Friday, January 31, 2014

Keystone XL and Its Impact on the Economics of Canada's Oil Sands

Updated November 2014

An analysis of the economics of Canada's oil sands by Carbon Tracker Initiative examines how Keystone XL (KXL) will impact the economics of Canada's oil sands.  Canada's oil sands producers have long regarded KXL (or its alternative, the Northern Gateway Pipeline) as the panacea to the problem with high price differentials, currently in the 40 percent range between oil sands-sourced oil and conventional oil (West Texas Intermediate).

As background, Canada's oil sands producers have rather ambitious expansion plans.  From a production level of 1.8 million BOPD in 2012, production from oil sands is expected to rise to 2.3 million BOPD in 2014, 4.5 million BOPD in 2020 and 5.2 million BOPD in 2025.  Here is a graph showing the ramping up of production from 2012 to 2030:

One of the biggest problems facing Canada's oil sands producers is the infrastructure bottleneck that prevents oil from flowing to the United States Gulf Coast.  This is creating local gluts of oil, pushing prices for Western Canadian Select (WCS) (in red) well below the price for the benchmark Maya crude (in blue) as shown on this chart:

Maya, a heavy crude sourced in Mexico, similar in quality to WCS, however, it is not land-locked and is available to international markets in the United States Gulf Coast.  For 2013, the average WCS price was discounted by $24.41 per barrel when compared to Maya.  In November 2014, WCS was discounted at over $42 per barrel when compared to West Texas Intermediate, the North American benchmark crude.

The proposed KXL pipeline will link Alberta with the United States Gulf Coast, allowing oil companies to export an additional 830,000 BOPD of which 730,000 BOPD would be available for oil sands production and 100,000 BOPD would be available for tight oil plays in the Williston Basin (i.e. the Bakken).  The KXL pipeline would provide:

1.) A direct link to the Gulf Coast which would provide oil sands producers a price improvement (a reduction in the differential) since the oil sands oil (Western Canadian Select or WCS) is closer in quality to Mexican Maya which trades closer to the price of West Texas Intermediate (WTI).  As I noted above, Mexican Maya is still more valuable than WCS.

2.) The pipeline will relieve the pressure on existing export routes, allowing prices on WCS to rise in the Midwest.

Now that we have some background information, let's look at CTI's analysis.  As we know, the producing costs for much of Canada's oil sands are at the upper end of the upper quartile of the world's oil production cost curve.  In-situ or steam-assisted-gravity-drainage (SAGD) methods are the least costly, followed by non-upgraded mining production and projects with integrated mining operations and upgraders being the most expensive (i.e. Syncrude/Suncor).  Data from several analysts suggests that the break-even oil price required to make an oil sands project economic range from $60 to $100 per barrel with SAGD projects having a break-even price of $65 to $85 per barrel.  Here is a graphic showing the cost curves for some of the key new oil projects around the world with Canada's heavy oil sands projects in red:

As I noted above, the cost to produce a barrel of heavy Canadian oil ranges from about $52 per barrel to about $93 per barrel, depending on the project.  This is particularly pertinent given that WTI is now trading at around $80 per barrel.

Here is a chart showing the outcome at a price of $69 per barrel for WCS and a price of $89 per barrel for Mexican Maya, both in 2015, assuming a break-even price of $65 per barrel assuming a 10 percent discount rate:

Please note that profit/loss is measured after producer netback post-transportation less the break-even price of $65 per barrel.  The break-even price is the price per barrel required to cover all costs and provide the oil company involved with the rate of return (in this case, 10 percent) that it requires to proceed with a project.  It is highly likely that this break-even price will rise over time; it already appears that the break-even price for some projects may be in excess of $80 per barrel.

Without KXL, each barrel of WCS produced loses $18.10.  With KXL, profit rises to $5.50 per barrel.  With an incremental carbon offset cost of $2.00 per barrel, producers will see a net of $3.50 per barrel, a rather skinny profit margin.  Using a $65 per barrel initial cost and assuming that there are minimal carbon offset costs, KXL can shift projects from being unprofitable to being marginally profitable provided that refiners on the Gulf Coast are willing to pay the same price for WCS as they do for heavy Mexican Maya crude.

