The Brownsville U-Turn Redux: Cartelization of the Alberta Oil Sector

The Brownsville U-Turn Redux: Cartelization of the Alberta Oil Sector
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The U.S.-Mexico-Canada Agreement on trade promises to continue the large economic benefits of the earlier North American Free Trade Agreement, but one threat to those benefits has emerged in the form of mandated production cuts in the Alberta oil sector. For U.S. firms operating in Alberta, this policy in effect can confiscate the value of their prior investments, an outcome both self-defeating and inconsistent with the overall objectives of USMCA. 

Alberta Premier Rachel Notley announced on December 2 that the provincial government would enforce a reduction of 325,000 barrels per day (b/d) in Alberta oil production, or about 8.7 percent. This decision was driven by a severe constraint in pipeline and rail capacity for export of Alberta oil either to the U.S. or to export facilities in eastern or western Canada, a bottleneck resulting to a significant degree from political opposition to Alberta oil production, driven in particular by the politics of climate policy.

The effect of this transport problem was a sharp reduction in the price of Alberta crude (“western Canada select”) relative to the price of U.S. crude oil (west Texas intermediate) on the U.S. Gulf coast. That WCS/WTI differential---$52 per barrel last October---now is about $10 per barrel in the wake of the announcement and the actual production cuts implemented January 1. The price of WCS increased from $11.56 per barrel on November 27 to $34.25 on December 4 to $43.36 on January 17.

Sounds like a successful policy? Not so fast: This production cut is an obvious cartelization of the Alberta oil production market, and the unintended consequences---there always are unintended consequences attendant upon government meddling in markets---now are just beginning to merge. The 325,000 b/d cut ostensibly will be in place only “until the excess crude in storage is drawn down. The cuts will then drop to 95,000 bpd until Dec. 31, 2019.” Seriously? Unless overall market conditions change significantly---there is no evidence for any such shifts observable in current price movements---it is not quite clear how the Alberta crude oil market over the next year will avoid a return to the conditions that led to Notley’s decision. It is no answer to say that supplies in storage will have been “drawn down,” because a return to the previous production/export balance obviously will create the same “excess” amounts in storage over time.

Bear in mind that because crude oil can be stored, current prices reflect market expectations of future prices. The fact that the price of WCS has increased and the WCS/WTI differential has declined so sharply over the past month suggests a market expectation that the production cut is not temporary; if WCS production were expected to return to the previous levels, with little effect on the production of WTI and other competitive crudes, then the WCS price would decline now in anticipation of that future production increase. Or do Notley and her advisers believe that market prices do not reflect expectations about the future?

This obvious reality is reinforced by a small detail that seems to have escaped notice in much of the reporting: The production cut is expected to increase Alberta royalty revenues by CA1.1 billion ($824 million) in the fiscal year beginning April of this year. Will those additional revenues not be spent? Will the beneficiaries of that spending not demand that it continue? Will new supplicants demanding a share of the revenues not emerge? The higher prices benefiting some subset of the industry and the new revenues yielding political benefits from this cartelization policy will work to engender an endless series of “temporary” delays in the promised winddown of the production cuts, a display of the rent-seeking that is an eternal effect of government meddling in market outcomes. Notley and Albertans generally are going to discover that such government interference is far easier to implement than to exit.

Notley has proposed that the province purchase 7000 rail cars to move Alberta crude to refinery markets. Transport of oil by pipeline is substantially safer and lower-risk in terms of spills than transport by rail (or truck). An examination of the data shows that for crude oil and petroleum products in the U.S., rail transport results in 2.1 incidents (accidents, spills, etc.) per ton/mile, while the figure for pipeline transport is 0.6, a difference factor of about 3.5. The Canadian experience is similar: Pipeline transport of petroleum has been 2.5 times less likely than rail transport to result in an incident resulting in a spill. The upshot of these realities is straightforward: Notley would serve the interests of Alberta far better were she to use her influence and political capital to overcome the political opposition in neighboring provinces and in Ottawa to construction of the pipeline capacity needed to move increasing quantities of Alberta crude oil to market. A mandated reduction in Alberta production is inconsistent with that goal, as politicians outside the province will ask why they should address the problem when Alberta has “solved” it unilaterally.

There also are the adverse investment effects of the production cuts, whether permanent or temporary. If permanent, then it is difficult to see how investment in new production capacity can be made consistent with the cartelization objective, unless the demand for Alberta crude oil is expected by government officials to increase over time; and even in that case, the allocation of production quotas necessarily will be politicized, an outcome not conducive to increased private-sector investment unless two-way promises between oil producers and politicians are made in advance. That is a process fraught with the potential for corruption. And how would such promises be enforced? Once an investment has been made, policymakers have powerful incentives to renege so as to allocate some of the promised production quotas to others, a reality that anyone can foresee, so that the overall depressing effect on investment is obvious.

If the production cuts are advertised as temporary---as discussed above, this will prove self-defeating---then the adverse investment effects of the policy are just as obvious for the opposite reason: Prices assumed to be higher only temporarily will not elicit more investment. The general problem with the Notley production cuts is that such meddling in market processes cannot be made consistent with the economic efficiency ordinarily driven by market prices reflecting known uncertainties, which then are exacerbated by additional political risks.

Notley’s gambit brings to mind the Brownsville U-Turn, a supremely amusing political response to one of the many distortions engendered by the 1959-1973 U.S. oil import quota program. This was a limit on U.S. oil imports justified rhetorically on the basis of a deeply-dubious national security rationale. Unsurprisingly, this political meddling with market forces created myriad problems, one resulting from the difficulty of defending the proposition that oil imported from Canada was “insecure.” Accordingly, a highly-complex “overland exemption” for Canadian oil was implemented, an outcome that made officials in Mexico, and their allies in the State Department, rather unhappy; they too wanted an allocation of rights to export oil to the U.S. because the quota program increased U.S. prices above world market prices. The solution was the Brownsville U-Turn, an arrangement under which Mexican oil was shipped by ocean tanker to Brownsville, Texas, then pumped into trucks that drove across the Rio Grande into Mexico, made a U-turn, and returned into the U.S., thus qualifying the Mexican oil for the “overland exemption.”

Albertans can expect similar absurdities as the distortions from the Notley policy grow, an outcome inconsistent with the larger goals of U.S.-Canada trade policy. A far-wiser course would be a renewed effort to reform Canadian pipeline regulatory policies; the Alberta cartelization scheme is a poor substitute.

Benjamin Zycher is a resident scholar at the American Enterprise Institute. 

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