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Commentary On The WTI-WCS Spread

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Includes: BNO, BP, CVE, DBO, DNO, DTO, DWT, ENB, OIL, OILD, OILK, OILU, OILX, OLEM, OLO, SCO, SZO, UCO, USAI, USL, USO, USOD, USOI, USOU, UWT, WTID, WTIU, XLE
by: Callum Turcan
Summary

Commentary on the macro situation facing Alberta's upstream industry.

Why the WTI-WCS differential matters.

What is being done to bring the WTI-WCS differential back down to manageable levels.

Canada produced 4.2 million barrels of crude oil per day on average last year, 3.3 million barrels of which were exported on a daily basis. Oil sands operators represented 64%, or 2.7 million bpd, of that crude output. Roughly 45% of oil sands output is from mining operations (scooping enormous amounts of dirt and bitumen from the ground, which is then separated via a froth treatment plant), while the remaining 55% is from in-situ operations (injecting steam into the ground to enable viscous heavy crude to move to a production well). Unfortunately for Alberta's upstream sector, there isn't enough pipeline takeaway capacity to move all of those barrels to refineries that need heavy crude, namely US refineries along the Gulf Coast region. Let's go over some recent updates regarding this very important space of the oil industry.

Getting crushed

Oil sands operators are getting crushed by the enormous gap between West Texas Intermediate, the benchmark for light sweet oil supplies to Cushing, Oklahoma, and Western Canadian Select, the benchmark for heavy sour oil supplies to Hardisty, Alberta. After treading water around $15-20 USD/barrel over the past few years, which is basically the cost of shipping oil barrels from Alberta to the US Gulf Coast via rail, the WTI-WCS differential was blown wide open in 2018. For the rest of 2018, the WTI-WCS differential is around $40-50 USD/barrel.

Part of this blow up is due to BP plc's (NYSE:BP) Whiting Refinery in Indiana going offline for maintenance activity, which happened in September. That turnaround activity is expected to last through the end of October. After an extensive upgrade in 2013, the Whiting Refinery can process hundreds of thousands of heavy sour oil barrels from Alberta, with the refinery's total crude throughput capacity currently sitting at 430,000 barrels per day.

Looking ahead

Going forward, the WTI-WCS differential is expected to come down back (according to the futures curve) to $25-30 USD/barrel for several reasons. The Whiting Refinery coming back online is clearly a very positive factor, as that adds several hundred thousand barrels per day of demand for heavy sour oil volumes from a refinery capable of receiving those supplies.

Another major factor that concerns upstream operators seeking out additional rail options for oil sands production. Cenvous Energy, Inc. (NYSE:CVE) signed several transportation agreements with various rail operators to ship 100,000 barrels per day of heavy Canadian oil from Alberta to the US Gulf Coast, with these deals coming into force during the fourth quarter of 2018. The volumes transported under this agreement are expected to ramp up through next year.

Pushing the WTI-WCS differential down to the cost of rail transportation would eventually see that gap move downwards to ~$20 USD/barrel. However, the futures curve indicates this won't be the case until 2020 at the earliest, if not later. This implies that market actors don't think enough crude-by-rail options will become available in a timely manner. It will be up to firms like Cenovus Energy to prove those speculators wrong.

The third key development readers should keep in mind is additional pipeline takeaway capacity coming online. In particular, Enbridge, Inc.'s (NYSE:ENB) Line 3 Replacement Program, which will bring Line 3 back up to its full capacity. Enbridge voluntarily curtailed the volumes transported along this system back in 2008, which removed a whopping 370,000 barrels per day of much needed takeaway capacity out of Alberta. When completed, whenever that will be, Line 3 will enable significantly larger heavy oil volumes to reach Superior, Wisconsin.

As things stand today, the project has a targeted late-2019/early-2020 state-up date, but that may not come to pass. Pipeline projects often have to deal with local and state regulatory and legal hurdles, on top of protests (depending on the situation), before getting completed. Simply being approved on the federal level doesn't mean a pipeline project, even one that is replacing an old system with newer and more reliable infrastructure, will cross the finish line. There are other pipeline projects in the works, but Line 3 is one of the most likely developments to be completed.

While all three of these endeavors will help give Alberta's upstream industry a break, there is a limit to what these developments can accomplish. In order to keep a lid on the WTI-WCS differential in the future, what is needed is more permanent takeaway capacity. Normally, that would be in the form of additional pipeline projects. However, it is clear projects like the Trans Mountain Expansion and the Keystone XL Pipeline will probably never get completed due to various political, regulatory, and legal hurdles. This makes crude-by-rail options all the more important.

Cenovus Energy made the right call by effectively locking in a good chunk of its oil sales at what probably will be prices based on Mexico's Maya benchmark (a heavy sour crude benchmark for the Gulf Coast region) minus transportation costs. While ~$20-25 USD/barrel below West Texas Intermediate may not seem great, keep in mind that is materially different than $40-50 USD/barrel below WTI.

Final thoughts

Usually oil sands players, depending on the operation (mining versus in-situ), require ~$30 USD/barrel realizations to break even on a cash cost basis. While WTI is trending around $70/barrel, oil sands operators would be struggling to not post negative operating cash flow at the current WTI-WCS differential (before taking hedging effects and firm transportation agreements into account). This is why it is so important for the upstream industry to secure long-term crude-by-rail transportation commitments to enable these barrels to start flowing south. Thanks for reading.

Some of the relevant tickers to this piece include the Energy Select Sector SPDR ETF (NYSE:XLE), United States Oil Fund LP (NYSE:USO), United States 3x Short Oil Fund (NYSE:USOD), and the United States 3x Oil Fund (NYSE:USOU).

Disclosure: I am/we are long BP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.