Refine it where you mine it? The value-adders are back.

We should be finding the most lucrative markets for our bitumen and charging an appropriate rate to extractors, writes Andrew Leach

World's largest tar sands deposits spark environmental crisisIn December, I wrote about the propensity for some to oppose pipelines on the basis that we should be refining the oil here, rather than shipping raw resources out of the country to more lucrative markets elsewhere. With today’s Northern Gateway announcement from the federal government, the value-adders are back. Given conversations I’ve been having on Twitter for the past couple of days, I thought I’d try to provide a few longer answers to some common questions.

1) Don’t you believe in value-added?

Yes, of course—mostly. Value-added in the strict economic sense implies that you generate value over-and-above the value of the inputs used in the process. In the case of refining, this should imply that the value of the refined product exceeds the value of the crude oil or bitumen feedstock by a sufficient margin to make up for the opportunity cost of the capital, labour, and other inputs used in production. Statistics Canada uses a particular definition of value-added, in which it effectively assigns the opportunity cost of capital and the value of labour to zero, which allows them to calculate the value-added of any activity as being equal to the sum of the profits, taxes, royalties and wages. According to this calculation, a refinery that breaks even in revenue to the operator net of depreciation of capital would be considered to add value, since the wages paid to employees would be positive.

Here’s my problem with that calculation: The opportunity cost of a tradesperson, engineer, or manager who might be employed in a refinery is not zero, as these people would not otherwise be unemployed. In fact, if we had an unemployed refinery workforce at the ready, it would be much easier for a company to build a refinery here.

2) So you think we should simply ship our raw resources?

No, I think we should maximize the value of our resources, not the degree to which we process them. Let me give you an example. It’s easy to look at a graph like the one below and conclude that we should refine more of our own oil, with bitumen priced, on average, $60 per barrel below the price of gasoline over the first half of 2014, when you’re not betting your own money. Now, think of building a refinery. To build a refinery to process the volume of bitumen proposed for shipment through Northern Gateway (about 400,000 barrels of bitumen, net of diluent), you’d likely have to: invest somewhere between $20 billion and $30 billion; wait five or more years to obtain all the permits and complete construction; and likely spend about $10 per barrel in operating cost to capture that spread. Still, it’s a great investment if you can count on $50 per barrel in operating profits. The question is whether you can count on that. If you can, a refinery under these conditions would be a no-brainer for any company.

Prices for oil sands bitumen (Western Canada Select prices net 30% per barrel condensate diluent), synthetic crude oil, global light oil (Brent) and gasoline (NY Harbour) in Canadian dollars.

Prices for oil sands bitumen (Western Canada Select prices net 30 per cent per barrel condensate diluent), synthetic crude oil, global light oil (Brent) and gasoline (NY Harbour) in Canadian dollars.

It’s important to think about the other side of the ledger, though (the refinery in this case would be underpinned by discounted bitumen): our resource trading below its fair price on world markets. The real question we should be asking is not whether more refining is viable, given discounts on bitumen, but why we are selling our resources at a discount.  If refining truly increases value, based on the true value of bitumen, I can’t see why you’d need a government to force it to happen.

I can’t see how advocating for policies which would devalue our resources under the guise that it allows domestic processors to add value to them makes sense.

3) But you must admit that there is less economic activity and lower wages with extraction than with extraction and refining?

Yes, in a simple calculation. In some research I pulled together for a conference put on by the MacDonald Laurier Institute, I looked at this issue by comparing three projects: a stand-alone bitumen mine similar to Imperial Oil’s Kearl Project, the same mine coupled with an integrated upgrader, or with a hydrocracking refinery.

Operating and capital costs for bitumen extraction, upgrading, and refining.

Operating and capital costs for bitumen extraction, upgrading, and refining

Obviously, the revenue per barrel produced and the total revenue over time is higher as you undertake more processing and produce a higher-value product. I want you to remark on a couple of other elements: First, the average taxes and royalties per barrel decrease as you increase the degree of processing, and the profit share of total revenue increases. Why? Because the added processing earns lower rates of return on capital and, so, takes longer before it begins paying taxes and, since royalties are only charged on bitumen, the royalties don’t increase with more upgrading or refining. By contrast, in free cash flow per barrel of bitumen produced, the refinery option looks much, much better. If you count operating costs as benefits, which some would, because these costs include wages, these also increase with the refinery. Based on this analysis, it seems clear that companies should seek to build more refining.

