Production cut has unintended consequences

Oil and gas industry suffering from Notley’s decision, Martin King writes

The celebration following Alberta Premier Rachel Notley’s controversial decision to force oil producers in the province to cut production is already coming to an abrupt halt as Albertan producers experience the first of many unintended consequences of the intrusive market intervention, the reduced incentive to move Alberta crude oil by rail due to the artificially tighter price differentials in relation to topline crude oil prices.

This development undermines one of Notley’s key goals: to reduce the current glut of oil in Alberta. Over the long term, it may turn out that Notley’s cut could be what ultimately hurts Alberta’s oil producers the most.

Intervention into a fastmoving and unpredictable industry like oil is always inappropriate and can prove to have volatile results.

OPEC, a much larger and more sophisticated oil player, has learned this hard lesson many times in the past, and most recently in the past few months as it sought to increase production, and is now scrambling to reduce production to prop up depressed prices.

U.S. refiners have been shipping barrels of the previously discounted Canadian crude by rail across the United States, which partially mitigated some of the excess inventory of Alberta oil. However, rail shipments of Canadian crude are less economical for Gulf Coast refiners because shipping by rail requires Canadian crude to cost around $18 less than oil produced in the Permian Basin. Since Albertan producers are primarily reliant on refiners in the United States and have limited pipeline infrastructure, they may now see one of their few additional options to get barrels to market rapidly dwindle.

The problem will be longlasting. Even if Alberta quickly took action to correct this unintended consequence, rail shipments for all of 2019 are now likely to be impacted since it could take four to six months to re-establish previous shipping patterns with rail companies, which were already skittish about making long-term commitments to moving crude by rail.

There are also longerterm consequences. At the very least, it significantly increases market uncertainty. Uncertainty reduces the likelihood that companies will invest in what is needed to really set Alberta (and Canada) on the right course: infrastructure. Less investment means a smaller oil and gas industry in Alberta, and government intervention is only raising the entire investment risk profile of the province.

Although many in Alberta understandably believe that desperate times called for desperate measures, this may set Alberta on a course that does not end with just one economic intervention. It is starting to show unpredicted impacts as businesses up and down the complex supply chain react to the new artificially tighter price differentials. In the end, the absolute price of Alberta’s heavy oil has barely budged as topline oil prices (WTI) have plunged, offsetting nearly all of the gains brought about from the production-curtailment-driven tighter price spreads. If OPEC can’t meddle in the markets successfully, neither can Alberta.

Notley may be tempted to respond to this new issue through further government intervention. Before the decision was made, the federal government considered a proposal from Alberta to buy rail cars to move oil stuck in the region. This was shortly after the federal government announced that it would buy the Trans Mountain pipeline. Unfortunately, all these interventions are short-term fixes, which lead to unintended problems that then require further short-term solutions.

To set Alberta back on the right course, Notley should resist the urge to keep intervening and ensure that the province once again becomes a stable bet for companies who want to invest in the oil and gas industry. Notley could simply allow oil producers to return to the triedand-true process of reducing (or increasing) production in response to price signals, as was already happening. This move would be a critical first step to permanently putting the failed experiment of mandated production cuts in the rear-view mirror before more unintended consequences leave Alberta further behind its competitors.