It seems the days of developing an outlook for Canadian light-heavy crude oil price differentials based primarily on fundamental factors (North American supply/demand/inventories) has become even more difficult than it used to be.
One has to exercise a certain degree of geopolitical savvy these days by including a volatile spectrum of geopolitically driven international factors that have begun to cast a greater influence on the benchmark price of Canadian heavy oil (Western Canada Select, WCS) and its differential to benchmark WTI.
RBN’s last outlook at the WCS-WTI price differential was published in September 2021, a time when oil markets were seemingly easier to understand and far less buffeted by the whims of political leaders and geopolitical events. Before we dig too deeply into that, let’s consider how our price forecast of one year ago stood up against what actually happened.
Primarily driven by our views that crude oil pipeline export capacity from Western Canada would be more than adequate (and still is) to handle rising volumes of Canadian crude oil production, along with incremental improvements in refinery demand in response to rising consumer consumption of refined products, our price differential forecast covering 4Q21 to 4Q22 was very optimistic in the sense of expecting a relatively narrow price differential between US$11.00/bbl and US$14.50/bbl (blue values and columns in chart below). The first two quarters of this forecast performed not too badly, with the differential being about $5/bbl and $2/bbl wider than we expected in 4Q21 and 1Q22 (compare to red values and columns). After that, the bottom fell out of our outlook, as those aforementioned geopolitical factors began to play a bigger role in driving North American and global light-heavy oil price differentials. The forecast miss widened to near US$8/bbl in 3Q22 and is approaching a US$13/bbl miss to date in 4Q22.
What were those geopolitical factors, either in isolation or in combination with others, that so dramatically widened the price differential? As you might have guessed, as it has affected so much of the world of energy and beyond, Russia’s invasion of Ukraine in late February this year, and the international community’s reaction to that invasion, has thrown the usual crude oil price playbook out the window. Sanctions on the Russian economy and the shunning of its crude oil supplies resulted in a shortage of crude oil in particular markets, primarily Europe.
In response, the collective action of member nations in the International Energy Agency (IEA) was a record release of strategic stockpiles of crude oil and some refined products, with the largest contributor to that release being the United States.
Although the U.S. and its fellow members in the IEA had been releasing modest quantities of strategic stocks in the months prior to the invasion in a thinly veiled attempt to slow the rise of global benchmark crude oil prices, Russia’s invasion and apparent supply shortages in some regional markets, sent the impetus for strategic releases into overdrive.
As part of the joint-IEA release of crude oil from the U.S. Strategic Petroleum Reserve (SPR), President Biden took the historic (and overtly political) step of authorizing up to 180 million barrels (MMb) of crude oil to be released in a six month span covering May to October 2022, in an unprecedented move to cover perceived supply shortfalls for allied nations and, increasingly, as a means to exert downward pressure on the politically sensitive topic of high retail gasoline prices in the United States. This was 90 million barrels more than what was authorized as part of the co-ordinated stock releases with IEA members. The extent of the downward influence on crude oil prices as a result of the strategic releases is debatable, as crude oil prices pulled back from their +US$110/bbl highs early in the spring on a combination of slowing demand and Russian supply disruptions that ended up being far smaller that was expected, but the SPR releases have remained an ongoing factor in the market (as does the Russia-Ukraine war).
It is this combination of two events: Russia’s invasion of Ukraine and Western nations’ reaction to that invasion, especially what has become an outsized release of crude oil from the U.S. SPR, that have played havoc with the price and price differentials of WCS. Consider first the sanctions on Russia and its supply of crude oil. It quickly became clear shortly after the invasion in late February that some apocalyptic views of an immense reduction in Russian crude supplies well in excess of 1 MMb/d were greatly overblown. The Russian supply pullback has been closer 0.5 MMb/d, with the nation able to sustain most crude oil exports to buyers not abiding by international sanctions (China and India, for example) by deeply discounting its flagship medium sour Urals crude stream. Typically trading at discount to the international price marker of Brent by a few dollars, that discount quickly blew out to more than US$30/bbl by April (chart below), shortly after the war and sanctions came into play. Though the discount has narrowed since then, it is much deeper than its pre-war historical average.
The steep discounts on those medium sour barrels have created a lot of buying interest from the likes of India and China, creating a downward price influence on Canadian heavy barrels that were being exported from the U.S. Gulf Coast to buyers such as India. By inadvertently creating an extremely cheap barrel that competes to some degree with exported Canadian heavy barrels, massive Urals price discounting has played a role in driving a deeper price discount for WCS.