But, as discussed above, Canada does not have reams of workers simply waiting around for the next refinery to open. The more likely scenario is that any increased activity in one part of the oil and gas sector will detract from another part; more refining would mean fewer other things, due to general equilibrium effects in the labour market, and so on. It’s not going to be perfectly zero-sum, of course: The increased activity in the oil and gas sector might cause a shift in resources from other manufacturing sectors, instead. What happens if we take that tradeoff seriously, and look at the returns per dollar invested? The graph below looks at what happens if we invest the same dollars we would have invested into extraction into smaller extraction projects with associated value-added processing.

Operating and capital costs for bitumen extraction, upgrading, and refining.

Operating and capital costs for bitumen extraction, upgrading, and refining

The picture changes a great deal. If we’re going to talk about what “we” should invest in, the above graph really muddies the waters. In taxes and royalties, it’s no contest—extraction wins. In payments to labour, the three investments  are fairly similar. In profits, the extraction plant with an integrated refinery earn a little more, given current pricing conditions, and a little less if you look at global pricing conditions.

If you are looking at value-added per dollar invested, or value-added per dollar of labour input, extraction trumps. If you are interested in labour productivity, value-added per unit of labour invested is what you should be looking at, not the value of the end product produced, per se.

4) Fine, so we’re stuck just giving away the bitumen.

No, exactly the opposite. We should be finding the most lucrative markets for our bitumen and making sure that we charge an appropriate rate for companies extracting it. We must take advantage of cheap, global refining capacity to maximize the value (again, as opposed to maximizing the processing) of our resources. Go back to the first graph, and ask how much bitumen should be worth if someone somewhere can convert it to gasoline for $10 per barrel—it should be worth gasoline prices, net $10 per barrel plus transportation costs to get it to their refinery. If we choose to have our bitumen processed in a more expensive refinery, we can make the math work only with either a discount on the bitumen or with other incentives; we’d be spending bitumen to finance refining. If your worry is that we’re not getting enough value for our bitumen, that’s a legitimate question to ask, but I’d ask whether you’d accept to have those higher royalties spent on subsidized refinery. If not, then don’t advocate for underpinning a refinery with bitumen discounted via trade policy. It’s exactly the same thing, with the intermediate step hidden.

 




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Refine it where you mine it? The value-adders are back.

  1. Would we also need to look at potential sales lost as some of the downstream customers will only buy raw bitumen so as to maximize the number of products they can convert that bitumen into? I would think that adding refining at our end only complicates the process of getting that refined product out into the broader petro-chemical refining and processing market. While there are always economic opportunities made available by refining here, do we run the risk of creating a refined product that isn’t price competitive due to the increased cost of then getting that product downstream to the next step in whatever process it will undergo?

    • Not really. Refining where it used is more economical, more green, more efficient and economical.

      A barrel of oil produces hundreds if not thousands of products, diesel, gas, 100s of plastics, solvents, engine oil and a lot more. To split them in Canada, needs all to be packaged and shipped desperately. Alberta already has a worker shortage, so to refine it here hasa huge human capital problem and the bureaucracy is astounding to do anything in Canada.

      But hey, media, politics, and greed corruption in Canada do like to BS people. But this is reality. And so few embrace reality, they illogically think they are exempt from it.

  2. Yes, in an unconstrained world, capital will flow to where the paper returns are greatest. Endlessly.

    • Capital and money flow to those that 1) know how to manage it and 2) the most productive people who make our lives better.

      But far too many Canadians are managed by fear, greed and lazy whine for other peoples money greeds. Heck, we even justify the immorality of using debt against our unborns futures….and excuse, like a debt-greed addict, one more fix.

      We love denying reality. But reality always wins in the end. In this story, the simple reason much of the oil/resources are not often processed in Canada is as simple as, it not efficient, its not economical to do so. But a lot of idiocracy loves making it more complex to make it easier for people to deny the reality.

  3. Amazing how economic stupidity and loonacy prevale in Canada.

    Resources should be processed where it makes economic sense, and not flea minded fuzzy logic sense. Its a lot more expensive to refile oil at source, packaging, shipping and handling costs would fo nuts, as shipping the parts would make no economic nor efficiency sense at all.

    But it is why we need pacific coast access, to get better prices than a US only and constrained market can offer. Remember, even the lazy able working age social assistance needs funding….we all benefit from fair and universal market access.

