U.S. shale oil producers have responded to the oil price collapse so quickly, and with such discipline, that they’ve shown they are able to turn production on and off as if with a light switch. As Keith Schaefer tells The Energy Report, that means it’s time to be nimble, and to keep small positions until oil finds a stable new price level.
The Energy Report: Keith, the first U.S. grassroots refinery in nearly 40 years just began operation in North Dakota. Is the growth in U.S. oil production going to catalyze refinery construction?
Keith Schaefer: I’m going to say no. U.S. production has peaked and we’re doing just fine, so I don’t see any great need for more refineries right now.
There was talk a couple of years ago, particularly in 2012–2013, that with unbridled shale oil growth we would need more refineries. But the producers have been more disciplined than anybody expected in the last three months, with the rig count declining sharply and then staying down. I think we’re going to see a drop in U.S. production, so I don’t see the need for any new refineries right now. The only thing that could change would be even more demand growth, which we’re seeing because of lower prices. Somebody might get the idea that we need another refinery to meet that demand.
Right now, refinery crack spreads are actually very good. They’re $20–25 per barrel ($20–25/bbl), which for this time of year is fantastic. But I don’t know if that’s good enough to warrant somebody spending tens of billions of dollars to build something new. The other thing is that the refinery industry has been pretty good at incrementally adding light oil capacity around the country. A thousand barrels a day (1 Mbbl/d) here, 2 Mbbl/d there—that has added up over the last two or three years. I don’t know what the exact number is, but certainly there’s been no problem in getting gasoline to market, as you can tell by the big drop we’ve had in gasoline prices over the last six months.
TER: Is the gasoline price going lower?
KS: No, I don’t think the price is going lower. We’ve had a nice little rally in the last month, with oil prices back to about $60/bbl on the WTI (West Texas Intermediate) and almost $70/bbl on Brent.
I think it’s important that investors realize the gasoline price is based on Brent pricing, not on WTI. We’re exporting more gasoline-refined products out of the U.S., so we’re competing with foreign buyers for our own energy. I think that’s why gas prices are a bit higher than people think they should be; they keep thinking about WTI, not Brent.
TER: The new U.S. production is lighter than what U.S. refineries were designed for. Are the U.S. refiners retooling?
KS: Well, a bit. Like I said, you’re getting 1 Mbbl/d here, 1 Mbbl/d there, of light oil capacity. Refiners are also trying to increase the amount of distillates they produce, because generally that’s a more profitable product—jet fuel and diesel fuel, which is what Asia uses. Asia runs on diesel. That’s definitely Brent pricing, so there’s more margin in that. Everybody’s been trying to reduce heavy oil. The big exception would be BP Plc’s (BP:NYSE; BP:LSE) Whiting, Indiana, refinery, which just went from mostly light oil to mostly heavy oil.
TER: How has the delay in approval of the Keystone XL pipeline and resistance to Canadian pipelines going both east and west affected Canadian oil sands producers?
KS: So far there is not much impact. The heavy oil discount is quite tight right now because the Gulf Coast is getting a lot of Canadian oil that it never used to get. Enbridge Inc. (ENB:NYSE) has got the Flanagan South Pipeline moving, so it’s able to bring 300–350 Mbbl/d more Canadian crude straight to the Gulf Coast than it used to. That’s not quite as big as Keystone, but between what rail has done in the last two years, going from zero to just under 200 Mbbl/d, the incremental oil sands production has been able to find a way down to the Gulf Coast. There’s actually more Canadian oil now going to the U.S. than ever before. That’s great news for Canadian producers.
“There’s a strong argument the oil price is going to pick up over the next eight weeks.”
As you said, most of the refineries down there are geared toward heavy oil. Keystone probably will start to be important next year or the year after. Rail and the Enbridge Flanagan South line bought Canadian producers one to two years’ grace on their growth in production. It’s going to hit the wall again very quickly because oil sands production is going to rise anywhere between 50 Mbbl/d and 120 Mbbl/d every year for the next five or six years. Keystone will come back into importance fairly quickly.
TER: Is refinery construction on the table in Canada?
KS: Oh yes. The Alberta government is building a refinery, the North West Upgrader. I think it’s relatively small—somewhere around 75 Mbbl/d. But from private industry, there is just no appetite for a refinery in Canada. You need a big petrochemical complex surrounding your refinery complex, and you just don’t have that in Canada. The refineries are either in Edmonton, Alberta, or in Sarnia, Ontario. Sarnia has a petrochemical complex, but with the government there now, you’re never going to see another refinery in Ontario. You might see one in Alberta, but, again, it’s not going be as economic because it would just be producing gasoline, and not as many petrochemical products.
TER: Speaking of Alberta, how will the election results there affect refiners and oil sands producers?
KS: I don’t know if it’s going to affect oil sands or refineries that much. Because of the dirty oil moniker, if there’s one thing the New Democratic Party (NDP) government might go after, it’s trying to get the image of the oil sands in better shape. I think stronger environmental rules could really help the industry in the long run. That’s going to cost some money, and potentially put a crimp into some cash flows. The producers don’t want to disturb their tailings; they just want to plant poplar trees over them and let them go back to nature. I don’t know if the NDP is going to allow that.
From a tax point of view, I don’t think the elections are going to make much difference. There is talk about raising corporate income taxes, but the reality is that most, if not all, the producers lose money every year on an accounting basis. There’s not going to be much impact for the oil patch. Royalties could go a little higher, but I don’t see them going much higher. Honestly, the fear is greater than what the reality will be. The bark is worse than the bite.
TER: Has the price of oil found its new level?
KS: I think there’s a strong argument the price is going to actually pick up over the next eight weeks. The harsh drop in the rig count in the U.S. should now translate into a pretty significant drop in U.S. production, which we’ll see each Wednesday when the U.S. Energy Information Administration (EIA) numbers come out. The EIA numbers for the next 6–10 weeks have the potential to drop quite a bit. The Street is very short-term-oriented right now. I think the market could take oil a lot higher than people would suspect because of the emotion that will follow the drop in U.S. oil production in the next 6–10 weeks.
Here’s what I tell my subscribers: Right now there are many crosscurrents in the market, but two things have happened that were a bit of a surprise to the market so far this calendar this year, and both of them were bullish.
One was that demand has picked up way more than anybody expected, way sooner than anybody expected. Before the oil price crash in late 2014, the market was seeing lots of stories about how oil demand was inelastic to price. It didn’t matter what the price of oil was, demand didn’t change much at all. You can throw that idea out the window. Even by January that had been completely debunked, and we were seeing 300–500 Mbbl/d or more increase in demand in the States. Right now, we are seeing 700–800 Mbbl/d more demand in the U.S. over last year. When you consider that production is up 1 MMbbl/d, the surplus doesn’t look like such a big deal anymore.
Internationally, we’re starting to see some big stats as well. China’s up 250 Mbbl/d. Japan’s up. Korea’s up 110 Mbbl/d. They haven’t been able to see the same benefit in the drop of oil that we have because the rising U.S. dollar has taken a lot of that away. Demand has been a big surprise.
“Refiners are trying to increase the amount of distillates they produce, because generally that’s a more profitable product.”
Second, as I said, nobody thought the U.S. producers would have the level of discipline that they’ve had in dropping the rig counts through this calendar year. The market has been stunned that we’re continuing to see rig drops week after week. We had that one big month—February—with 90 rigs a week getting dropped. Even now, it’s at least 20 rigs. In Canada, for example, there are only 16 oil rigs working—in all of Canada! That’s stunning to me.