A Brief to the Standing Committee on Natural Resources

Posted on: Thursday, February 2nd, 2012

THANK YOU FOR YOUR INVITATION TO APPEAR BEFORE THIS COMMITTEE ON THE SUBJECT OF THE CURRENT AND FUTURE STATE OF OIL AND GAS PIPELINES AND REFINING CAPACITY IN CANADA.

MY FIRM, MJ ERVIN & ASSOCIATES, IS A PETROLEUM INDUSTRY CONSULTANCY THAT SPECIALIZES IN THE DOWNSTREAM – OR REFINING AND MARKETING – SIDE OF THIS INDUSTRY. OUR CLIENTS SPAN A BROAD RANGE OF INTERESTS, AND I BELIEVE THAT WE ARE WELL-REGARDED FOR OUR UNBIASED VIEWS OF THIS INDUSTRY.

MY REMARKS TODAY WILL FOCUS ON THE REFINING SECTOR, AND ITS CURRENT AND FUTURE STATE.

THE NORTH AMERICAN REFINING SECTOR HAS SEEN A SIGNIFICANT DECLINE IN THE NUMBERS OF PLANTS, HAVING DROPPED FROM OVER 360 IN THE 1970’S AND 80’S, TO LESS THAN 140 TODAY, OF WHICH THE CANADIAN REFINERY POPULATION HAS DROPPED FROM OVER 40, TO ITS CURRENT LEVEL OF 15 REFINERIES CAPABLE OF PRODUCING A BROAD RANGE OF FUEL PRODUCTS.

ONE MIGHT GUESS THAT DECLINING DEMAND MIGHT HAVE BEEN RESPONSIBLE FOR THIS DECLINE IN REFINERIES, BUT IN FACT, FROM THE LATE 80’S UNTIL ABOUT 2008, PETROLEUM DEMAND IN NORTH AMERICA WAS STEADILY CLIMBING. INSTEAD, THE CLOSURE OF ABOUT 200 REFINERIES SINCE 1970 WAS A CONSEQUENCE OF POOR RETURNS ON CAPITAL, WHICH IN TURN WAS A CONSEQUENCE OF EXCESS CAPACITY AND POOR CRACK SPREADS.

CRACK SPREAD IS THE DIFFERENCE BETWEEN THE REVENUE PER BARREL THAT A REFINER SEES FROM THE SALE OF A PRODUCT SUCH AS GASOLINE, AND THE COST OF THE CRUDE OIL THAT WENT INTO MAKING THAT VOLUME OF GASOLINE. IT IS THE KEY PERFORMANCE INDICATOR USED BY INDUSTRY FINANCIAL AND INVESTMENT ANALYSTS TO DETERMINE THE HEALTH OF THE REFINING SECTOR.

SO, WHY DID WE SEE SO MANY REFINERY CLOSURES? IN THAT TIME, CRACK SPREADS WERE INSUFFICIENT TO SUSTAIN SMALLER AND LESS EFFICIENT REFINERY PLANTS, AS THEIR RETURNS ON CAPITAL DID NOT JUSTIFY THEIR CONTINUED OPERATION. ONE MIGHT ARGUE THAT ONCE A REFINERY IS BUILT, RETURN ON CAPITAL IS LESS IMPORTANT A FACTOR IN DECIDING ITS FATE, BUT DUE TO A PROGRESSION OF FUEL QUALITY MANDATES, SUCH AS THOSE FOR REDUCTIONS IN LEAD, BENZENE, OLEFINS, VAPOUR PRESSURE, AND SULPHUR; MANY SMALLER REFINERIES COULD NOT JUSTIFY THE MULTI-MILLION DOLLAR INVESTMENTS NEEDED TO COMPLY WITH THESE MANDATES, AND WERE FORCED TO CLOSE.

IT WAS ONLY UNTIL THE MID-1990’S THAT CRACK SPREADS BEGAN TO ACHIEVE RATES OF RETURN THAT MIGHT ACTUALLY ATTRACT CAPITAL INVESTMENT BEYOND THAT REQUIRED BY FUEL QUALITY MANDATES. IN FACT, DUE TO A STEADY INCREASE IN PETROLEUM DEMAND, NORTH AMERICAN REFINERIES BEGAN TO EXPERIENCE UTILIZATION RATES WELL ABOVE NINETY PERCENT, AND MANY HAD EXPANDED IN ORDER TO MEET THIS GROWING DEMAND, AND TO TAKE ADVANTAGE OF IMPROVED CRACK SPREADS.

