The Globe and Mail
In Texas, oil sands firms fight for their share
Pipeline extension to Gulf Coast refineries is key for Canadian producers
Shawn McCarthy
Port Arthur, Tex. — Globe and Mail Update Saturday, Nov. 07, 2009
There is an air of disquiet along the Gulf Coast of the United States, an industrial strip that could have a profound influence on the future of Canada’s oil-fuelled economy.
The refineries that dot the coast represent a major new market that could fuel the expansion of Canada’s oil sands
producers, as well as a major pipeline player. And indeed, on the surface, growth appears to be the order of the day. But after a brief golden age, there is a growing fear along refiners’ alley that the bubble has burst.
In the muddy fields adjacent to Motiva Enterprises LLC’s sprawling Port Arthur refinery, teams of contractors toil on stainless steel vessels and refining modules that resemble so many giant Lego pieces, all waiting for assembly in a $7-billion (U.S.) expansion of the plant.
Motiva – a joint venture between Royal Dutch Shell PLC and state-owned Saudi Aramco – is doubling its refining capacity to 600,000 barrels a day. The site will also add a coker so it can process the heavy grades of crude, such as bitumen from Canada’s oil sands, that make up a growing share of the world’s oil supply.
Because the U.S. is the only export market for Canadian crude, expanded U.S. refineries like Motiva’s are key to Alberta’s ambitions to double, or even triple, oil sands production over the next decade.
But here’s the catch. The Motiva refinery is proceeding only because the company, after weighing discouraging trends in the market, decided not to kill it.
“In general, the outlook for total refining capacity in the U.S. is downward pressure,” says Motiva’s chief executive officer, Robert Pease.
“As new capacity like ours comes on stream, there will be even greater pressure on others to close down eventually.”
The U.S. petroleum market is facing what one analysis has called a “tsunami of change.” The industry faces the unhappy combination of depressed demand, growing competition from foreign refiners and a sector-wide rationalization that will force refinery closings.
Moreover, looming regulatory changes requiring reductions in greenhouse gas emissions will drive up refiners’ costs, particularly for the energy-intensive, emissions-heavy processing of heavy crudes.
“We’re facing a lot of challenges,” Tom Botts, a senior refining executive from Shell, told a decidedly downbeat industry conference in Houston last week. “And not all of us are going to survive the coming shakeout.”
From the Canadian perspective, all this adds up to a less-than-sunny forecast. The hopes of oil sands producers such as EnCana Corp. and Shell ride on getting a larger slice of a shrinking pie – and those hopes are hobbled by the high environmental cost of oil sands crude. The producers will face downward pressure on bitumen prices as refiners look to pass added regulatory costs to their suppliers.
What’s more, Canadian producers face an array of other countries, from Brazil to Saudi Arabia, that are keen to export to the Gulf Coast, joining traditional suppliers such as Mexico and Venezuela.
Taken together, the U.S. demand and supply challenges raise questions about whether investment in the oil sands will ever reach the peaks that enthusiasts in the sector have imagined.
The refiners’ dilemma
The Port Arthur complex, located 140 kilometres east of Houston on the Intracoastal Waterway, is one of the oldest refineries in the United States, dating back to the founding of the Texas oil industry.
It was built to handle oil from the famed 1901 Spindletop gusher in nearby Beaumont, and has long been one of the workhorses of the Gulf Coast region, which boasts the world’s largest concentration of refineries, accounting for nearly half of U.S. production.
Over the years, its successive owners have invested heavily in new technology – investments to reduce operating costs, keep up with the expanding market, or to meet environmental requirements such as the elimination of sulphur from gasoline and diesel.
When Shell and Aramco approved the current expansion three years ago, North American refiners were earning fat profits and were looking to expand capacity to meet booming demand.
At the time, refining bottlenecks were a hallmark of the industry. Every time a plant went down or a hurricane threatened the Gulf Coast, gasoline prices and refining profits soared.
But record-high oil prices in 2008 and the ensuing recession bludgeoned demand for petroleum products. Profits evaporated, and many refiners responded this year by shelving expansion plans or even shutting down operating units.
Last March, Motiva management sat down with its Shell and Aramco shareholders to re-evaluate whether it made sense to plow $7-billion (U.S.) into a project that would refine an additional 320,000 barrels a day of crude oil.
The decision: Proceed, but at a slower pace, pushing back the startup date by two years in order to shave costs and give the market some time to recover.
The cancellation of the Motiva project would have dealt a major blow to Canadian plans.
Currently, virtually all Canadian exports go to refineries in the Midwest, whether as bitumen or upgraded synthetic crude. Some exports do make their way to the East Coast, but only small amounts are exported to the Texas-Louisiana refining hub and to the West Coast.
In order to expand production in Canada, oil companies need to either add domestic upgrading capacity – which is tremendously expensive and raises emissions concerns – or count on American refiners increasing their ability to process the raw bitumen.
