Canada’s heavy crude oil discount to West Texas Intermediate (WTI) crude has increased to its highest level. This has raised the spectre of a prolonged downturn for domestic oil producers who have opted to restrict operations. According to data compiled by Bloomberg, the discount to WTI widened to over $50 this fall, which is the largest on record.
The production of Western Canada Select (WCS) crude oil from Alberta has been increasing, but as pipelines fill up, firms are receiving far less compensations for their oil compared to their counterparts in the United States.
In 2013, Canadian grain farmers experienced a similar situation (and again last winter) when their grain harvest outshined the transport capability of Canada’s rail companies. This year, Western Canada’s oil corporations are treading on the same boat thanks to production increases that cannot be matched by export pipeline capacity gains.
Just like those grain farmers, oil firms have been forced to fill their storages as they wait for the government to provide a solution. Worst yet, the differentials and price discounts that affected heavy oil have spread to upgraded synthetic oil and light oil.
How will it impact the Canadian Economy if oil prices stay low?
For starters, Canada’s GDP will be reduced immensely if the low oil prices persist. This will further cut into Canada’s spending power and national income. According to a report released by the Fraser Institute, Canadian oil companies have lost around $21 billion from 2013 to 2017, which equals approximately 1% of the nation’s GDP.
The discount’s impact on employment will be a combination of both positive and negative effects (but mostly negative). Thousands of people have lost their jobs already as a result of the current oil price collapse, and more jobs will be lost if the prices continue to plummet in the energy sector (particularly on construction and drilling projects).
On the flip side, this could create more jobs in sectors that benefit from lower energy costs (such as agriculture and transportation), as well as industries that benefit from low exchange rates. The manufacturing sector, for instance, creates more job opportunities per unit of investment compared to the energy sector, so even though the petroleum sector’s employment rate may fall sharply over the coming years, the overall impact will be less severe.
That said, while the petroleum industry is less labor intensive compared to the agricultural and manufacturing sector, it needs more skilled workers who are also well compensated for their efforts. The difference between the petroleum and manufacturing sector in terms of compensation amounts to more than 24 percent: which implies that losing higher paid jobs and highly skilled workers in the petroleum industry will pose a larger impact compared to creating a multitude of lower paying and less skilled jobs in labor intensive sectors.
Given that the federal government tax revenue also depends on company revenues and personal taxes paid by employees, the decrease in profitability, employment, and wages in the energy sector will no doubt lower government tax revenues. By some estimates, this situation is leading to a loss of $80 million a day for the economy.
The lack of progress in dealing with bottlenecks that have led to this massive discount in the Canadian Crude Benchmark is causing investment dollars to flow out of the country. Several large international energy corporations, including Kinder Morgan, have already retreated and pulled out from their Canadian investments. The latest examples of this exodus of capital include Canadian exploration and production firms such as Encana moving employees, capital, and production to the United States in an effort to sure up profits. Canadian energy service companies like Precision Drilling, Ensign, and Akita are also looking to shift more crews and rigs south of the border.
With crude oil production ramping up in the US and infrastructure constraints showing no signs of improvement north of the border, Canadian energy producers have little to no flexibility in getting their product to market. One consideration on the table is to ship more oil by rail. Others are planning to transport the excess production by truck.
That said, while the overall situation in the Canadian energy sector looks very pessimistic at present, we know that negative sentiment can at times compel investors to disregard longer-term opportunities shaping up in the nation right now due to the changing dynamics in the energy sector, and other industries. Investors should take a long-term perspective while evaluating these developing opportunities.
Garnet O. Powell, MBA, CFA is the President & CEO of Allvista Investment Management Inc., a firm with a dedicated team of investment professionals that manage investment portfolios on behalf of individuals, corporations, and trusts to help them reach their investment goals. He has more than 20 years of experience in the financial markets and investing. He is also the Editor-in-Chief of the Canadian Wealth Advisors Network (CWAN) magazine. He can be reached at gpowell@allvista.ca