On bubbles of bitumen

On January 24th, Premier Redford used a televised address to Albertans to declare that price discounts for Alberta bitumen would lead Alberta to a significant deficit position – “this ‘bitumen bubble’ means the Alberta Government will collect about six billion dollars less in revenue, this year alone.” In much of the coverage which has followed this announcement, the level of misinformation has been high, so I am going to use this post to look back at fiscal year 2012-2013, to parse some of the statements made by the Premier and others, and to take a look ahead.

Was there a bitumen bubble in 2012-2013? If you go back through fiscal years 2005-2006 to 2012-2013, bitumen has always traded at an implied value* far below global light oil benchmarks, for reasons which we’ll discuss in greater depth below.  The lowest this discount has been was $16.75/bbl in 2009-2010, and the highest it’s been over that period was an average of $56.17/bbl in 2012-2013.  Without a doubt, the last 2 fiscal years (the discount was $48.91/bbl in 2011-2012) have seen historic discounts of Alberta bitumen relative to world prices.  When you produce 2 million barrels per day of bitumen, that’s certainly something which should get your attention.

Let’s take apart the history of Alberta bitumen discounts so that you can actually get a sense for what’s going on.  Caveat: there are a few ways that you can parse the discount, and I’ve chosen one of them here.  Let’s start with a global light, low sulphur oil benchmark – Brent crude – and work our way to bitumen.  Historically, light oil at Cushing and at Edmonton has traded at a premium to world light oil prices, since the marginal barrel was moving into the mid-continent and Alberta barrels were close to that demand center.  In 2009, that relationship began to reverse, and through 2011 and 2012, light oil at Edmonton traded at massive discounts to similar crude streams on global markets – an average of $22.83/bbl in fiscal year 2012-2013, as shown in the blue wedge at the top of the graphic below.

The second discount is the heavy-light differential, which reflects the fact that heavy oil has lower value to refineries, for which I’ve used Edmonton Par to Western Canada Select (WCS) for the red wedge in the graphic below.  This discount averaged $17.67/bbl in 2012-2013, and was by no means historically high – the average since 2005 has been $17.96/bbl.

The final discount, and one which most people have ignored, is the difference between bitumen and heavy oil.  Since diluted bitumen is sold into heavy oil streams (usually at a small discount to heavy oil), you need to account for the fact that a barrel of bitumen is worth less than a barrel of heavy oil, because the added diluent is a higher value product. The diluent, usually natural gas liquids, was valued at a premium to light oil in 2012-2013 of $13.88/bbl, compared to an average since 2005 of $4.96/bbl.  Holding diluted bitumen prices constant, the more diluent is worth, the less the bitumen in a barrel of diluted bitumen is worth – that’s the green wedge you see on the graph below.

Components of bitumen value. Data: Sproule Associates. Author’s Calculations.

Let’s add all that together.  If you’ve got a bitumen project, and you’re buying diluent and selling diluted bitumen, you had a really tough year in 2012-2013, at least relative to world oil prices. On a historic basis, the value of bitumen in Alberta was at its lowest since 2008 during fiscal year 2012-2013, averaging just $52.78/bbl, compared to $64.58 the previous year.  Given that 73% of Alberta’s crude oil production pays royalties based on the value of bitumen (even integrated projects pay bitumen-based royalties), that’s a major hit to the province’s revenue as well.

If you stop the story at the discount of bitumen relative to light oil, you’ll miss the impact of WTI pricing, or mid-continent crude discounts in general.  Despite the premier’s statement that, ” it isn’t the price of oil in Texas that is causing the real problem,” I would argue that it was the lion’s share of the problem, or at least a good barometer for the problem.  As discussed above, the issue was not that the heavy-light or bitumen-light differential was abnormally high in Alberta – it’s that all Alberta and other mid-continent oil traded at a significant discount to world prices.

Of course, I would be remiss if I didn’t discuss the issue of forecasting.  The Premier stated that their government had used a conservative oil price forecast, but that’s simply not the case.  Put simply, had an oil company located in Alberta used the Alberta government’s oil price forecast to value their reserves, they would almost certainly have run afoul of the Alberta Securities regulator.  The graph below, a modified version of a graph I used in this post, shows the issue.  The real bubble was caused by the fact that the Alberta government’s forecast for light oil was far above what the markets were predicting at the time based on the 3 year NYMEX strip used by Sproule Associates to forecast future oil prices.  In the graph below, you can see that we may be in line for more of the same, unless the market is wrong about oil futures, since the Budget 2013 WTI forecast again lies above the futures price.

So, what’s the bottom line? Essentially 2012-2013 proved to be a perfect storm for Alberta’s resource revenues.  First, an overly aggressive oil price forecast implied that Alberta’s budget targets were reliant on oil prices exceeding market expectations and instead oil prices fell below expectations.  You can’t blame the Alberta government for missing the second part, but the first seems to me to be fair game.  Second, the value of bitumen relative to the value of heavy oil was lower than expected, leading to a lower than expected royalty base on which the province was collecting royalties at lower than expected rates due to low WTI prices.  If it’s all the same to you, I think I’ll stay away from the term bitumen bubble.

* Here, the implied value of bitumen is based on value parity between diluted bitumen and WCS, and a 30% blending ratio of condensate to bitumen in a barrel of diluted bitumen, with all prices at Hardisty.  The value of bitumen at a production site would be lower due to transportation costs and diluted bitumen frequently trades at a discount to WCS.