As of two years ago, companies like Motiva, Valero Energy Corp., Marathon Oil Co. and ConocoPhillips Co. had all announced plans to add cokers both along the Gulf Coast and in the Midwest to process bitumen. Some have proceeded, but many projects have either been delayed or slowed down, like Motiva’s, or shelved.
The pipeline factor
The unfolding fate of the southern refinery sector is being watched closely not only by oil sands producers but also by Canada’s big pipeline companies, which are likewise banking on growth. TransCanada Corp. and Enbridge Inc. have announced a series of expansions of their network, both adding volumes into traditional Midwest markets and extending pipelines deeper into the U.S.
TransCanada is seeking approval from state regulators in the U.S. and Canada’s National Energy Board to build a pipeline extension, dubbed Keystone XL, to deliver 500,000 barrels a day of bitumen to Gulf Coast refiners.
Backing TransCanada’s plan are some of the biggest producers in the oil sands, including Shell, EnCana, ConocoPhillips and Canadian Natural Resources Ltd. TransCanada’s competitor, Enbridge, has opposed Keystone XL, saying that, for at least several years, there won’t be enough production from the oil sands to keep all the new pipeline capacity full.
In seeking to reassure the NEB and the industry that Keystone XL makes sense, TransCanada paints a glowing picture of the appetite among Gulf Coast refiners for oil sands product. The company also pointed to the prospect of Canada making up for lower imports from Mexico and Venezuela, two of the biggest suppliers of heavy oil to the Gulf Coast.
Area refiners now import about six million barrels a day of crude, including two million barrels of Mexican and Venezuelan heavy. With little pipeline access, Canada exports a mere 100,000 barrels to the region.
Production at Mexico’s largest field, Canterell, is dropping rapidly, while Venezuela is not investing in expanding production and, as a result of the predilections of president Hugo Chavez, is looking to shift exports away from the U.S.
Meanwhile, TransCanada argues that oil sands producers could easily move an additional 500,000 barrels a day to the Gulf Coast once Keystone XL is in place.
“There are tremendous opportunities for Canadian crude to access a new market,” says Paul Miller, a vice-president at TransCanada. “You have significant reserves up in the Alberta oil sands, and to the extent you need crude oil for your refinery, you look to the closest, most available and less risky supply.”
The competitors
Canadian producers have long pursued a “market share” strategy in the U.S. The idea is that driving deeper into the heart of the continent can reap new revenue even if the overall market is not growing.
EnCana is a joint venture partner with ConocoPhillips on two U.S. refineries, and is in the midst of $3.6-billion expansion of its coking capacity at Wood River, Ill.
EnCana spokesman Alan Boras says the Keystone project represents a continuation of the southern campaign.
“Canadians have been very successful at pushing their volumes south and competing on a cost basis,” Mr. Boras says. “And the challenge will be to continually have low-cost supplies – or costs competitive with those supplies that are coming in from offshore.”
But there are limits to a strategy predicated on taking a greater share of a stagnant market, says economist Peter Tertzakian of Calgary-based ARC Financial Corp.
“They can count on it to a point, but they need to be very cautious,” Mr. Tertzakian says. “The challenge is going to arise when the potential for displacement stops – in other words, when Venezuela’s and Mexico’s production levels out or even start to rise again.”
Motiva’s Mr. Pease says the Gulf Coast is the “logical” market for Canadian crude. But he also acknowledges that, as a buyer of crude, he has a vested interested in seeing as much supply in the market as possible, to drive down prices.
And there will be plenty of competition from other producers as Canada looks to increase its share of the market. In fact, Motiva configured its Port Arthur expansion specifically to process growing volumes of heavy oil from Saudi Arabia and Brazil.
At the moment, the Saudis have shut down much of their heavy oil production as part of the effort by the Organization of Petroleum Exporting Countries to defend prices in a weakened global economy.
But as the recovery takes hold, the kingdom will ratchet up production of its heavy crude, with the Gulf Coast and growing Asian markets vying as key export destinations.
In keeping with Washington’s rhetoric about America’s unhealthy addiction to Middle East oil, Canadian suppliers like to tout the oil sands as a secure source for U.S. customers.
But Mr. Pease plays down those political considerations, saying commercial factors will determine where Motiva buys its crude. “We have no better supplier than Saudi Arabia,” he says regarding his shareholder. “Their ability to hit what they say they’re going to hit, deliver when they say they’re going to deliver, is unmatched.”
Meanwhile, Brazil’s state-controlled Petrobras SA is planning to increase production by two million barrels a day by 2020 as it develops its offshore discoveries. While much of that production is targeted for domestic refineries, some will also be shipped to the U.S.
As well, analysts say it would be a mistake to count out Mexico and Venezuela. While both countries face supply challenges, the Gulf Coast market is simply too important for them to abandon without a fight.
A ‘tsunami of change’
Despite all the unfavourable portents, Canadian producers believe two trends favour their expansion plans in the U.S.: Rising demand in emerging markets will draw off imports from traditional American suppliers, and the global industry will find it difficult to increase the overall supply base.
