Energy security and the Energy East pipeline -

Energy security and the Energy East pipeline

Does Stephen Harper’s promise make sense? Andrew Leach explains.

Etienne de Malglaive/REA/Redux

During his visit to the Irving Refinery on August 8th, Prime Minister Stephen Harper stated that the Energy East pipeline was not just about moving Alberta’s energy to markets, but that the government would, make sure “that Canadians themselves benefit from these projects and from that gain in energy security.” That got me to thinking about energy security, what it means, and how we might benefit (or lose) from what it implies. In what follows, I argue that there are some potential benefits, but also some false-economies and pitfalls in terms of delivering energy security with Energy East.

When it comes to energy security, Michael Levi* at the Council on Foreign Relations is one of the world’s leading experts. In his May 2009 paper “The Canadian Oil Sands: Energy Security vs. Climate Change” (long one of my favorite sources), Levi identifies a list of six security and economic consequences of oil consumption and production and then examines how increased oil sands production and exports to the U.S. would mitigate or exacerbate these impacts. I thought it would be a useful exercise to use a modified version of Levi’s checklist to think about Energy East and its impact on Canadian energy security, so here we go:

1. Oil revenues empower exporting states whose interests often conflict with our national interests.

The trade impacts of Energy East depend on what you view as the alternative scenario, but let’s take the most likely – barrels shipped on Energy East would otherwise be shipped south or east by pipe or rail, and these barrels displace barrels which would otherwise be imported from a similar set of countries as we import from today.  At the same time, this would imply an increase in imports into the U.S. from countries other than Canada to replace the foregone barrels.  The countries from which we imported the largest volumes into Ontario, Quebec and the Atlantic provinces over the previous 12 months are shown below:

Imports to Ontario, Quebec, and the Atlantic Provinces, May 2012-April 2013. Source: Statistics Canada.

Certainly there are many points of disagreement between Canada and many countries on that list. However, if you are worried about empowering these nations, you really want to worry about whether Energy East affects their ability to sell oil much more than you want to worry about whether they are selling it to Canadians or to someone else. In that sense, the net effect on world oil demand of Energy East is what matters, and it would be negligible. If the construction of Energy East also does not put significant new supply into the world market, it will not have a material impact on the revenues collected by other oil producing nations either. So, the impact on the empowerment of rogue states is likely a wash.

2. Economic growth is hurt by oil price volatility.

Volatility in any price is costly, so its worth asking whether Energy East would reduce oil price volatility significantly. Assuming there is no further legislation affecting oil trade, Canadian firms (producers, distributors, and refiners) would remain exposed to the world’s oil markets, but that exposure would change. Energy East would allow eastern refiners to purchase oil in western Canada, increasing their market size, and allow western producers to export product from the east coast, or sell to eastern refiners, again increasing market size. It will also aid in reducing the recent disconnect between mid-continent and coastal oil prices, but that’s not really a volatility effect. For western heavy oil and bitumen producers, tidewater access may have an important stabilizing effect as it would greatly expand the market for the product, which has previously been subject to large price swings motivated by refinery or pipeline outages in the midwest. For eastern refiners, it’s not clear that access to 1.1 million barrels of oil by pipeline will have a large impact on volatility, although a wider market will always lead to some reduction in volatility. Over the past 25 years, there has been lower crude price volatility in the mid-continent regions than on the coasts (WTI vs. Brent), so there may be some improvement here, at the margin.

People often confound the heavy-light differential with oil price volatility. Canadian heavy trades at a discount to world prices largely because it is heavy oil and thus less valuable to refiners. Since Canadian light oil has also been discounted to world prices in the last couple of years, the heavy (WCS) discount has looked even larger. However, no matter what you think this pipeline will do, I can promise you that it won’t convert heavy oil to light oil.

