May 2017 CERI Crude Oil Report The Price-Value Debate of the Around the same time, the Government of Alberta (GoA) Sturgeon Northwest Refinery pursued ways to diversify its economy, and given hydrocarbon extraction is a significant contributor to the Alpha Sow provincial economy, it makes sense to capture as much value as possible in the midstream and downstream of “Price is what you pay, Value is what you get” the hydrocarbon extraction value chain. Thus, the way to Warren Buffet achieve this goal was to promote/invest into refineries, upgraders, petrochemicals and chemicals manufacturing There is a debate whether or not the Sturgeon Refinery plants through sound policy and/or incentive programs. project1 is in the best interest of Albertans as part of The promotion of the diversification is based on the provincial efforts to diversify its economy. At the core of market-economy rules, where the role of government is the debate is a misunderstanding that tends to mix two to set the policy and let market forces play out. concepts of price and value. The opposition side talks about a project’s high cost and risk profile, while Faithful to the market economy and seeing competitive proponents speak of its importance to the provincial and forces emerging in the US and around the world, the GoA national economy. While the project was proposed a saw a royalty system (“a share of production from decade ago, this misconception is still present, even as resources the government owns on behalf of the refinery is soon to be commissioned and scheduled 2 Albertans ”) as an effective way to intervene. Apart from to deliver its first barrel of low-sulphur diesel in late that, under the Mines and Minerals Act, the government 2017. has the authority to take royalties in kind instead of cash for any of its resources, recognizing “that to build a This article analyzes the concepts of value and price for stable and prosperous future, the province must get the new refining/upgrading capacity to be built in the best economic return on the development of its energy province. Since the Sturgeon Refinery is the only refinery resources.” The program for oil sands resources was to be built in Canada since 1984, these concepts will be coined as “Bitumen Royalty In Kind” (BRIK), and its discussed in the context of this project. objectives are to: Background i. foster value added oil sands development and use As the oil sands industry was developing, bitumen was the royalty bitumen to stimulate economic growth by mined and upgraded into light synthetic crude oil (SCO) facilitating the development of upgrading facilities; and shipped for further refining to the US. When the in ii. enhance the transparency and liquidity in the situ Steam Assisted Gravity Drainage (SAGD) process bitumen market and share the gains and risks became commercial, oil producers started to dilute the between synthetic and crude bitumen. bitumen and ship it directly to the market without any transformation; as a result, the anticipated upgraded In May 2010, the GoA’s successful applicant for the bitumen fell below 50% share of total bitumen request for proposal on “…applications in using Bitumen production. Royalty-in-Kind” at a “value-added facility…” was announced as the North West Redwater Partnership, equally owned by the North West Upgrading Inc. (NWU) CERI Commodity Report – Crude Oil Editorial Committee: Ganesh Doluweera, Paul Kralovic, Dinara Millington, Megan and Canadian Natural Upgrading Ltd. (a subsidiary of Murphy, Allan Fogwill Canadian Natural Resources Ltd.). About CERI The Canadian Energy Research Institute is an independent, not-for-profit research establishment created through a partnership of industry, academia, and government in An agreement was signed between the GoA agent, 1975. Our mission is to provide relevant, independent, objective economic research in Alberta Petroleum Marketing Commission (APMC) and energy and related environmental issues. For more information about CERI, please visit our website at www.ceri.ca or contact us at [email protected]. the North West Redwater Partnership for a 30-year term Relevant • Independent • Objective Page 2 cost of the service contract. The North West Redwater Figure 1: Modification of the Northwest Refinery Partnership will construct and operate the Sturgeon Project Refinery, refine the bitumen supplied by the GoA and CNRL and market the end products. The province will retain ownership of the products (in the same proportion as bitumen feedstock) and pay the processing toll to the NWR for refining the bitumen.3 The capital cost was estimated to be $5.6 billion, and any overruns above $6.5 billion should not be part of the processing fees. The original terms also stated that construction shall begin in spring 2013.4 Project Description Today, the refinery