What’s Impacting Canadian Oil Prices?May 18, 2018

Historically, the later part of the economic cycle has been Canada’s time to shine, as classic late-cycle resource sectors tend to outperform with faster economic growth, closing output gaps and rising inflation and energy prices. However, last year’s breakdown in Western Canadian Select (WCS) crude prices relative to US West Texas Intermediate (WTI) crude prices has put this historical relationship in jeopardy. Although a recent recoupling has improved the outlook for Canada, the persistent volatility begs two questions: what caused the divergence, and can improved WCS performance boost Canadian assets like the loonie and our energy-heavy S&P/TSX Composite?

The chart below shows WCS shrugging off its terrible performance at the end of 2017 as it fell while WTI moved higher. Year-to-date, WCS has tripled the performance of WTI, and is now up 65% as of mid-May.

What caused the divergence between WCS and WTI?

To answer the first question, we believe the main reason for WCS underperformance in recent years was from increased demand for alternatives to WCS. In particular, robust US shale oil production has meant more competition for Canadian oil that largely didn’t exist a decade ago. Production in areas like the Permian Basin, Eagle Ford, Bakken and Marcellus is now larger than Canada’s total production, reaching eight million barrels per day (up almost 25% in the past year!). Additionally, US shale oil is lighter and less energy-intensive than heavy WCS to convert into oil products like gasoline, so shale oil supply has likely displaced some WCS demand.

On the supply side, WCS suffers from insufficient infrastructure capacity like pipelines and rail, leading to a discount on Canadian crude and often leaving it stranded and unable to reach key refining markets in the US. Although the Keystone XL Pipeline has been approved, it is years off from being built, and continuing uncertainty over the Kinder Morgan Trans Mountain Pipeline further clouds the WCS supply outlook. Rail is being used to ship WCS, but capacity is limited to the point where trucks are being used to transport it— this inefficient method shows how producers are awash in oil and desperate to move their product to market.

A light at end of the tunnel for WCS?

The knock on shale oil has always been that of uncertain production, due to potentially rapid depletion rates. The below chart illustrates this point. After a massive productivity surge in 2016, where average production per rig jumped to over 17,000 barrels per day, the following year saw shale production fall by roughly half, providing an opening for more WCS demand.

Furthermore, WCS has been benefiting from a 35% collapse in Venezuelan heavy oil production as the country is engulfed in political turmoil. This may also improve the demand for WCS, given the similar crude oil characteristics as Venezuelan oil.

One of the reasons we have been cautious about Canadian assets over the past year has been our view that oil prices and—in particular WCS prices—may be restrained, preventing Canada from achieving its historical relationship as a late cycle winner. If higher oil prices are sustained (recent sanctions imposed on Iran could take up to one million barrels per day off the market), this could mean positive earnings revisions for Canadian oil companies that have unhedged production, and a stronger Canadian dollar, given its historical correlation to oil prices. Should the environment continue to improve for WCS, we would look to overweight Canadian stocks and currency.

Stephen Lingard’s comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.