In fact, those two factors help explain why crude prices rebounded smartly from their recessionary lows hit earlier this year.
But oil sands producers face risks as their U.S. refining customers cope with weak petroleum demand and the environmental costs that could drive down the value of the heavy crudes.
A recent report from Deloitte & Touche’s energy practice warned of a “tsunami of change [that is] bearing down on the refining industry.”
“What had been a profitable industry running at respectable operating rates will see higher costs, steadily declining demand and excess capacity,” Deloitte partner Roger Ihne says.
U.S. demand for gasoline may well have peaked in 2005. While overall consumptions of products like gasoline, diesel and jet fuel should recover from recessionary lows, the U.S. Energy Information Administration (EIA) forecasts virtually no growth between now and 2020.
American motorists are expected to cut their gasoline consumption by 8 per cent between 2006 and 2018, and by 13 per cent by 2030, the agency forecasts.
Combine that lower demand with rising production from offshore drilling in the American area of the Gulf of Mexico, and the EIA foresees a sharp drop in U.S. crude imports. From the peak of imports in 2006, the agency says demand for foreign crude will fall by more than two million barrels a day by 2018, and by an additional one million barrels a day by 2030.
Even now, as a result of weak demand and facility expansions of the past few years, U.S. refiners are running at about 82 per cent of capacity. The number is projected to drop further in the next decade after being above 90 per cent for much of the previous one.
As a result, the industry expects a rationalization that could reduce its demand for crude by 1.5 million barrels a day from the current 17.5 million barrels. And the less-competitive, higher-cost refineries will close, Mr. Ihne predicts.
The profit squeeze has already bit refiners in Canada. Earlier this year, Irving Oil Ltd. cancelled its planned expansion in Saint John, N.B., while Shell announced it is considering the closing of its Montreal East refinery, which processes 130,000 barrels a day of imported crude.
The forecast decline in demand suggests the industry is on the wrong side of a number of demographic and public-policy trends.
Higher pump prices will likely encourage consumers to switch to smaller vehicles, according to the EIA. An aging population will also drive less.
A cap-and-trade killer?
Meanwhile, federal regulations in both the U.S. and Canada will force greater fuel efficiency and more use of biofuels.
And looming on the horizon is the refiners’ greatest fear: cap-and-trade regulations that would increase the costs of refining by forcing companies to pay for every tonne of carbon dioxide they emit. The regulations would drive up fuel costs, further dampening demand.
The U.S. House of Representatives has passed cap-and-trade legislation and a similar bill is now being debated in the Senate. But even if the bill fails to pass, the Environmental Protection Agency has vowed to regulate emissions.
Mr. Ihne calculates that refiners could see $8 per barrel added to their costs, a burden that would virtually wipe out their current profit margins.
The Canadian industry is particularly vulnerable because the refining process for oil sands bitumen is so energy-intensive, producing more emissions per barrel than light or medium-grade crudes.
Motiva’s Mr. Pease says his company has included as many energy-saving and emission-reducing technologies as possible in the Port Arthur expansion. He acknowledges, however, that refining heavier-grade crudes, like Canadian bitumen, would be more costly under the expected regulations.
“The emissions costs will go into what we are willing to pay,” he says. “You would expect emission limitations to put downward pressure on the value of heavy sours [like Canadian bitumen].”
U.S. refiners worry that the cap-and-trade legislation will lead to a greater reliance on imported gasoline and diesel from countries like Brazil, India and Saudi Arabia. Those emerging economies are refusing to impose emission caps on their industries, giving their expanding refinery sectors a cost advantage over American refiners.
India’s Reliance Industries Ltd. has just completed a 600,000-barrel-a-day refinery that is aimed exclusively at export markets. The Indian company has purchased sizable storage terminals in the U.S. and is clearly focusing on the American market.
“We feel this is a game changer in the worldwide refining industry,” Reliance’s president of corporate development, Mat Malladi told an industry audience in Houston.
Such moves could further reduce American refiners’ demand for Canadian crude.
But what of other markets? In recent years, Canadian producers have shown little interest in gaining access to fast-growing Asian markets through a pipeline to the West Coast, preferring to expand their presence in the U.S.
That appears to be changing. Enbridge is pursuing such an option with its $4.5-billion Northern Gateway project, a 1,170-kilometre pipeline that would deliver 525,000 barrels a day of oil sands crude to a terminal in Kitimat, B.C.
The industry failed to support Enbridge’s first run at the Gateway project three years ago, but there is more support for the current bid. However, critics – including first nations on the coast – have raised objections over the potential environmental impact from oil spills and tanker traffic.
Without such access to overseas market, Canada’s oil sands producers will face a future where their prosperity depends wholly on a risk-filled American market.
“There needs to be recognition of that, and a wake-up call,” Mr. Tertzakian says. “We need to diversify into growth markets if we’ve made the conscious decision to develop these resources and export them.”
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