This policy brief, which is the second of three companion pieces, was commissioned by Oxford Analytica. The first piece, explainded the legislation and the other, which will be published in the next few days, focuses on the impact of the California legislation on Brazil potential ethanol exports to the US.
SUBJECT: The challenges facing the Canadian oil sands industry.
SIGNIFICANCE: With the return of oil prices to a range of 60-70 dollars per barrel, the oil sands industry is regaining profitability, attracting investment and generating merger activity. However, projected production growth over the next decade faces a number of potential downside risks, including the danger that US legislation designed to control CO2 emissions may restrain the growth of the industry’s US market share.
ANALYSIS: The production of crude oil from the massive reserves present in Alberta’s oil sands is a large and growing industry. However, realising value from this resource faces a number of challenges, most recently from US federal and state efforts to curb the threat of climate change by reducing CO2 emissions.
Massive oil sands potential. In terms of proven reserves, the 172.7 billion barrels contained in Alberta’s oil sands are second globally only to Saudi Arabia. In 2007, production averaged 1.32 million barrels per day (b/d), and current forecasts from the Alberta government indicate that from 2008-17 production will more than double, perhaps reaching 5.0 million b/d by 2030. Presently, marketable oil sands account for over 70% of Alberta’s and 43% of Canada’s total crude production. From 2000-08 an estimated 86 billion Canadian dollars (75 billion dollars) were invested in the oil sands. Before the financial crisis and concomitant drop in oil prices, another 170 billion Canadian dollars in investment was expected.
Post-crisis outlook. However, these projections have recently been revised downward. The slowing pace of oil sands industry expansion is only in part attributable to the financial crisis, the resultant tightening of capital markets and the precipitous drop in oil prices. Other factors have also come into play:
- US regulatory uncertainty. Uncertainty over future environmental legislation, principally in the United States, where environmentalists are waging a relentless campaign against this particular source of crude oil, is contributing to the slowdown.
- Canadian domestic concerns. At home, resistance comes from many groups, including the First Nations, and are not restricted to the question of emissions and energy use. Concerns over water usage and availability in Alberta are also central
- US federal regulation. While the Waxman-Markey Climate Change Bill approved by the US House of Representatives and now being debated in the Senate is certain to have an impact on oil sands producers, the details will only be known if and when the bill is approved by the upper chamber, goes through the reconciliation process and is signed by President Barack Obama.
Yet the most immediate concern is not the federal legislation slowly taking shape in Washington, DC, but the new fuel regulations approved by the state of California in April.
California regulatory risk. The fact that California is determined to diversify away from hydrocarbons does not bode well for Canada, particularly Alberta, a province that is counting on developing its massive oil sands reserves to serve the US market:
- US market potential. While current sales from Alberta to California are paltry and represent less than 1% of the state’s total supply, Alberta producers were counting on the future potential of that market. California is the largest gasoline consumer in the United States and its indigenous production, as well as that of Alaska — the state’s other domestic US supplier — are both in decline. Although Canadian producers expect increased competition from alternative fuels, they are cognisant that the United States will continue to consume hydrocarbons for decades to come. Given Washington’s desire to reduce Middle Eastern oil imports, Canada has been banking on its position as a secure energy supplier to its southern neighbour.
- California regulatory hurdles? Consequently, Canadian producers were chagrined with the California Air Resources Board’s (CARB’s) arbitrary decision to include only suppliers of at least 2% of total production in the ‘2006 California Baseline Mix’ — which automatically forces Alberta to create a separate pathway for crudes coming from the oil sands. In addition, emissions from this source will have to be below 15g/MJ (grams per mega-Joule) — another arbitrary level — for the product not to be labelled ‘high carbon intensity’, a classification that is sure to make any product arising from oil sands-derived crude less competitive.
- Canadian government objections. Both Ottawa and the Alberta government have written to CARB and California Governor Arnold Schwarzenegger expressing their concerns. They stress that, as designed, the state’s Low Carbon Fuel Standards (LCFS) do not consider energy security, favour different crudes which might not lead to any decrease in global ‘greenhouse gas’ (GHG) emissions, and may unfairly target oil sands crudes. Their contention has three key bases:
- Increased OPEC dependence. Limiting to the future use of oil sands in California means that the state will need to increase future imports from less stable parts of the world. The rationale is that over the last 20 years imports have increased from 5% to 45% of total supply. Of this total, more than 80% comes from OPEC countries.
- No overall emissions reductions. By favouring lighter crudes from other sources, California is likely to displace heavier crudes, such as the oil sands product, to other US jurisdictions, leading to no overall reduction in US or global GHG emissions. Moreover, they stress that the difference among crudes is marginal as approximately 75-80% of GHG emissions come from fuels’ use in vehicles, rather than fuel production.
- Covert protectionism. They point out that California’s own heavy crude, which is part of the ‘baseline mix’, is estimated to have recovery emissions of approximately 19g/MJ — which is similar to or even higher than the range of emissions associated with extracting oils sands crudes. Canadian officials have warned state authorities that “unjustifiable discrimination against Canadian crude oil” would potentially violate US global trade obligations.
- Anti-regulatory efforts. If the Canadian and Alberta governments are relatively circumspect in their communications, their lawyers are less restrained — and are preparing to lobby and to prepare cases against the new CARB rules:
- Rhetorical salvos. One of the CARB’s own board members told the US media on April 30 that an important objective of the LCFS was to “discourage those investments” in fuel sourced from oil sands.
- Legal counterblow. However, there may also be more substantive grounds to lodge a formal complaint against the LCFS at the WTO and at the NAFTA tribunal. There is a plausible case that the California LCFS are in violation of the Most Favoured Nation clause that prohibits member states from imposing treatment “less favourable than that accorded to like products of national origin”. In this case, the claim would be that oil sands crude is like some California crudes, and consequently, should receive the same treatment.
Both WTO and NAFTA rules also contain provisions which allow for otherwise impermissible trade-effecting measures, in cases where there is reasonable scope for regulation on the grounds of individual health or environmental protection. Yet these would be difficult arguments for Washington to make before the WTO. For example, in the case of individual health protection, the United States would have to prove that additional emissions from Alberta oil sands poses a threat to the life or health of individuals, animals or plants in California.
CONCLUSION: While investors, producers, and the Alberta and Canadian governments are ready substantially to increase production of oil sands to meet US energy demand and energy security woes, the heavy environmental footprint of this energy source is meeting public resistance. Future legislation is likely to impose penalties on oil sands, reducing profits and acting as a constraint on expansion of production.