The Petroleum Economics Monthly

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1 The Petroleum Economics Monthly Philip K. Verleger, Jr. Volume XXVIII, No. 2 February 2011 THE TAR SANDS ROAD TO CHINA: THE LONG, TORTURED ROUTE FROM ALBERTA TO DALIAN The Tar Sands Crude Oil Road: Alberta, Canada to Dalian, China Source: PKVerleger LLC. (Publication Date: 3/22/2011) 2011, PKVerleger LLC. All rights reserved. ISSN Reproduction of The Petroleum Economics Monthly in any form (photostatically, electronically, or via facsimile), including via local- and wide-area networks, is strictly forbidden without direct licensed permission from PKVerleger LLC. Contact Dr. Verleger at 2000 E. 12 th Ave, Unit 32, Denver, CO 80206; 540 Fox Run Dr, Carbondale, CO 81623; or phil@pkverlegerllc.com.

2 The Tar Sands Road to China: The Long, Tortured Route from Alberta to Dalian Philip K. Verleger, Jr. PKVerleger LLC Disclaimer: Although the statements of fact in this report have been obtained from and are based upon sources that PKVerleger LLC believes to be reliable, we do not guarantee their accuracy, and any such information may be incomplete or condensed. All opinions and estimates included in this report constitute the judgment of PKVerleger LLC as of the date of this report and are subject to change without notice.

3 Table of Contents Summary... 1 Section I. The Tar Sands Pipeline... 3 Section II. Oil Price Implications of Forced Suspension of Libyan Exports and Disruption of Japanese Distillate Exports Glossary Statistical Appendix List of Figures Figure 1. Crude Oil Production in Canada History and Projection... 4 Figure 2. Current Keystone Pipeline and Proposed Keystone XL Pipeline... 5 Figure 3. Daily Spot Prices for Crude Oil and Principal Products, July 1990 to January Figure 4. Daily Spot Prices for Gasoline and Distillate Fuel Oil in New York and on the Gulf Coast, August 1, 2005 to December 31, Figure 5. Weekly Crude Inputs to U.S. Refineries in Figure 6. Weekly U.S. Imports of Petroleum Products in Figure 7. Evolution of Spot Prices for Three Petroleum Products, January 2007 to December Figure 8. Retail Gasoline and Diesel Fuel Prices in Germany and France, January 2006 to January Figure 9. Retail Diesel Prices as a Percentage of Retail Gasoline Prices (including taxes) in Germany and France, January 2006 to January Figure 10. Forward Price Curve for WTI: Early August, Early September, and Mid-September in Figure 11. Forward Price Curve for Heating Oil: Early August, Early September, and Mid-September in Figure 12. Rise in Crude Oil Forward Price Curve, July 27, 1990 to October 26, Figure 13. Reversion of Crude Forward Price Curve, November 2, 1990 to December 28, Figure 14. Reversion to Stability: Weekly Forward Price Curve for Crude, Beginning of January to Beginning of February Figure 15. Monthly Libyan Crude Oil Production, 1999 to List of Tables Table 1. U.S. Gulf Coast Refiners Expected to Purchase Crude from Canada... 9 Table 2. Estimated Distribution of Libyan Exports, Early Table 3. Price Increase Predicted for Libyan Disruption vs. Disruption of Persian Gulf Exports Table 4. Price Forecast i

4 Summary This issue of The Petroleum Economics Monthly covers two topics: 1) the market impact of the Libyan disruption and the earthquake in Japan, and 2) the implications of efforts by Canadians to expand the Keystone pipeline, a facility for starting tar sands crude on the first leg of a long journey from Alberta to China. If built, the Keystone XL pipeline would run from Hardisty to Houston. The report begins with the pipeline. The TransCanada Corporation is behind the Keystone XL pipeline. The U.S. State Department is now reviewing the company s environmental impact statement. According to Platts, the State Department decision should come by the end of the year. 1 The pipeline s proponents claim it will improve U.S. energy security by allowing us to replace oil imported from politically volatile foreign sources such as the Middle East and Venezuela. In filing with Canadian regulators, the proponents also assert the pipeline will allow Canadians to manipulate U.S. oil prices and thus extract an extra $4 billion per year from American consumers. 2 The pipeline s opponents object to the environmental impacts of producing crude from Canadian oil sands. They believe production will boost greenhouse gas emissions and destroy Canadian resources unnecessarily. Consumer groups also oppose the project based on its stated intent to push gasoline and diesel prices in the U.S. Midwest higher. This debate is almost irrelevant, however. The proposed pipeline is really the Canadian equivalent of the Silk Road, that is, a long, torturous way to move crude oil from Canada to China. As the cover-page map shows, crude will flow south from Alberta to Houston and then east on large tankers through the Gulf of Mexico. From there, it will go southeast to the Cape of Good Hope and then east to China or south to Cape Horn and then northwest to China. The crude path that begins with the Keystone pipeline is no different from Marco Polo s famous trade route through Asia. We call our version the Tar Sands Road. If it is built, the Tar Sands Road Pipeline (TSRP), in addition to allowing Canadian crude to reach China, will turn the U.S. Gulf Coast into the world s most profitable refining center. Margins on the Gulf will likely be $4 to $6 per barrel higher than margins in Asia, the Middle East, or Europe for equivalent facilities. The high margins result from shipping economics that will force all crude prices on the U.S. Gulf to be $3 to $6 per barrel lower than in Asia. By implication, the TSRP will also lead to lower prices for crude oil produced from U.S. facilities in the Gulf of Mexico and midcontinent. In short, Canada s push to market its crude will hurt U.S. producers but benefit U.S. refiners. TSRP proponents disagree with this view. The pipeline, they argue, will displace crude from the Middle East and Venezuela. They present an analysis by energy industry consultants Purvin & Gertz to support their view. The study is an excellent example of static economic analysis, that is, analysis that does not account for market behavior. Purvin & Gertz ignore the economic incentive of Gulf Coast refiners to limit Canadian crude purchases to force sales to China. Exercise of such market power profits refiners because it depresses all prices. Purvin & Gertz also 1 Platts Oilgram News, March 18, See Purvin & Gertz, Western Canada Supply and Markets, February 12,

5 ignore the fact that Saudi Arabia, a key U.S. Gulf supplier, sells crude on a market-related basis and thus cannot be pushed out. Saudi Arabia may also want to sell crude to the U.S. Gulf to depress North American prices and discourage production there. As we explain in Section I, if built, the TSRP will contribute to much larger refining margins in the Gulf and lower U.S. crude prices, including for WTI. It will also link Canadian with Chinese markets. Section II reviews the market situation after the Libyan crisis and the Japanese earthquake. These events will once again squeeze the global ultra-low-sulfur diesel (ULSD) market. Our analysis suggests prices could easily surpass the 2008 peaks absent actions by consuming governments. These could include the release of strategic sweet crude reserves or the relaxation of sulfur standards for some petroleum products. We view either action as unlikely and anticipate much higher crude prices as a result. Section II concludes with a price scenario. 2

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