How you’ve suffered of late.
To wit, Merrill Lynch’s commodity analysts are asking on Tuesday whether mining the Canadian oil sands is even needed in the midst of a global recession?
Brent and WTI oil prices have dramatically decoupled in recent weeks, as WTI piles up at Cushing, Oklahoma, the physical delivery point for the crude. Put simply, there’s too much oil in the US and exploratory projects like the Canadian oil sands are now at risk — Canada being the top foreign crude supplier to the US, according to Merrill, with major pipelines into Cushing (map below):
Virtually all Canadian oil exports are destined to the US and a good portion of it ends up in PADD II, which is also served by coastal import terminals. Oil pipeline flows cannot easily be reversed, so this continuous flow of Canadian crude can occasionally result in a major supply glut around the NYMEX WTI delivery point. As a result we have seen strong downward pressure on front-dated WTI crude oil contracts.
How long could this WTI price weakness go on for? Our Canadian equity research team estimates that existing integrated and in situ oil sands projects should generate positive cash flows all the way down to about US$32/bbl WTI. Thus, should the OPEC output cuts fail to balance the
global oil markets, WTI crude oil prices may need to temporarily dip below this level to force a reduction in Canadian oil flows into PADD II.
Furthermore, there are the long-term impacts of WTI over-supply:
This year and next, the United States could continue to suffer from an oversupplied crude oil market on the back of a bleak demand picture. More importantly, should consumption in other parts of the world deteriorate further in the next few months, the supply glut in North America could continue. In turn, this situation could force some of the existing Canadian sands producers into cash flow losses. According to our Canadian equity research team, this event would occur if WTI prices dropped below $32/bbl. Longer-term, however, the string of major delays in new Canadian oil sands projects will only exacerbate the structural investment shortfall in the global crude oil market. Our Canadian equity research team continue to believe that new integrated oil sands developments will require flat long term pricing of US$80/bbl to generate economic returns (namely an internal rate of return of 10%+ after tax). With collapsing global oil prices and the rapidly increasing cost of funding, we would expect delays on expensive development projects like Canadian oil sands to continue [see table below].
It’s something of a vicious cycle — as the global economy starts to recover, the energy supply needed to sustain the rebound will only come on stream in tandem with higher prices. (We should note here, however, that the Canadian oil sands are never going to be the answer to the word’s energy supply problems, with the potential to yield just 3m barrels per day by 2025, according to 2007 IEA estimates, or about 2.5 per cent of forecast world demand).
Nevertheless, with potential supply setbacks in projects like the oil sands, Merrill, like others, sees the return of the oil bull market:
Thus, the current WTI crude oil price weakness may be setting the stage for another rally in crude oil prices as the world emerges from the recession. Delayed and cancelled projects on energy infrastructure will only add to the same supply bottlenecks that gave origin to the commodity super-cycle of the last seven years… In our view, we are likely to hit a trough in global crude oil prices sometime in 1H09. However, the recovery in energy prices will depend crucially on the ability of policy makers to jump start economic activity and provide convincing signs that the global economy has turned around the corner.
Related links:
Big oil’s a buy – Barron’s
Are Canadian tar sands the answer to our oil needs – MoneyWeek
Goldman oil bulls are back – FT Alphaville