    But then, I am far more economically minded than 98% of the population. At least that is what my accountant and bank balance says.

  4. Hey, I would invest if like workers, this investor can make money. But the reality is refining oil near where it is used is the most efficient, most economical way to process oil and many resources. Competitive business is about removing waste, providing sustainable jobs and economic/tax activities.

    But the fact remains, processing oil for non-domestic use is just insane idiocracy.

    Reason manufacturing left Canada is because of taxation inflation and debt. We are so taxed not just on incomes, but in hidden taxes and tax as inflation it needs uncompetitive wages that drive jobs to USA, Mexico, China and elsewhere.

    Hey, tax my dentist more, I get the bill and will spend less on someone else’s job. Tax the business more, they pay less or worse, move out. Tax the people more, they want higher uncompetitive wages and jobs leave. Its really boils down to too much government consumption and waste on corporate, bank, union, auto, inflated contracts and a massive amount of money for nothing of durable value wastes.

    Its why I moved more investment moneys offshore this last week, as Canada in its current mode is unsustainable. As a successful investor, I even saw 2008 coming, and made off like bandit. But today we seem to have media embellishing economic stupidity.

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  7. Here’s the thing: people in BC don’t want their environment destroyed by 2 pipelines and tankers carrying diluent and diluted dirty oil.

    There’s no benefit to us.

    Just a lot of downside.

    • Yes, that’s all fine and dandy, but as a member of a federation, BC also has no legal right within Confederation to install artificial barriers to lawful commercial products (oil) being transported through to reach foreign markets.
      Then there is the issue of various Indian bands proclaiming that unwritten (and therefore unverifiable) laws that supposedly pre-date Confederation can suddenly be invoked in order to block the pipleline. Really? maybe these people should decide if Canadian law is paramount or unwritten “Indian” laws are? I guess if the laws of Confederation aren’t good enough, then maybe all of the other benefits of Confederation need to be rescinded for people who believe this kind of thing.

    • The people of other provinces might not want BC logging trucks on their highways as they are a risk to the safety of the citizens of those provinces with no benefit to them. Also BC has oil pipelines that run through other provinces with no benefits to those provinces and all downside. Sadly resources are owned by individual provinces but they go to market via pipeline, highway & rail through other provinces and there is always risk with no benefit to those other provinces. Why is this situation so different? Please explain.

    • Sharon,

      If that is the case…then why does BC already deal in pipelines and other resources?

      BC is already dealing with resources…..they would approve of the Northern Gateway if they could get a bigger “cut”……

      They just want more $$’s.

  8. I think people are confused about what is shipped. It’s not raw bitumen; it’s upgraded synthetic crude. This synthetic crude then gets shipped to a refinery. We have upgraders in Alberta, but not refineries capable of processing the heavy crude. Those are already available in Texas, which is why we wanted the XL pipeline there.

    • Actually, about half the production is upgraded, half shipped as dilbit and we do have refineries capable of processing heavy crude (Suncor in Edmonton for example.)

  9. Thanks for your clearest article yet wrt your thinking on the subject Andrew. However, I still have an issue with the statement:

    “The opportunity cost of a tradesperson, engineer, or manager who might be employed in a refinery is not zero, as these people would not otherwise be unemployed. ”

    First off, some of these people would be unemployed (or underemployed) when the new refinery opened but that is a quibble. The real point is that provided the refinery produces stable, long term employment the tradespeople required will literally be grown to meet the need. So while your model may work for 2016, by 2025 I am not convinced. Having stable, long term employment will cause a portion of the workforce to elevate their training & credentials in order to meet that need. In many cases, they will have upgraded from careers in the service industry to obtain positions in manufacturing that pay more. The opportunity cost of not having those people flip burgers is essentially zero.

    • The effect on employment of adding a new refinery capacity is miniscule. Accrording to Cansim Table 301-0006

      http://www5.statcan.gc.ca/cansim/a26?lang=eng&retrLang=eng&id=3010006&pattern=refining&tabMode=dataTable&srchLan=-1&p1=1&p2=-1

      Something like 7000 people are employed in refineries. Doubling Canadian oil refinery capacity would increase employment by about 0.05%.

      Refineries are massively capital intensive; they’re not a source of job creation.

      • Refineries are massively capital intensive; they’re not a source of job creation.

