the US. But the US is effectively trapped and primarily relies on Canada, Mexico and Venezuela (to a smaller degree Colombia) for its heavy oil supply. And with Mexico and Venezuela continuing to be in decline, the basic supply demand fundamentals continue in a positive trend for Cdn heavy oil. Volatility and seasonality will still be here, but the positive trends mean it is less likely to see Cdn heavy oil differentials blow out for any extended period or to the same $/bbl magnitude as seen in 2014.
Its been a good start to 2017 for Cdn heavy oil differentials. We highlighted this in our Jan 16, 2017 blog “Narrowing Cdn Heavy Oil Differentials, Even Before OPEC Cuts Reduce Deliveries To US” [LINK]. By mid-Jan, Cdn heavy oil differentials had already narrowed by ~US$2.50/b to US$12.50/b. In the last two weeks, Cdn heavy oil differentials dropped below US$10/b driven, in particular, by the reported shut in of heavy oil at ConocoPhillips Surmount heavy oil that was caused by Syncrude’s shut in and a lack of synthetic oil to blend for shipping. Heavy oil needs to blended with a diluent (Syncrude’s synthetic oi is one, condensate is another) to meet pipeline specs.
April/May are always good months for Cdn heavy oil differentials. This is the normal time each year when Cdn heavy oil differentials narrow. It is when refineries tend to maximize production of asphalt ahead of the annual summer paving season. As is said in Canada, there are two seasons in Canada – winter and paving season.
Cdn heavy oil is also being helped by OPEC cuts. The US imports heavy/medium oil from Venezuela, Iraq and Saudi Arabia into the Gulf of Mexico. In the OPEC quota cuts, Saudi Arabia was to cut 486,000 b/d, Iraq 210,000 b/d, and Venezuela 95,000 b/d. Venezuela is all heavy oil so any cuts will be heavy oil cuts. Saudi Arabia and Iraq both produce light and would tend to cut heavy/medium sour preferentially to sell more higher revenue light oil barrels. The below Platts graph shows the 2016 US Gulf of Mexico oil imports by type, excluding any Cdn oil imports. We also included a table showing the country, API, H2S for all the crudes.
Source: Platts, ExxonMobil, Wikipedia, Stream Asset Financial
Looking past 2017, there is the case for continuing narrow Cdn heavy oil differentials. Despite being a trapped market for Cdn heavy oil, the positive heavy oil supply/demand fundamentals are gong to continue past 2018. US oil refineries rely on imports for heavy oil. It does not have the heavy oil resources to replace heavy oil imports. The US oil growth story has been light oil, and not heavy oil. The major sources of heavy oil imports remain Canada, Mexico and Venezuela. Refineries can’t easily change crude quality input and its major heavy oil supply sources outside of Canada are in decline – Mexico and Venezuela.
Mexico oil production is in decline leading to declining US oil imports of heavy oil from Mexico. Mexico is the primary competitor for Cdn heavy oil in the Gulf of Mexico refineries, and it is not part of OPEC. Mexico’s crude oil production peaked in 2004 at approx. 3.3 million b/d of crude oil, and has been in decline since then. By 2013, it was down to 2.52 million b/d, and in the last 4 years is now down to 2.02 million b/d in Feb 2017. Pemex’s base business plan below [LINK] forecasts declining heavy oil production in 2017, 2018, and 2019. Note the Pemex “improved case” assumes success in an “aggressive farmout” program. The lower Mexico heavy oil production has directly led to lower US heavy oil imports from Mexico. Below is the EIA’s currently US crude oil import from Mexico graph. [LINK]
Source: EIA
Mexico – Crude Oil Production As Per Pemex Business Plan (mb/d)
Source: Pemex
Venezuela oil production is in decline leading to declining US oil imports of heavy oil from Venezuela. Venezuela’s crude oil production decline hasn’t been as steep as Mexico and arguably can be turned around if western capital ever begins to flow back more aggressively into Venezuela. Venezuela’s crude oil production peaked in 2006 and since then has declined by ~0.7 million b/d as of year end 2015. We expect it will be down more in 2016. Similarly, US crude oil imports from Venezuela have also declined in the same period. Below is the EIA’s currently US crude oil import from Venezuela graph. [LINK]
Source: EIA
Canada has been the big winner from Mexico and Venezuela oil declines. As part of the big 3 suppliers of heavy oil to the US, Canada has been the big winner from the decline of Venezuela and Mexico oil production. Not all Canada exports to the US are heavy oil, but Cdn heavy oil has been the big winner. The other winner from the declining Mexico and Venezuela production is Colombia that has increased its exports to US by ~0.3 million b/d in the last 10 years. Below is the EIA’s currently US crude oil import from Canada graph. Please note the EIA has a different scale in the Canada whereas the Mexico and Venezuela graphs are on the same scale. [LINK]
Source: EIA
Cdn heavy oil differentials post 2017 should also be helped by slower Cdn heavy oil growth. Cdn heavy oil differentials will also be helped in 2018 and beyond by a slowdown in Cdn heavy oil growth related to a lack of major new bitumen projects being approved in 2015 and 2016. We expect to see lower heavy oil growth forecasts in CAPP’s upcoming annual June oil forecast. Last June, CAPP forecast heavy oil growth of 0.9 million b/d from 2016 to 2015.
Mid term wildcards should support an outlook of narrow Cdn heavy oil differentials.. There are also mid term wildcards that should help support an outlook of narrower Cdn heavy oil differentials. (i) The NEB approved Trans Mountain pipeline expansion is planned to start late 2019. The May 9 BC election could impact that if the NDP forms government. The current capacity is 300,000 b/d, and the expansion will see line 2 of 540,000 dedicated to heavy oil. Opening a sizeable second market for Cdn heavy oil should help narrow differentials. (ii) Trump ran on an energy platform that included a goal to be energy independent from importing oil from OPEC and hostile nations. Venezuela is part of OPEC. Our Nov 9, 2016 blog “Piecing Together Trump’s Oil And Gas Impact” [LINK] noted this goal and how, if this happened, it could be a huge opportunity for Cdn heavy oil. (iii) Infrastructure spending in Canada and in the US, post Trump, is expected to increase in 2018 and 2019, and any increased road work is positive to heavy oil/asphalt demand.
Cdn heavy oil differentials are narrow in 2017, likely also beyond. We recognize that Cdn heavy oil differentials will be subject to volatility since there is only one end market right now – the US. But with the positive trend of continuing decline in Mexico and Venezuela, it makes it less likely to see Cdn heavy oil differentials blow out for any extended period or to the same $/bbl magnitude as seen in 2014. Cdn heavy oil differentials should have a solid year in 2017, especially if OPEC extends its cuts. Plus as we look forward to 2018 and beyond, we see the same continuing fundamentals helping to reduce the volatility and provide an outlook for relatively narrow Cdn heavy oil differentials. Then there is the wildcard of opening up new markets for Cdn heavy oil with the Trans Mountain expansion planned for late 2019, and lastly a big wildcard if Trump makes any moves to fulfill his election promise to eliminate oil imports from OPEC.