3. Wealth transfers resulting from a lack of national infrastructure hurt economic growth.

Here, we again need an exercise of follow-the-money. Absent Energy East, assume we take a barrel of oil and sell it in the U.S. for the world price, and buy a barrel of oil for world prices on the east coast, perhaps from one of the countries listed above. In terms of wealth transfers (ignoring price differentials), that’s a wash for us and a loss for the U.S. and a gain for the country from which we buy oil on the east coast. If, instead of that trade, we ship the barrel of oil east, the U.S. still ends up out the cost of a barrel of oil which they have to purchase from the world market instead of us, the exporting country ends up with the revenue from a barrel of oil, and Canada ends up with an offsetting revenue and cost. In other words, unless there are significant price differentials, the wealth transfers avoided by Energy East will be small. The project effectively contributes to reducing its own impact here, since its existence will ensure differentials are lower than they would otherwise be. If the price differential would otherwise be larger, then Energy East eliminates a wealth transfer from Canadian producers and taxpayers to mid-western refiners. In that sense, there would be an economic growth impact from eliminating that wealth transfer.

4. Barriers to well-functioning oil markets, including but not restricted to price manipulation by OPEC or national governments, raise oil prices and hence hurt the economy.

From the perspective of Energy East, Canada is simply electing to sell oil to itself (presumably at world prices) rather than importing at world prices on the east coast and exporting at (eventually, hopefully) world prices in the west. Unless you are supposing that, with Energy East, there will be some sort of domestic consumption priority akin to the crude oil export ban in the U.S., there is no reason that Canadian crude would be sold at or below its market price to Canadian refiners. If it were, for whatever reason, that would still not constitute a gain for the economy overall, but rather an introduction of an inefficient price signal and a wealth transfer from west to east (a policy that would no doubt bring out the bumper stickers in Alberta again). If what the Prime Minister has in mind when he says energy security is a Canadian oil market isolated from the world market, it will come as a surprise to western producers and to the Irvings who have pledged to build an export terminal in Saint John, and he will need some additional legislation to make it so.

5. Canada is potentially vulnerable to supply disruptions resulting from states’ decisions to withhold oil supplies from world markets or from damage to oil supply chains by nonstate actors or natural disasters.

Economist Peter Terzakian wrote a couple of days ago about Canada’s failure to maintain oil self-sufficiency, and tells us that, “it’s naive to think that global oil disruption can’t happen again.” Sure, it’s possible that an event will lead to a very high temporary value for west-east infrastructure.  What should also be mentioned here is that insurance comes at a cost — had we decided in the 1970?s to build significant west-east oil infrastructure and ensure domestic priority, we would have lost out on a winning trade with the U.S. — for 23 out of the past 25 years, oil prices have been higher in the U.S. Midwest than at eastern Canadian ports (adjusted for quality) and the U.S. midwest is closer to Alberta. Yes, we’d have been well-prepared for an oil crisis that has yet to re-emerge, but we would have lost money month after month on insuring ourselves. We should account for any insurance value which is provided by the pipeline, but we should also remember who is underwriting that insurance. If you believe that, in times of crisis, a West-East pipeline will provide eastern refiners at oil below the world price, you are assuming that western producers will sell oil below world prices in times of crisis. That’s not preventing damage — it’s transferring damage.

6. Dependence on oil from unstable regions may necessitate military expenditures to ameliorate risk.

This isn’t as big an issue for Canada as for the U.S., and certainly not my area of expertise, so I will rely more heavily on Levi here. Levi writes that as a justification for enhancing domestic and North American oil production, “the underlying argument is weak. While U.S. commitments in the Middle East may have strong historical ties to oil, current U.S. commitments are anchored in other fundamental problems. In particular, the long-term challenges posed by transnational terrorism, by Iran’s pursuit of nuclear weapons, and by threats to Israel’s security will require strong U.S. security commitments in the Middle East regardless of whether oil is also a major regional concern.” To apply this to Energy East, you have to go back to the questions above as well. First, as Levi puts it, oil is far from the only reason for U.S. military involvement in oil producing regions. Second, Energy East is unlikely to change the amount of oil imported to North America from these regions. Insofar as our military interests remain reasonably aligned with the U.S., it’s hard to see how Energy East brings about a material change.

In a 2010 piece discussing the impact of climate change legislation on the U.S., Levi and Trevor Houser write that, “energy security is notoriously difficult to define and thus serves as the perfect weapon for attacking legislation.” It seems that is largely the case here, albeit as a weapon for supporting pipelines – if you can promise someone that the pipeline will enhance energy security, they are more likely to smile and nod than to ask you to define it, so you can get away with it as a soundbite. Canadians would be much better served to ask what it means when someone says it, especially if that someone is the prime minister.

*Since I have borrowed so heavily from Levi in this post, you may be interested in his book Power Surge. Check it out here.