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Who wins and who loses from more upgrading in Alberta?

Andrew Leach on extra upgraders


 

Jeff McIntosh/CP

The NDP put forth a motion in the House last week which states that, “the Keystone XL pipeline would intensify the export of unprocessed raw bitumen and would export more than 40,000 well-paying Canadian jobs, and is therefore not in Canada’s best interest.”

Where do they get 40,000 jobs? This jobs number seems to be sourced from evidence tabled by Informetrica (PDF) in the application for the Keystone (not XL) pipeline in 2007. This study states that, “expansion of the Canadian refining industry as a source of demand for 400,000 barrels per day of heavy oil would add approximately 18,000 jobs per year to the Canadian economy as compared to the additional jobs generated by export of the crude.” If you take that number, scale it up in proportion to the capacity of Keystone XL, you get 40,000 jobs.

However, adding that extra upgrading capacity would take both capital and labour, and both of those have to come from somewhere. At the very least, increasing demand for oil and gas sector workers by 18,000 people would increase wages across the sector and the economy, which would decrease employment in other sectors and decrease corporate taxes and royalties. Further, the capital to build the refinery would come at the expense of investment elsewhere (perhaps in Canada or perhaps not) or at the expense of shareholder dividends—if you force an oil company to build a refinery, that doesn’t pay for the steel or the labour to do so.

Suppose you had a fixed amount of capital to invest in the oil sands. Would you generate the largest return on investment in terms of total wages, royalties, taxes, and profits with extraction or with extraction and upgrading? And how would these returns be distributed?

I looked at the amount of capital it would take (about $42 billion over the life of the project) to build a mine the size of Suncor’s Fort Hills project combined with an upgrader to process the produced bitumen into higher-value synthetic crude oil. I then compared the financial outcomes from this hypothetical project to the construction of a larger, standalone bitumen mine shipping diluted bitumen.

The `economics’ for the two projects for the investor look remarkably similar at first glance (You can read about all the pricing assumptions underlying the analysis here). The standalone mine provides an after-tax rate of return of 12.3% and earns a conventional minimum rate of return on capital of 10% at a West Texas Intermediate (WTI) oil price of $70.57 per barrel. The upgrader and mine combined earns a slightly lower rate of return, at 11.66%, and requires an oil price of $78.24 to reach a 10% rate of return. Subtle differences, but not huge and certainty not large enough that you could say that one would proceed while the other would not.

On a per-barrel basis, the numbers are equally ambiguous – in fact, you’d probably say that the upgrader looks better. Revenues per barrel of bitumen extracted are higher with the upgrader, at an average of $80.80 per barrel vs. $62.93 for the mining project alone. Average costs (capital, debt, and operating costs combined) are higher for the integrated project, at $43 per barrel of bitumen produced and upgraded versus $29.15 for the mine, while royalties and taxes are similar at around $19 per barrel of produced bitumen in both cases. The result is that the upgrader earns higher cumulative cash flows, by $4.10, per barrel of bitumen produced.

Case closed, right? On with the upgraders and the jobs!  Not so fast. First off, in 2012, despite 46% of the bitumen produced in Alberta being upgraded, the Petroleum Human Resources Council estimates (PDF) that only 20% of oil sands sector employment is in upgrading. The evidence that you’d have higher labour demand if you forced upgrading in a tight labour market is spotty at best.

There’s also a trick in the per-barrel numbers above – the project with an upgrader earns higher cash flow per barrel, but it produces far fewer barrels—1.7 billion fewer. So, over the life of the two projects, the total royalties and taxes collected from mining and upgrading combined versus bitumen extraction alone would be lower by $36.6 billion, while the profits to the producer would be lower by $13.4 billion. Combined, for a similar capital investment and with similar associated jobs, the bitumen extraction project returns $50 billion more in royalties, taxes, and profits.

Now, I know what you’re going to say – I’ve cooked the books against the upgrader. Well, as discussed above, I low-balled the costs. Let’s go one step further—let’s assume you can operate the upgrader at no additional cost beyond the energy used. This free value-added reduces the gap from $50 billion to $27 billion (but, of course, if you can operate the upgrader for free, it’s not employing a lot of people).

Bottom line: if you are willing to accept that both labour and capital markets in Alberta are tight, you can’t look at any new investment or job in a vaccum—you must think of it as displacing another job or investment somewhere else in the economy. If the displaced investment is one in oil extraction, you may be surprised to find that total profits, taxes, and royalties go down significantly and that you don’t create many (if any) additional jobs while producing a higher-value product. 


 

Who wins and who loses from more upgrading in Alberta?

    • In an unconstrained world, maximizing profit means producing until marginal cost = marginal revenue (Economics 101).

