Narrower than expected Cdn heavy oil differentials continue to surprise to the positive. They narrowed at the beginning of 2017 and continue to benefit, just like global heavy oil differentials, from OPEC cuts. Heavy oil differentials normally widen in June/July/Aug every year, but that has not happened this summer. We probably shouldn’t be surprised given the warning from US refiner Valero that narrower than normal heavy oil differentials are expected to continue as along as OPEC cuts stay in place. This has been a big plus for producers as they review their 2017 budgets and start to look ahead to 2018. 2017 budgets were generally set on higher WTI oil prices, higher AECO gas prices, lower Cdn $ exchange and likely flat interest rates. Cdn heavy oil differentials have been the bright spot.
US refiners see the narrower than normal heavy oil differentials continuing thru 2017 driven by OPEC cuts. One of the highlight items from our July 2, 2017 Energy Tidbits was “Valero sees tight heavy oil differentials until OPEC ends cuts”. Valero had presented on June 27 at the last pre summer US sellside energy conference. OPEC cuts tend to be heavy/medium sour first so they can maximize the volume of higher revenue light oil barrels. This theme was reinforced by Valero in its June 27 presentation. In the Q&A portion, Valero noted they are doing all they can in the short term to maximize their light oil mix for their refineries, but also noted that tighter (narrower) heavy oil differentials should continue. In the Q&A, mgmt. replied “Yeah. I think certainly, while the OPEC cuts remain intact, you will see fairly narrow quality discounts on the crude. I think we’ve probably got them as tight as they’ll go. I can certainly tell you in our systems, starting with our June operating plan, we began to maximize light sweet crude. We’re running record volumes of light sweet crude in our June operating plan, and so it tells us that the pricing got in about as narrow as it could. And we actually started shoving some of the heavy barrels and some of the medium sour barrels back to the market. So, I think you’ll see a little bit improvement in the quality differentials as we move forward, but you won’t have significant increase until the OPEC cuts wind down, which I’m not exactly sure when that will occur. What we read in the marketplace is probably the end of the first quarter of next year. I think when that happens, then, you’ll have to start seeing the medium sours fight for market share with some of the shale producers, and you’ll see the discounts begin to widen at that point.”
Narrower heavy oil differentials continue to be the good news story in 2017 for Cdn producers. We have highlighted our positive view for heavy oil differentials in 2017 in several blogs and the heavy oil differentials being narrower than expected have been the good news story in 2017 for Cdn producers. Our Jan 16, 2017 blog “Narrowing Cdn Heavy Oil Differentials, Even Before OPEC Cuts Reduce Deliveries To US” [LINK] noted how Cdn heavy oil differentials quickly narrowed by mid Jan to ~US$12.50/b. Our April 11, 2017 blog “Cdn Heavy Oil Differentials Are Narrow In 2017, Likely Also Beyond” [LINK] noted the normal March/April tightening of Cdn heavy oil differentials but that the fundamentals (OPEC cuts, Mexico/Venezuela declines) were setting up the likelihood for narrower than expected Cdn heavy oil differentials into 2018. So far so good, narrower Cdn heavy oil differentials have continued through the summer. The below graph shows how the WTI less WCS differential has basically stayed between $9.15/b and $10.15/b in July and is currently $9.85/b.
WTI Less WCS Differential (US$/b)
Source: Bloomberg, Stream Asset Financial
Plus, thanks to OPEC, Cdn heavy oil differentials are narrow, and not widening as normally happens every summer. The above graph shows how March/April/May are normally good months for Cdn heavy oil differentials. That 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. But what is different in 2017 is that heavy oil differentials have stayed narrow in June/July, when they normally seasonally widen thru Q3. This is the Valero point, OPEC cuts have helped to make the differentials stay narrow for longer than normal.
Its not just Cdn heavy oil, its global heavy oil differentials that are winning. Narrower than expected heavy oil differentials is not just a Cdn heavy oil differential win. Heavy oil prices around the world have been winning with narrower differentials due to the OPEC cuts. This has been one of the regular oil market headlines in 2017. The below graph shows the differential between Tapis (Singapore benchmark, API 43-45, sulphur 0.04%) and Saudi Arab Heavy (API 27.4, sulphur 2.8%).
Tapis Less Arab Heavy (US$/b)
Source: Bloomberg, Stream Asset Financial
No negatives on Cdn heavy oil from Trump’s objecives for NAFTA renegotiations. This week, the Trump administration published their NAFTA objectives [LINK]. The US objectives on oil trade was to “preserve” and It shouldn’t have surprised anyone that the US didn’t want anything more from Canada on their oil imports. The US knows their US Midwest refineries can’t operate without Cdn heavy oil.
Looking past 2017, there is the continuing case for narrower than expected Cdn heavy oil differentials. We are well aware that Cdn heavy oil is trapped with only one export market – the US. But we always remind that the US is also trapped and needs Cdn heavy oil, especially with the production declines in its two other major heavy oil sources – Venezuela and Mexico. The US Midwest (PADD II) gets 98% of its crude oil imports from Canada and this is the major heavy oil market for Canada. So the Midwest is a captive market for Canada as lack of needed pipeline infrastructure effectives prevents foreign heavy oil from replacing Canada heavy oil in PADD II. Our prior blogs have provided the data showing how Venezuela and Mexico’s production decline has been a big boost to Canada heavy oil exports to the US, which provides the fundamental support for relatively narrower Cdn heavy oil differentials in 2017 and 2018. We may worry that, at a minimum, Trans Mountain expansion is delayed, but a Trans Mountain expansion in late 2019 would be a big plus for Cdn heavy by opening up new markets for Cdn heavy oil.