SO FOR A FEW YEARS LEADING UP TO 2008, THE REFINING SECTOR BEGAN TO EXPERIENCE PROFITS THAT MET OBJECTIVE THRESHOLDS FOR ADDITIONAL GROWTH INVESTMENT, SUCH THAT IN THAT TIME, A FEW NORTH AMERICAN REFINERS EVEN ANNOUNCED PLANS FOR NEW, GREENFIELD REFINERIES.

SINCE THEN OF COURSE, WE HAVE WITNESSED A GLOBAL RECESSION, ONE WHICH LED TO A LARGE DROP IN REFINED PRODUCTS DEMAND IN THE U.S. AND OTHER REGIONS, AND TO A LESSER EXTENT IN CANADA. WHERE A FEW SHORT YEARS AGO REFINERIES WERE ALL RUNNING AT FULL CAPACITY, WE ARE NOW WITNESSING REFINERY CLOSURES, AND THE SHELVING IF NOT TOTAL ABANDONMENT OF PREVIOUS PLANS TO BUILD BRAND-NEW REFINERIES.

THAT BRINGS US TO THE PRESENT; SO WHAT ABOUT THE FUTURE?

A NUMBER OF FACTORS WILL CONTRIBUTE TO A LONG-TERM DECLINE IN DEMAND FOR GASOLINE IN NORTH AMERICA, ALL AS A RESULT OF CHANGING CONSUMER PRACTICES, IMPROVING AUTOMOTIVE TECHNOLOGIES, OR, FUTURE GOVERNMENT INTERVENTIONS, SUCH AS THE RECENT MANDATING OF RENEWABLE CONTENT IN GASOLINE AND DIESEL FUEL.

GASOLINE IS THE MOST COMMONLY PRODUCED PETROLEUM PRODUCT IN NORTH AMERICA, COMPRISING ABOUT 40 PERCENT OF THE BARREL, SO A DECLINE IN ITS DEMAND WILL HAVE A SIGNIFICANT INFLUENCE ON THE U.S. AND CANADA’S NET REFINERY THROUGHPUT, EVEN AMIDST AN INCREASED GLOBAL DEMAND FOR CRUDE OIL OVER THE NEXT 20 YEARS, AND EVEN CONSIDERING THE LIKELY IMPROVEMENT IN DIESEL CONSUMPTION, ONCE THE U.S. ECONOMY GETS BACK INTO FULL SWING. IN LIGHT OF THESE DEMAND PROJECTIONS, AND CONSIDERING THE SPATE OF RECENT REFINERY CLOSURES IN NORTH AMERICA, THERE IS VIRTUALLY NO CHANCE OF NORTH AMERICAN REFINERS CONSIDERING MAJOR CAPACITY EXPANSIONS IN THE FORESEEABLE FUTURE.

I SOMETIMES HEAR SPECULATION THAT THE BUILDING OF MORE CANADIAN REFINERIES WOULD LOWER THE PRICE OF WHOLESALE AND RETAIL FUELS FOR CANADIAN CONSUMERS. IT IS IMPORTANT TO UNDERSTAND HOWEVER, THAT CANADIAN REFINERIES ARE REALLY JUST PART OF A LARGER NORTH AMERICAN CAPACITY POOL, AND THAT LOWER WHOLESALE PRICES IN CANADA BROUGHT ABOUT BY MORE CAPACITY WOULD QUICKLY ATTRACT WHOLESALE BUYERS IN THE U.S., THUS NEGATING ANY HOPES OF SUSTAINED LOWER PRICES IN CANADA.

ANOTHER TOPIC THAT MAY BE RELEVANT TO THIS COMMITTEE’S WORK MAY BE THE MATTER OF BITUMEN UPGRADER CAPACITY. TO BE CLEAR, WE DON’T DEFINE UPGRADERS AS REFINERIES, SO WHEN I PROJECT A LACK OF DEMAND FOR MORE REFINERY CAPACITY, THERE WILL BE A NEED FOR CONTINUED EXPANSION OF UPGRADER CAPACITY, AS THE PRODUCTION CAPACITY OF CANADA’S OILSANDS CONTINUES TO INCREASE.