      The basis of this analysis, is that there is an either/or investment scenario (both appear to exceed the hurdle rate of 10%) and that only capital/labour is constrained. And an endless supply of oilsands primary production scenarios (whose economics decline as the ones with the best returns would be assumed to be developed first).

      I’m not sure that withstands closer scrutiny. Especially the assumption that transportation (by pipeline and/or train) is not constrained, physically, or politically. For example, to ship diluted bitumen vs upgraded synthetic crude oil (SCO) requires approx 66% more pipeline capacity /railcar trips.

      Since the project economics are highly sensitive to product prices in Edmonton (which we know can be affected tremendously by what happens in the deep US) it’s an assumption worth testing, through sensitivity analysis.

      • Oops. Should have read: “For example, to ship bitumen [not dilbit] vs upgraded synthetic crude oil (SCO) requires approx 66% more pipeline capacity /railcar trip”

        Calcs:

        SCO = bitumen x .86 (using 14% shrinkage). Dilbit = bitumen/(0.7) = 1.43. So, Bitumen/SCO = 1.43/.86 = 1.66

      • MC = MR maximizes the total of producer and consumer surplus in a very restricted case where MC is not changing. Profit is not necessarily a direct function of either (Average cost matters more than MC). Labor is also generally not even considered in that equation (at least at the 101 level). Obviously you know this as the important part of that statement is “in an unconstrained world”.

        In any case, free market economics barely apply to the oil industry. It sells to a world market of short term fixed demand, while the price is set by monopolistic (or at least oligopolistic) players unrelated to those operating in Canada.

        The rest of your statement is not bad, except for the extra capacity requirements for dilbit: Why would you dilute that much to ship on a train? I’m not sure you need to dilute at all.

        • My economics 101 reference was thrown in there to address the “opportunity cost” link. For quite sometime, many have argued that it is not economic to upgrade in AB – the argument being that if it was, O&G companies would do so. This analysis (of AL’s) suggests that it is economic. It is still my contention that the only difference between AB and say southern US would be relative labour costs and taxes. And if a greenfield site in AB vs retrofitting an existing US refinery (bolting an upgrader on the front), cheaper to build on a greenfield site (notwithstanding labour and taxes).

          Yeah, some are suggesting raw bitumen on trains vs. railbit (17%) vs dilbit (30%). RBN Energy has looked at this somewhat. Lots of logistics challenges with heating /handling with raw bitumen. And capital investment for such heating/handling. Still think p/line will prevail. Stand to be proven wrong.

      • Your economics 101 point needs to be augmented – economics 101 analysis would look at the costs of production from each opportunity, and sum them horizontally to formulate a merit order. The reason upgraders are not getting built is not because they don’t “make money” – it’s because you’d have to be willing to accept a lower adjusted rate of return on your dollar than for other opportunities in the same space. To do so would be a negative marginal revenue, since all economics 101 revenues and costs are treated relative to the best available outside option, i.e. exactly what is in the link on opportunity cost. You could make the case, as you have, that using a broader view including transportation, diversification of markets, etc. that the upgrader investment climbs that merit order a little bit.

        • That’s finance. Where capital is constrained and hence projects ranked. Which is what happens in O&G companies, agreed.

          • In economics 101, we call it a “supply curve”.

          • I always tuned out when there were two imaginary straight intersecting lines on a graph. So, perhaps I could be excused…

  1. You don’t seem to have provided any evidence for the assertion that an upgrader would produce far fewer barrels than a larger mine. Is this somehow related to the projected life span of the upgrader itself? Still, a larger mine would have additional production and remediation costs. To say nothing of additional inflationary pressure on resources, both labour and the environment, and local in terms of infrastructure demands
    From an environmental pov a slowing down of extraction would be a public and global good. Particularly if this were to free up some of the labour and capital resources from the sharp end of production/extraction..

    • He assumed the same up front capital cost of both. For the same price, an integrated project would obviously be smaller than just a mine.

      • I levelized them in terms of capital cost, so the mine is larger. Remediation costs per barrel would be, likely, a little higher with a larger mine, but should be roughly to scale. The inflationary pressures should be about the same if they employ roughly the same number of people and require the same capital investment – that’s why I levelized them. The Informetrica piece is (implicitly) comparing investments of two different scales, whereas I am trying to avoid that. If you want to slow extraction or internalize costs imposed on others, there are better to do that then by forcing more upgrading or blocking pipelines.

        • What better ways[sic]? From a purely cynical and practical pov, blocking pipelines is working just fine right now. Especially if you happen to feel you aren’t getting a truly fair shake during the hearing process.

          • I suppose it depends on your perspective of “fine”. Given that the gains from extraction are more than 50% gov’t, and refining and transportation tax take is much lower, creating bottlenecks and resource price discounts through pipeline blockades leads to losses for Canadians at a pretty high rate. Maybe that’s a reasonable price to pay in your world, but it stacks up poorly compared to policies which actually address the issues you bring up by looking at the approvals process, the royalty regime, etc.