There are risks associated with this scenario:

1.) The demand for Canadian crude could drop as United States oil production rises (i.e. the Bakken and Eagle Ford among others) and more energy efficient vehicles reduce demand.  United States imports of crude oil and products have already dropped from 12 million BOPD in 2007 to 9.3 million barrels in mid-2014 as shown on this graph:

2.) Competitive pressures from imports of WCS could depress the price of Mexican Maya as PEMEX (Mexico's state oil company) seeks to maintain its market share by lowering prices.

3.) KXL could create a production cost inflation as development of new oil sands projects creates additional shortages of materials and labour.  If the cost of production were to rise by as little as 10 percent, this would push profits down by $6.50 per barrel in the analysis noted above.

4.) Highly volatile oil pricing could easily affect profitability.

5.) An increase in the desired rate of return will negatively impact the break-even point.  The return on projects demanded by oil companies will rise in lockstep with interest rates.

To summarize, if investors automatically assume that the green lighting of the Keystone XL pipeline will mean huge returns to shareholders, perhaps they should think twice.  Unless it appears that the world's oil markets will sustain a price scenario similar to what was seen through most of 2013 and early 2014 over the long-term, the economics of expanding Canada's oil sands industry looks like it could well be marginal at best.

What Politicians Say When the Cameras Are Off (or not)

Have you ever wondered what politicians really think?  Here’s a video showing what Republican Congressman Michael Grimm from Staten Island had to say to New York 1 reporter Michael Scotto:

So, there you go.  That’s what politicians really think when they don’t have their talking points doing the thinking for them.

North Korea, Diplomacy and Rare Earth Elements

Just as we've seen the world make overtures toward Iran in recent months, I suspect that next on the "diplomacy" schedule will be North Korea.  But first, let's look at a bit of background information.

Rare earth elements (REEs) or rare earth metals are a group of 17 elements in the periodic table (doesn't that take you back to high school?), consisting of 15 lanthanide metals: lanthanum, cerium, praseodymium, promethium, neodymium, samarium, europium, gadolinium, terbium, dysprosium, holmium, erbium, thulium, ytterbium and lutetium with atomic numbers ranging from 57 to 71.  In addition, scandium and yttrium are considered rare earths since they often occur in the same ore deposits as the lanthanides as you can see on this periodic table:

Despite their name, rare earth elements are not really all that rare; for example, cerium is the 25th most abundant element in the earth's crust at 68 parts per million, about the same concentration as copper and more abundant than lead, gold and platinum.  The problem is that the rare earths are rarely found in high concentrations and are rarely concentrated in an ore body that is easily exploitable.

Rare metals are critical to the world for several reasons, one of the key ones being the growing green energy sector.  Rare earths are used in LED lighting, hybrid cars, wind turbines, thin-film solar cells, permanent magnets, laptop hard drives and the red colour for computer and television screens.  Here is a pie chart showing projected rare earth demand by application for the year 2015 for the United States and the world as a whole:

United States demand for rare earth elements is expected to grow over the coming years; permanent magnet demand is expected to rise by 10 to 16 percent annually and demand for REEs in auto catalysts and petroleum cracking is also expected to increase between 6 and 8 percent annually.  The Department of Defense uses about 5 percent of domestic rare earth production, particularly in permanent magnets, a key part of military weapons systems.

Here is a table showing rare earth element production and reserves for the entire world for 2011:

I think that you can see where a potential geopolitical conflict could occur.  China controls 89 million metric tons of the world's total reserve base of REE or 59.3 percent of the 154 million metric tons in the entire world.  Russia controls 21 million metric tons or 14 percent of the world's total and the United States controls a relatively modest 14 million metric tons or 9.3 percent of the world's total.  On the production side, in 2011, China produced 105,000 metric tons of REE or 95 percent of the world's total with India and Australia producing 2.5 percent and 2.0 percent respectively.  The United States produces no rare earth elements.  This is largely because of environmental regulations associated with the mining of REEs due to the toxic and radioactive waste that is a legacy of rare earth mining.  In fact, Mitsubishi Chemical is now spending $100 million to clean up its Bukit Merah rare earths processing site in Malaysia which was closed in 1992.  The site is one of Asia's largest radioactive waste cleanup sites.

