Canadian Crude Discount Rising Anew
Growing differential borne by Canadian heavy barrels is more about quality than pipelines this time
WCS differentials have widened to a pandemic-era high of more than $21 per barrel under WTI.
While pipeline bottlenecks have typically driven relative WCS value over recent years, the latest widening is more so the result of crude quality preferences.
The generalized heavy oil cheapening appears to be driven by a combination of factors including (i) stronger Canadian production and the start-up of Line 3, (ii) heavier OPEC barrels coming back to market, (iii) higher natural gas prices pushing up the costs associated with refining heavier crudes, and (iv) the US Gulf Coast oil industry’s uneven recovery from hurricane Ida.
Many heavier crude grades are now trading at wider than pre-pandemic differentials and, while these will likely regain some relative value, this breakdown marks the end of a pandemic goldilocks period for heavier sour crudes defined by tight and uncharacteristically stable spreads.
In some ways, this is good news for Canadian oil producers because it does not necessitate the reopening of the age-old pipeline debate; however, the bad news is that we can’t really do anything to change it.
Western Canadian heavy crude is getting cheaper again relative to the North American benchmark West Texas Intermediate (WTI), but it’s not for the usual pipeline-related reasons. The differential between Western Canadian Select (WCS), Canada’s primary heavy sour export crude blend, and WTI recently spiked to a pandemic-era high of $21 per barrel after more than a year of tight spreads and relative stability. However, WCS hasn’t only gotten cheaper in Alberta: it’s getting cheaper at the other end of the pipes—in Oklahoma and at the US Gulf Coast as well—which reflects a broader quality-related headwind that we’re seeing across global crude differentials. This implied quality differential has widened from about $4 per barrel to more than $10 per barrel over recent months while the implied transportation differential has remained fairly steady at around $7 per barrel.
Anatomy of a Crude Oil Differential
Volatile and crushing differentials have plagued the Western Canadian oil industry for much of the past decade. The relative value of WCS, like that of all crudes, is driven by a cocktail of factors related to the chemical make-up and geographic location of the barrel. At some point I’ll do a longer write-up on how this all works, but in brief:
Quality: Different grades of crude vary widely across multiple attributes, but the two main factors are the oil’s “gravity” or density (i.e., light, medium, or heavy) and its sulphur concentration (i.e., sweet or sour). Lighter barrels typically command a premium because they yield a higher proportion of more valuable petroleum products, like gasoline, with less expensive refining techniques. Sweet barrels are also typically preferred since many jurisdictions require that most of a crude’s sulphur content is removed before reaching consumers (because sulphur is nasty; see: acid rain, respiratory harm, etc.). WCS is an especially heavy, sour crude, which means that it will almost always be worth less than a light, sweet barrel like WTI. That relative value of WCS shifts over time alongside availability of and demand for different grades.
Geography: All oil is priced at a specific location because transporting or storing crude is expensive and complicated. WCS is priced at an oil storage tank terminal in Hardisty, Alberta and WTI is priced nearly 2,200 KM away in Cushing, Oklahoma, with the US Gulf Coast refining hub another 800 KM further down the line (see map). This geographic reality coupled with insufficient pipeline capacity has been the traditional source of heartache for Western Canadian oil producers.
Over the past decade, whenever production in the Western Canadian Sedimentary Basin (WCSB) outpaced available takeaway capacity, a glut of crude would get trapped on the Alberta end of the pipes. This would only be resolved when the local prices were sufficiently depressed such that the difference between the price in Hardisty and the desired destination could cover the higher cost of incremental transport (typically, rail). This cycle was most acutely felt in October 2018 when the WCS differential widened to an unprecedented $50/bbl, which ultimately prompted the provincial government to temporarily curtail domestic production to reduce competition for takeaway capacity.
(I was writing a lot about Canadian heavy crude and pipeline bottlenecks back in those days, and it’s honestly kind of shocking that I haven’t waxed poetic on Canadian crude differentials until this, my 12th newsletter.)
Heavy is the Crude that Wears the Discount
So, what’s happening today? Given the still-fresh pain of the acute 2018 differential blowouts, a widening WCS differential harkens renewed pipeline worries. However, this time WCS’ marketing struggles have much more to do with quality than geography, as evidenced by the simultaneous and equivalent widening of the WCS differential marked in Cushing as well as the US Gulf Coast. Indeed, the implied transportation differential has remained almost entirely stable through this latest bout of widening at around $7 per barrel (see map, “implied transportation”). The quality discounting problem seen today is bigger—more global and more complicated—than the expected Canadian crude transportation story.
We’re seeing similar widening trends across other regional and global crude differentials. At the highest level, the differential between Brent, the light sweet global benchmark, and Dubai, the medium sour benchmark used across most of Asia, recently widened to an 8-year high of more than $5 per barrel. Closer to home, medium sour crudes like Mars and Poseidon at the US Gulf Coast have also sold off relative to their lighter, sweeter counterparts over the past few weeks.
This heavy crude weakening is being driven by a variety of factors that I’ll dig deeper into over the coming weeks. First, we’re seeing strong Canadian production and the start-up of Line 3, Canada’s first new[ish] pipeline in ages, which facilitates even more heavy crude inflows. At a global level, the return of withheld, predominantly heavier OPEC+ production increases the availability of these heavy crudes, while crisis-level natural gas prices push up the costs associated with refining heavier barrels. This is compounded on a local level as US Gulf Coast refineries continue to struggle to recover after hurricane Ida-related shutdowns, with offshore platforms pumping heavier grades restarting more quickly. Now you have more heavy crude available than the refining market wants to process—at least at narrow differentials. I also note that some industry players have claimed simple seasonal weakness as refiners switch up their product mix; however, this seasonal weakness hasn’t really been seen over the past two years.
The latest bout of WCS differential widening is very much a good news/bad news story for Canadian oil producers. The good news: This (finally) isn’t a pipeline or Canada-specific problem. Moreover, quality differential widening has much less room to run compared to almost-ceilingless transportation-related discounting. The bad news: there’s nothing really to be done about the widening from a Canadian industry perspective and it seems to mark the end of a short-lived pandemic goldilocks period for heavy crude differentials. In many ways, the recent weakness of WCS, and heavy crudes more broadly, is yet another post-pandemic return to “normal”: WCS’ implied quality differential spent most of the pandemic at an abnormally narrow $2-4 per barrel versus the pre-2020 norm of nearer $5-8 per barrel, though we’ve now overshot that norm which means we’re likely to gradually tighten again as markets normalize.