is almost operational at $8.6 billion (2015 C$) capital cost, is 45-km northeast of Edmonton, and composed of more than 7,0005 pieces of equipment, 1,1506 modules, and as many as 20,0007 process loops. The project was reclassified from an upgrader to a refinery in 2016 to process raw bitumen to high-value Source: T. Morton, SPP Communique, Vol 7, April 2015 end-product such as low-sulphur diesel (see Table 1). The facility incorporated a carbon capture and storage One of the most striking features of the agreement is the system that will send the captured carbon to toll structure agreed by the GoA and its partners. It is a conventional oil fields for enhanced oil recovery through monthly fee, composed of the cost of debt, equity, the Alberta Trunk Line (ACTL). ACTL is a 240-km, 16” inch operating and incentive fees. The incentive fees stipulate diameter pipeline built by Enhance Energy Inc. bridging that if revenue net of feedstock and operating costs is the CO2 capture site at the Sturgeon Refinery (Alberta positive, NWR will charge the GoA 15 percent of the amount. If it is negative, a deduction is made on the next Heartland) to the central Alberta oil fields. 8 positive revenue cycle within 24 months’ maximum. The Table 1: Northwest Refinery Output direct consequence of this incentive will always be to Capacity Units Status deliver a positive margin for the NWR. Otherwise, it Startup late bears a significant risk transfer to GoA. Figure 2 Phase No 1 50,000 bpd 2017 describes how margin, tolls and incentives are related. Project Phases Phase No 2 50,000 bpd NA Phase No 3 50,000 bpd NA The incentive means that if there are losses, they are Ultra Low Sulphur Diesel 40,250 bpd GoA losses, and if there are gains, they are shared gains, Low sulphur Vacuum gasoil 8790 bpd an arrangement viewed by many as a serious “Achilles Phase No 1 Output Mixed of LPGs 3,363 bpd heel” for the GoA. Diluent Mixed 28266 bpd Carbon Capture 3,500 Ton/day Sulphur 431 Ton/day Figure 2: Average Sturgeon Refinery Cost of Service Toll Source: Conference Board Canada (2015 C$ per bbl) Project Timeline and Financing Arrangement The project started off with low capital cost and low risk for both parties, but as time went on and the economic conditions started to deteriorate, changes were made to the parties’ agreements (see Figure 1). The GoA engagement evolved from supplying the bitumen feedstock to the revenue guarantee (30-year toll fees) and then lending $300 million to the project. Source: Conference Board of Canada CERI Commodity Report - Crude Oil Page 3 Price Versus Value light-heavy crude differential risk as any other refinery By looking at the initial quote closer: “Price is what you shareholder. The narrower the spread, the higher the pay, Value is what you get,” price is a paid amount in risk for the province to lose money by paying toll fees order to get goods or services. On the other hand, value and selling the product. implies a utility or a worth of a good or service for an individual or entities. In the Oil Sands Dialogue11 initiated by IHS CERA on June 7, 2012, participants were asked the following question In this example, the province is willing to pursue efforts “Upgrading or Refining in Alberta (or Not).” The draft to process bitumen to capture more value before report was completed and published in March 2013. It sending it to the market as a means of an attractive concluded that there is no economic case for the economic policy. Moreover, prices are set by the market greenfield upgrading units in Alberta due to the narrow conditions; value is often determined subjectively. There spreads between light and heavy crudes and prohibitive is a case to be made that no private investor was willing construction costs. Furthermore, constrained labor to build a new refinery or an upgrader, in fact, many market conditions (at that time), meant that there is upgrader projects were canceled. Yet, the price tag of higher economic value for Alberta to continue to export “adding value to bitumen” before selling it seems to be raw bitumen than build new refineries or upgraders. measured in the economic impacts of the project rather Alternatively, the impact on the labor market might not than through a conventional project finance analysis stand true anymore because of the 2014 oil price (IRR). downturn, which caused many firms to lay people off. The unemployment rate in Alberta rose from 4.7 percent In the absence of a liquid market where price is set by an in January 2014 and peaked at 9% in November 2016. equilibrium supply/demand, the price for the current project is set by an agreement between GoA and the The report went on to say that efforts should focus on NWU through a negotiation based on the assumptions of modifying existing upgraders or refineries to process oil a forecast.