          • Then slow the pace of extraction and take more seriously other options for exiting the carbon economy.[ if you happen to be a an energy company]
            I take your point about not cutting off our resource noses to spite our govt revenue faces. And i’m a Liberal and consequently not in the no pipelines or anti tar sands camp per se. But i’m also an environmentalist who refuses to accept that some things don’t command a higher value in my world then pure bottom line. NGP is a case in point, whereas keystone seems a reasonable if poor compromise. There’s probably no decent economic argument why NG should not proceed. Anyone who truly
            knows the BC coast is aware there are lots of others as to why it should not proceed. Energy producers then irresponsibly resorting to trains in a fit of pique, doesn’t do much to decrease my inner envrionmentalist radical either.
            I’m certainly not opposed to reasonable compromise. Some reasonable compromise on the part of our AB and federal govt might be nice in fact.

          • “exiting the carbon economy” is hardly a sort of compromise.

            It’s just another attack on the economy.

          • Try to think outside the box, at least a bit. It doesn’t have to happen overnight. But since I know your views on CC, I’ll just assume you’re in no position to know what might constitute a compromise.

          • It doesn’t have to happen at all.

            The observations demonstrate that CO2 cannot be the Great Climate Boogeyman it’s been made out to be.

            http://www.cru.uea.ac.uk/cru/data/temperature/HadCRUT4.pdf

            A compromise between an artificially forced economic recession due to carbon strangulation policies and an artificially forced economic depression due to even more stringent carbon strangulation policies is nothing to be happy about.

          • Sure, the AGW consensus exists merely to force an economic depression. Give your head a shake. Even if the consensus is wrong it won’t be because David Suzuki wants to make you a slave on his bean shoot farm.

          • For many people, the AGW fear mongery is indeed supported with the purpose of forcing economic degradation, particularly against the developed economies of the western world.

          • Got evidence for that opinion have you? Other then bizarre allegations against the likes of Suzuki?
            Otoh there’s plenty of circumstantial evidence that big oil is putting its size 15 boot on the scales.

          • kcm2, still hard aground on that lee shore……………hahahaha

          • You bin up on the rocks for most of your life there Bubba,you just don’t know it yet.

          • This comment was deleted.

          • that should read leech………….oops

          • Nope, wrong again dim wit. I work for myself and pull casual shifts for the town. Haven’t seen anything like a welfare cheque in more then 25 years.
            What’s your contribution, beyond posting bilge and propaganda here?

          • pull casual shifts for the town…………..that should read on call municipal worker

            Haven’t seen anything like a welfare cheque in more then 25 years…………..good for you

            bilge and propaganda……………that would be your department swab

          • Almost right. I fill in for the sick ones at out town arena. Facility maintainer i believe it is pompously officially called. In reality general dogs body and in extreme emergency, zamboni driver.
            I have my own seasonal business. But your quite right. I think work’s overrated, i’d rather play on my boat full time when i’m on the coast.
            O’Leary would be sad to hear you claim your building the economy. Very few people are in business other then for their own sake, every thing else is incidental; i doubt you would operate your business with 5 people if you could manage with 2. Sorry, i don’t buy the RW bilge that i’m doing this for my country…at least not in the main. There are extraordinary citizens out there though.

          • Four farmers killed while trying to rescue the animals.

            A cold front with snow storms hit in recent days to the departments
            of La Paz (west) , Cochabamba (center) , Potosi (southwest) and
            Chuquisaca ( southeast) .

            A report by the Vice Ministry of Civil Defense said that the snow
            storms impacted on livestock killing “40 000 head of sheep and 30,000
            cattle and camels in Cochabamba , Chuquisaca , Potosí and La Paz.”

            “…most damage is in Cochabamba , La Paz and Potosi, said Oscar Cabrera , Deputy Minister of Civil Defense.

            Four farmers were killed and 3500 families were affected by the heavy snow, according to official reports published Friday.

            Heavy machinery has cleared snow blocking access to the town , said
            Mayor Pedro Padilla. The cold weather in Cochabamba caused the loss of
            at least 2000 head of livestock, including sheep and camels, said Víctor
            Hugo Vásquez, Deputy Minister of Rural Development.

            In the mining center Caracoles (400 km from La Paz ), activities were paralyzed as a result of snow.

            “Even doctors left,” said a clerk at the Erbol mine.

            http://www.hoy.com.ec/noticias-ecuador/bolivia-cuatro-muertos-y-3-500-familias-afectadas-589630.html#cxrecs_s

            Thanks to Argiris Diamantis for this link

          • Over here we got weather > over there we got climate. See if you can tell which is which?

