Earlier this week, the Alberta government announced that it will require the province’s energy producers to cut back on oil production starting next year. Cancelled and delayed pipeline projects have been problematic for the industry for several years. But a recent ramp-up in production from expanded oil sands capacity, in addition to temporary shutdowns of refining assets south of the border, has severely exacerbated the problem—sending the price of Alberta’s crude oil to record lows in comparison with U.S. benchmark prices. The government’s unprecedented intervention is a desperate measure to alleviate bottlenecks and bolster prices. Whether there’s a payoff will be hard to determine and will depend on whose opinion you ask on this complex issue with its far-reaching implications across Canada.
According to the government’s plan, cuts will be imposed on operators for all volumes above a 10,000 barrels per day threshold, with a target of cutting a total of 325,000 barrels per day of production at the start of 2019 but winding down to 95,000 by year-end. The initial cut is equivalent to an 8.7 per cent reduction and is meant to alleviate inventories and transportation bottlenecks and help narrow the price differential between Alberta’s crude oil and other benchmark crudes.
This is a significant move, one that is certain to have an impact on the province’s economic performance. Oil production contributes roughly 25 per cent to Alberta’s economy annually. If sustained throughout the year, and all else being equal, we estimate the production cutbacks could shave 1.6 percentage points off Alberta’s previously anticipated headline GDP growth rate for 2019 of above 2 per cent. To the east and west of the province, the cuts are also bound to have implications for Canada’s economy due to strong trade and supply-chain linkages. The big question is whether the production declines will bolster prices enough to make up the difference, and whether that difference would generate future economic activity that would have not taken place without the mandated cuts.
Meanwhile, the reaction from industry and analysts has been mixed. As always when governments interfere in markets, there are bound to be winners and losers, and there will likely be unintended consequences. For example, producers below the 10,000 barrels per day threshold, will not suffer from imposed cuts and will benefit from higher prices. This will also be the case for oil producers in neighbouring British Columbia, Saskatchewan, and Manitoba. Meanwhile, larger integrated producers that have invested in upgrading and refining, and whose income statements are less exposed to crude oil differentials, will also be forced to curtail their production volumes. If prices don’t appreciate as much as production pulls back, these producers are likely to be losers. Large producers that have hedged future production levels at higher (pre-collapse) prices and those that must pay for the use of pipeline transportation regardless of whether or not they use it (“take or pay”) are also less likely to see any upside from the mandated cuts. The list goes on.
Certainly, the free-market’s invisible hand was already at work. Drilling intentions and production were adjusting to the low prices and higher transport costs, and the price differential between Western Canada Select and West Texas Intermediate (the U.S. benchmark) had recently narrowed from the peak of over US$50 per barrel reached in early October. The premise of a free market is that stresses to economic conditions will weed out costlier producers and allow the most efficient and productive to survive. But letting markets react can take time and be harmful to productive capacity once the stress is relieved.
Moreover, we must consider that the situation that Alberta is currently facing is aberrant. The industry was given the green light to develop production with the expectation that transportation capacity would follow. Many pipeline projects were planned, but over the years too many of them have been cancelled or delayed, leaving less-efficient rail transportation to try to absorb the overflow. The current situation, influenced by political and judicial decisions both north and south of the border, would have been difficult for Alberta’s oil patch investors to plan for or anticipate.
In turn, the mandated cuts are the latest in a patchwork of near-to-long-term government initiatives aimed at shoring up the current market distortion that is largely the result of failures in pipeline infrastructure development policy. Other initiatives include the federal government’s owning of pipeline assets, the large fiscal incentives offered by Alberta to encourage investment in new upgrading assets, and, more recently, the provincial government footing the bill for new locomotives and rail cars for transporting crude.
While intervening in industry production plans is unconventional and could hurt the province’s attractiveness for future investment over the long term, the provincial government’s near-term solution will likely be effective in shoring up prices and heading off a decline in royalties and a larger pullback in activity in the oilfield services sector. Reducing the cuts as inventories are absorbed and setting a firm end date (the end of 2019) for the program are important measures that will help mitigate negative views about market intervention. In the end, the government’s measure of success will depend on whether prices rise by at least 8.7 per cent more in 2019 than they would have risen had the production cuts not been imposed.
But quantifying the counterfactual is a problem that economists regularly face. Because it will be difficult to isolate what effect the cuts themselves have had on prices, the controversy over this policy action is certain to linger. By the end of next year, we won’t know with any precision what the price of Alberta’s oil would have been had the cuts not been imposed. What we can hope for is that, by the end of 2019, Canada will have found long-term and permanent solutions to the transportation bottlenecks. It will be a relief to all those involved if the province does not have to even consider stepping in again to control production.
Pedro Antunes is Chief Economist and Executive Director, Economic Outlook and Analysis, at The Conference Board of Canada.
Carlos A. Murillo is Senior Research Associate with the Conference Board’s Energy, Environment, and Transportation Policy Group.