ONE SCHOOL OF THOUGHT SUGGESTS THAT A CONSIDERABLE OPPORTUNITY EXISTS TO MAKE CANADA A SIGNIFICANT EXPORTER OF REFINED PETROLEUM PRODUCTS, INSTEAD OF EXPORTING CANADA’S GROWING PRODUCTION OF BITUMEN, BY MEANS OF A PROGRAM OR POLICY OF UPGRADER AND REFINERY EXPANSION IN CANADA. THIS WOULD HAVE THE BENEFIT OF CREATING AND RETAINING MORE HIGHLY-SKILLED JOBS IN CANADA.

WHILE THAT PROSPECT IS APPEALING, IT WOULD CREATE THE PARADOXICAL SITUATION OF CANADA UNDERTAKING A MASSIVE EXPANSION OF REFINERY CAPACITY, CONCURRENT WITH THE UNITED STATES UNDERTAKING A MASSIVE DOWNSIZING OF ITS REFINING INFRASTRUCTURE. TO SAY THAT SUCH A SCENARIO WOULD BE AN INEFFICIENT USE OF CAPITAL WOULD BE A GROSS UNDERSTATEMENT.

I WILL CONCLUDE BY POINTING OUT SOME WILD-CARD FACTORS THAT COULD HAVE A SIGNIFICANT IMPACT ON FUTURE REFINERY CAPACITY IN CANADA, AND INDEED, IN NORTH AMERICA. FIRST, IT IS A CERTAINTY THAT IN THE NEXT DECADE, THERE WILL BE AN EXPANSION OF REFINERY CAPACITY IN SOME REGIONS, NOTABLY THE SO-CALLED BRIC COUNTRIES. THIS, COMBINED WITH A GLUT OF CAPACITY IN NORTH AMERICA AND EUROPE, WILL LIKELY KEEP CRACK SPREADS DEPRESSED FOR THE FORESEEABLE FUTURE.

SIMILARLY, THE BUILDING OF ONE OR MORE OF THE KEYSTONE XL PIPELINE, THE NORTHERN GATEWAY PIPELINE, OR THE RE-REVERSAL OF LINE 9, WILL IMPROVE ACCESS BY MID-CONTINENT CRUDE OILS TO WORLD MARKETS, THEREBY BRINGING THOSE CRUDE PRICES BACK UP INTO PARITY

WITH WATERBORNE CRUDES SUCH AS BRENT. WHILE THIS WILL BE GOOD NEWS FOR CANADA’S UPSTREAM INDUSTRY, IT WILL HAVE THE EFFECT OF REDUCING CRACK SPREADS ON THE DOWNSTREAM SIDE, FOR THOSE REFINERIES THAT PROCESS CRUDES FROM THE WESTERN CANADA SEDIMENTARY BASIN.

FINALLY, ANY FUTURE PRODUCT SPECIFICATION MANDATES WILL HAVE THE INEVITABLE CONSEQUENCE OF NECESSITATING MORE CAPITAL INVESTMENT THAT DOES NOT INCREASE CAPACITY, AND WOULD THEREFORE REDUCE THE SUSTAINABILITY OF THE MORE MARGINAL PLAYERS IN THIS SECTOR.

ALL OF THESE ADD UP TO A PROGNOSIS THAT WE ARE UNLIKELY TO SEE ANY SIGNIFICANT EXPANSION OF CANADIAN REFINING CAPACITY IN THE NEXT DECADE AND PERHAPS BEYOND, AND DEPENDING UPON THE OUTCOMES OF THE WILD-CARD FACTORS I HAD MENTIONED, MAY EVEN LEAD TO A CONTRACTION OF CAPACITY. ALL OF THOSE FACTORS ARE BEYOND THE CONTROL OF REFINERS, AND ALL BUT ONE ARE BEYOND THE CONTROL OF CANADA’S POLICYMAKERS, THE ONE EXCEPTION BEING PRODUCT SPECIFICATIONS.

THANK YOU FOR GIVING ME THE OPPORTUNITY TO SHARE MY PERSPECTIVES WITH THIS COMMITTEE, AND I LOOK FORWARD TO THE ENSUING DISCUSSION.

THANK YOU.