  2. Another point, already discussed with AL via email.

    When you look at investing in a mine you have to also include the cost to acquire the mineral rights in the overall project economics. If they have already been purchased through bid, it would be considered as a “sunk cost” and show up on the company’s balance sheet. So, on a go “forward basis”, this analysis holds.

    But, you could also sell off that lease/rights to say a CNOOC (an opportunity cost). From CNOOC’s perspective, the investment decision would also include that upfront capital expenditure. Hence why it should also be included. (btw, this is basically how a company determines how much it will bid for a lease – a prediction of costs/revenues and a hurdle rate. Anything above that, on a NPV basis would set the upper limit on bid price)

    • In theory, but historically it seems very clear that there is no (or limited) bid competition. It’s gotten more competitive, but generally when a big 5 request parcels and bid on them, the other 4 stay out of the picture.

      • Now that possibility of shipping and development constraints seem more real, I expect we will start to see more and more real competition for the sub surface rights.

        • Many good leases left? I was under the impression land sales have dropped off considerably with a fire sale in the early 00’s.

          Still, upfront capital costs need to be included when looking at standalone mine vs. upgrader.

          • There have actually been fairly big sales in the last two years as well. These companies are capital constrained and can’t develop everything at once and the lease agreements have development time requirements so no, not all the “good” area is gone. You would assume that the best (or lowest extraction cost) areas would go first but when it comes to insitu extraction there is actually a lot left out there of relatively equal quality and although the bids have gone up some in the last little bit it still seems like the big players buy leases unopposed.

  3. The NDP fails to say where the 40,000 extra workers would come from. They would be far better to ship the bitumen to Montreal and get the jobs there. Alberta labor is already in short supply

  4. Leach’s argument rests on a predictably Alberta-centric view of the world — i.e, all the upgrading would occur in a tight Albertan job market. Last I checked the dippers were big fans of Energy East. Also, there’s no mention either by Leach or the NDP of the additional carbon emissions arising from more domestic upgrading. My hunch is the dippers would cap ’em. Not sure what Leach would do.

    • The comparison is between a bitumen mine plus upgrader or a bitumen mine alone.

      Adding additional comparisons between different provinces would only complicate the story.

      In any case, Leach minimizes the labour difference in pointing out that despite 46% of the bitumen being upgraded, only some 20% of the employment is involved with upgrading.

    • As it becomes ever more obvious that increasing CO2 concentrations are having no effect on global temperature, it is very probable that by the time a putative upgrader project were on line, carbon emissions will have become irrelevant to policy.

    • Chris, thanks for reading. If you click on the FrogBlog link, you’ll see the more detailed numbers. While I don’t go into it in detail, the upgrader/mine combo produces more total emissions despite producing fewer barrels. Most life-cycle analyses show that refined product produced from bitumen upgraded and then shipped to a refinery will have higher total GHG emissions “wells-to-tank” than refined product product from bitumen shipped directly, as dilbit, to a full conversion refinery.

      • Irrespective of the WTT relative emissions of the upgrading combos, the poiny i was making was spatial – where the emissions would accrue. Obviously, if more processing is done in canada, canadian emissions will be higher than if that processing is done in the US.

      • Most life-cycle analyses show that refined product produced from bitumen upgraded and then shipped to a refinery will have higher total GHG emissions “wells-to-tank” than refined product product from bitumen shipped directly, as dilbit, to a full conversion refinery.

        Find that hard to fathom. What’s the diff? Need to heat up bitumen/SCO once again vs extra energy to transport 66% more volume perhaps over thousands of kms.

        Got a link?

  5. Can you please tell me why you’d build a mine coupled with a refinery when we already have plenty of mines? Presumably, after all, a local refinery would be able to see slightly more profit from the bitumen than one that had to ship it out of the country first, meaning that it could raise the amount it pays the driller and thus take the supply that would normally have been going elsewhere, right?

    Also, why does it have to be built in Alberta? If the capital development cost is so high in Alberta, then doesn’t it makes sense to build it in a province where the capital costs aren’t so high? Say Manitoba or Quebec? Again, I would expect (though I may well be wrong here) that shipping unrefined product interprovincially would still be cheaper than internationally.

  6. The bitumen should be refined to consumer products. More jobs means more money staying in Alberta (Canada), more expertise developed in Alberta (Canada) including the reclamation of the area once the oil is gone – might want to cost those into you estimates as well; maybe include a carbon tax. I can’t see how that’s a bad thing. Those thousands of workers are going to spend the money in Alberta; corporations will ship it off shore. Why sell the Euros/Am/Chinese bitumen cheap when you can sell them Gasoline? Be easier to justify shipping gasoline/diesel to the east where we could burn it. Corporations are just going to have to figure out how to upgrade the work force they require (such as they’ve been doing in Germany since the dawn of time) and how to extract dollars from them as the process develops.

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