        Say you spend $30 billion. You get a) three mines or b) one refinery.

        Anything to suggest capital invested during construction in a) generates more person-yrs than b) ?

        I

      • That is a very weak use of numbers Stephen, taking a single sector and comparing it to the entire country. I am not saying you are wrong, just that your argument is lacks precision.

        Say you invest in a refinery. Take the direct employment, then add the indirect employment from services a refinery would need, then compare to an equivalent investment in another sector. Perhaps the numbers show that “refineries are massively capital intensive.. not a source of job creation”. Perhaps they show that refineries could be anchors for communities, spawning long term supply chain based jobs in industries that support that capital intensive investment.

        You are the economist not I, but you are hardly making a valid scientific statement with your comment.

        • I might be wrong but I believe we also have another issue in Canada and that is a shortage of skilled labour to build refineries. We certainly have a shortage of skilled trades in Alberta. This makes it very difficult to train other trades and get the refineries built in a timely fashion.

          • Not to mention all of the related unfunded public infrastructure. Value not added.

    • Sure, but explain to me why your logic doesn’t apply to building anything – sell bitumen at market value and use the royalty and tax dollars to build more X and people will train to do X rather than flipping burgers. Assuming that the money which would go to underpin your refinery would otherwise be vapourized is at the heart of most of the poor analysis on this issue.

      • Assuming that the money which would go to underpin your refinery would otherwise be vapourized is at the heart of most of the poor analysis on this issue.

        Assuming perfectly efficient markets. And completely unfettered development.

        I suspect their is a real disparity between economists who believe every activity should be profit maximizing, and the ROC.

        • there their

      • Are saying by any chance that product x might be green alternatives Andrew? Perhaps we might even call it a wind fall tax in order to produce another greater good we require – a shift away from a carbon based economy. I think someone[Trudeau for instance] might have some traction in pushing this notion. It might even get us over the social license hump enough to build a couple of pipelines out to the coast or the north[?] so that AB can get some of its product to market[ even in dibilt form] if it was understood that a portion of profits would go to some form of technology or green transition fund.[ this might even preclude the necessity of a national CT. Perhaps it might even be a targeted price on carbon?]
        One of the problems of the current set up as i see it is it unduly rewards investors[ yes i know this amounts to nearly all of us one way or another] There is a considerable incentive for large investors not to rock the boat; not much of an incentive to look for long term[or even medium term] solutions, other than bad PR and public pressure from critics.
        Personally i would still have grave doubts about the potential risks of moving large quantities of dibilt[ and condensate the other way] particularly in remote and sensitive habitats. For this reason Gateway should be a no go in any case. But there are alternatives where risk factors might be more readily mitigated…tanker traffic via Vancouver and PR for one.
        Someone has to grab the ball and propose a workable compromise that would get less product to the coast than producers/large investors want, and link this development clearly to a national commitment to incent energy companies and provinces to go green, and make it so. An obvious choice for this role is JT. I hope it has the nerve to take it on.

  10. It’s a simplification, as I’m sure Dr. Leach realizes. First, a barrel of bitumen does not turn into a barrel of gasoline, it turns into a variety of products of different prices and waste products, less than a barrel in total. You need to have a fair bit of flexibility in inputs, outputs, and processing in order to produce the highest-margin mix. An upgrader certainly does not do this, it produces synthetic crude and a bit of diesel, and hydrocracking is an ancient technology that is barely applicable to bitumen any more. What you need is even more expensive delayed cokers like those on the Gulf coast, which have more waste products but produce a more valuable mix of products. Delayed cokers also have the benefit that they emit considerably less GHGs if you figure out what to do with the mountains of petroleum coke.

    The other factor is transportation and storage. If you suddenly start to produce large quantities of gasoline in Saskatchewan, its price will drop. You have to ship it away. You have to ship not just one raw product to US markets but dozens of different refined products, each requiring infrastructure, each losing a bit of margin with every kilometre traveled. For byproducts like sulfur the cost of production and shipping can be higher than the price of the product at destination. Beyond that is the supply risk. If you process what you produce, a supply interruption wipes out your revenues but not your operating costs. It’s safer to process near a hub where there are multiple sources of supply of feedstock and some storage, so that a week’s interruption does not cost you a year’s worth of profits. Alberta is too far from the markets and has too little flexibility to make it worth the risk, especially now with low-cost high-quality Bakken sitting between it and the buyers.