Here is a map showing the flow of rare earth elements around the world:

In 2010, the world demand for REEs was estimated at 136,100 tons with global production of around 133,600 tons.  By 2015, global demand is expected to rise to 210,000 tons per year with China producing around 130,000 tons per year by 2016, leaving a rather substantial shortfall, a situation that  could grow even worse if China continues to set quotas on rare earth exports.  It is suspected that shortfalls will occur in yttrium, dysprosium, terbium, neodymium and europium.  One nation that feels particularly vulnerable to China's REE whims is Japan, particularly given the recent friction between the two nations and Japan's reliance on imported rare earths for its automotive and electronics sectors.

Now, on to North Korea, the subject of this posting.  A recent press release by SRE Minerals, a United Kingdom private equity firm, announced the results of an exploration program in the Democratic People's Republic of Korea (DPRK or North Korea as it is known to most of us).  A joint venture agreement between the Korea Natural Resources Trading Corporation and SRE known as Pacific Century Rare Earth Mineral Limited has announced that an initial assessment of the Jongju REE Exploration Target located about 150 kilometres north of Pyongyang in North Pyongyam Province has indicated a total mineralization potential of 6 billion tons with total rare earth oxide potential of 216.2 million tons.  This deposit alone would more than double the world's total REE reserves.  In total, 664.9 million tons of the target have greater than 9 percent total rare earth mineralization.  According to the company, this would make the Jongju target the world's largest REE occurrence.  A further exploration program is planned for the third quarter of 2014.

As was the case in Iran and its world-leading natural gas and oil reserves, one has to wonder if North Korea's rare earth reserve base pans out to be economically viable, whether the world will beat a path to the nation's door, trying to gain a foothold in a very lucrative natural resource base.

Thursday, January 30, 2014

Job Openings and America's Competitive Job Market

The Job Openings and Labor Turnover Survey (JOLTS) provides us with an interesting insight into America's job market.  According to the January 2014 data release, there was an increase in the number of total private and government sector job openings, hitting 4.001 million in November 2013 as shown here:

Note that this level is still nearly 500,000 job openings short of the level in back in 2006 - 2007.

That said, as you can see on this graph from FRED, that while the total number of job openings is up from a year ago, the number of hires is up very slightly on a year-over-year basis and is nearly 20 percent below the levels seen before the Great Recession, factors that are particularly concerning given that the economy is supposed to be much stronger this year than last:

According to the Bureau of Labor Statistics, there were 10.4 million job seekers in December 2013.  With only 4 million job openings available, that means that there were 2.6 job seekers for every job available.  

Here is a graph showing the number of unemployed workers divided by the number of job openings (i.e. the number of potential applicants for each available job opening):

Just prior to the Great Recession, over the period between the beginning of 2006 and the middle of 2007, there were between 1.5 and 1.6 unemployed Americans for every job opening.  The low point was hit in March 2007 when there were only 1.43 unemployed Americans for every job opening.  During and after the Great Recession, this ratio rose quickly, hitting a  peak of 6.7 unemployed for every job opening in July 2009.  Since then, it has fallen rather substantially, however, as you can see from the graph, the current ratio is still worse than just about any time since December 2000, excluding the Great Recession.

In actuality, the situation is far worse than these numbers show.  If Americans that are neither employed nor looking for work because of the weak labor market were added to the 10.4 million officially unemployed (the U3 unemployed), the ratio between job seekers and job openings would look far worse.  Estimates suggest that there are at least 6 million additional potential workers out there that will enter or reenter the job market once the economy looks stronger or desperation for income sets in.  If the number of job openings does not grow or even if it grows to the level seen before the Great Recession, the ratio between job seekers and job openings could rise from its current level of 2.6 to between 3.4 and 4.0, a level that has not been seen in years between 2001 and 2008.

From this data, we can see that America's job market is caught between a rock and a hard place.  Relatively low levels of job openings and a large number of officially unemployed plus the potential addition of millions of workers to the labor pool will make the job market extremely competitive, even if the economic expansion strengthens and the number of job openings increase.  Unless the number of hires increases to pre-Great Recession levels, the competition for the relatively sparse number of jobs will continue to make life difficult for out-of-work Americans.