Those medium sour barrels bring us to the immense releases of crude oil from the U.S. SPR, releases which head directly into the Gulf of Mexico and compete with exported WCS from the region. The immense SPR drawdown that got underway at the end of April (columns to the right of the dashed line in the chart below) has been primarily driven by releases of medium sour barrels. To the week ending October 21, 2022, 96.1 MMb, or about two thirds of the 146.3 MMb released so far from the SPR, have been medium sour.
When combined with the Russian Urals competition and the SPR releases, it is no surprise that the WCS-WTI price differential began to immediately widen in May (chart below) and has since collapsed to a discount in excess of US$27/bbl, its lowest value since November 2018 (remember the bitumen bubble?).
Worse for the near-term consideration of WCS pricing is that the releases from the SPR, originally planned to conclude by the end of October, will be extended into November and December with another 15 MMb being made available. Depending on the rate of uptake by the market, the release could slip into January 2023. With President Biden making it abundantly clear that he has not been satisfied by the degree to which U.S. domestic gasoline prices have fallen over the past few months, he has hinted at additional SPR releases in a blatantly political attempt to tamp down crude oil and gasoline prices prior to the U.S. midterm elections on November 8.
As for Russia, additional sanctions to deny insurance to any tanker carrying Russian crude as well as an orchestrated attempt by the U.S. and European Union to slap a price cap on Russian crude sold in the international market, will only stiffen the resolve of Russian President Putin to further slip around sanctions. Early thinking is that the insurance and price cap strategy may largely be ineffective as Russia will either self insure its own tankers or rely on non-participating countries to provide insurance. The end result, however, is likely to be a relatively steady supply of Russian barrels to the international market, but still hefty discounting to ensure that those barrels flow to buyers.
These two factors, upcoming and potential further (politically motivated) releases of crude oil from the SPR, and an ever more complicated situation for the sale of Russian crude supplies, should result in sustained competitive pressures on WCS prices in the U.S. Gulf Coast for at least the next few months, forcing price discounting back up the Canadian crude oil supply chain and into the WCS-WTI price differential.
Though less likely to make a splash on the global crude oil market in the near term — or ever — has been attempts by the U.S. and European Union to broker a new nuclear agreement with Iran and an easing of sanctions on its exports of crude oil. Those Iranian barrels are usually heavier in nature and would form another competitive wedge with other heavy oil suppliers. However, negotiations that originally looked promising in the summer, have now hit what seem to be insurmountable hurdles in the past couple of months, pointing to the likelihood that a new agreement will not be reached and keep larger volumes of Iranian heavy oil supplies off the market.
President Biden’s international team has also been making overtures to Venezuela this summer and its pariah President, Nicolas Maduro, in another overt political attempt to bring more crude supplies back to the market and drive down prices. In exchange for some additional political freedoms for Venezuela’s opposition parties and an easing of government crackdowns, the U.S. has been aiming to lighten up its sanctions, and allow additional Venezuelan barrels back onto the market and permit some U.S. companies to begin investing in the Venezuelan oil sector once again. It remains unclear as to how far these negotiations might go and whether a deal will ever be reached but, as you might have guessed, those Venezuelan barrels are all heavy (or extra heavy) in nature, which would create another competitive headache for WCS prices.
Although the global crude oil market has always been something of a geopolitical animal going back to its earliest days at the dawn of the 20th century, the geopolitical influences at play in the current market are easily the most volatile and diverse that have been witnessed since the days of the OPEC oil embargoes of the 1970s. Back then, heavy oil and heavy oil pricing were far less important to the overall health of the Canadian crude oil market. Today, nearly 80 per cent of Canadian crude oil production is heavy (conventional, bitumen, and upgraded bitumen), meaning that significant revenue, royalties and investments — not to mention jobs — are being influenced to a larger degree than ever by international geopolitics compared to the usual array of typical fundamentals such as refinery demand, regional inventories and growth in Canadian supplies.
By our assessment, these geopolitical influences will carry a higher weight on WCS crude oil price formation for at least the first half of 2023 on some combination of SPR releases and machinations in the Russian crude oil story. In the concluding part of this analysis, we’ll turn to the more typical fundamental aspects of the Canadian heavy oil market which will we combine with the geopolitical discussion to produce our next outlook for the WCS-WTI price differential.