    • That’s a good technical argument (dist’n of refinery products) why it makes sense for refineries close to domestic consumption.

      But, set refining aside. Upgrading: the largely untested assumption is that the heavy/light spread on the world market mirrors US Gulf today -not 10 yrs ago when it made sense to upgrade in Canada.

      Got any insight to add on this part?

    • Yes, it’s a simplification. In the model runs shown, the outputs are diesel and naptha, with diesel priced based on gulf coast netbacks and naptha priced based on Edmonton condensate pricing. It’s not perfect, but it’s likely a good approximation. The remaining refinery assumptions are, basically, a modified version of the Northwest refinery. I have a delayed coker version as well, and you end up with lower capex and opex, different exposure to gas, different product mix, and of course the coking loss.

      • Any model depends upon what assumptions are made – and when and where you took the snapshot. And cost relationships change over time (certainly not static).

        Often, you can pick data or make assumptions to just about show anything.

  11. “We should be finding the most lucrative markets for our bitumen and charging an appropriate rate to extractors, writes Andrew Leach”…

    …if it can be done safely with the minimum risk to the environment, and the most likelihood of securing social license to continue extraction of said bitumen. And that’s before we address the global carbon footprint issue, and how to deal with it globally.

    There, fixed. You’re a busy guy, guess you didn’t have time to finish your thought Andrew. But seriously, you go on to say we must take advantage of cheap global refining; again i say, at what cost to the environment if it can’t be safely done or at a low enough risk threshold? [ that's why NGP is going to fail]

    “So you think we should simply ship our raw resources?No, I think we should maximize the value of our resources, not the degree to which we process them.”

    I just can’t believe you think this is true, except in the abstract! As i’ve said to the point of tedium…apply this logic to the forest sector in BC and not another mill would ever get built again in a small town. It makes total sense in the abstract to simply ship out the raw logs and damn the consequences.People live in small towns in this country still Andrew; i live in one right now.

  12. The most economic way to go is to refine the dibit into value added products at tidewater.

    One pipeline, one product from Alberta to the BC coast.

    No refinery or pipeline operator is going to run a displacement of one product for another through an 1,100 km pipeline.

    • Google “transmountain pipeline” and “products shipped” – everything from dilbit to jet fuel.

      • Yes, apparently they do Andrew, but the line has to be flushed (displaced) after pumping unrefined or semi-refined before going back to jet or gasoline.

        It is still more economic to run one product only being dibit and refine it at tidewater.

        • No, it doesn’t. They run the products back-to-back with appropriate staging of batches, and cut into the lighter product. Don’t make stuff up.

          • Ha. Thank for calling him out Andrew, just don’t get him going on globull warming.

          • Sorry Andrew, you are wrong, you can have an interface between batches going from refined to unrefined, not the other way around.

          • Hey KC, I see Andrew has joined you hard aground on that lee shore.

          • And Andrew, why do you think Kinder Morgan wants to twin it’s pipeline?

            So they can run dibit only, straight through to Burnaby where some will be refined, but most will go to the BP refinery at Cherry Point in Washington State via shuttle tanker out Vancouver Harbour.

          • Some diesel can contaminate gasoline, it lowers the grade.

            Gasoline can not be present in diesel.

            Any refined product interface mixed in with crude goes back through refining, as does flushed product containing crude residues.

          • That’s why you cut into the refined product. So that you keep any mixing out.

          • You don’t have a clue as to what you’re talking about Andrew.

            I work in the Oil Transportation Industry, you do not, you rely on rudimentary explanations provided to the general public.

            Hope you enjoy “simple” graphic.

          • The significant difference in viscosity between diesel and crude causes more mixing of product, a long interface (flushing time) is normal before the diesel batch is within tolerances to be delivered. Density measuring instrumentation and samples taken from the pipeline show when the diesel package is “clean” enough.

            Refined products with closer densities are sent through the pipeline in a batch train, followed by a shipment of crude

      • “You don’t have a clue as to what you’re talking about Andrew. I work in the Oil Transportation Industry, you do not, you rely on rudimentary explanations provided to the general public.”

        Noted. Who is it that you work for again? Oh, right, we have no idea.

  13. Why do you think Kinder Morgan wants to twin it’s pipeline?

    Too separate dibit and refined product, too make operations more efficient.

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