The deep discounts applied to Canadian crude blends compared to the North American benchmark West Texas Intermediate (WTI) have attracted considerable attention. The severity of the discount applied to Canadian heavy oil known as Western Canadian Select (WCS), which is the benchmark price for bitumen, caused the government of Alberta to impose mandatory production cuts on oil producers. Those cuts, which begin in January 2019 and will reduce daily production initially by 325,000 barrels, are aimed at draining the massive supply glut that has accumulated in Western Canada to see oil inventories at record levels. The cuts have already…
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The deep discounts applied to Canadian crude blends compared to the North American benchmark West Texas Intermediate (WTI) have attracted considerable attention. The severity of the discount applied to Canadian heavy oil known as Western Canadian Select (WCS), which is the benchmark price for bitumen, caused the government of Alberta to impose mandatory production cuts on oil producers.
Those cuts, which begin in January 2019 and will reduce daily production initially by 325,000 barrels, are aimed at draining the massive supply glut that has accumulated in Western Canada to see oil inventories at record levels. The cuts have already buoyed Canadian oil prices with WCS more than doubling from the record low hit in November 2018.
Emerging natural gas glut
While the issues facing oil have garnered most of the attention from pundits, Canadian natural gas is facing an almost identical crisis. A lack of pipeline exit capacity, which was the key driver of the wide differential between WCS and WTI, is also affecting natural gas prices. The Canadian benchmark AECO price for domestically produced natural gas has been depressed for some time, trading at a steep discount to the U.S. benchmark Henry Hub price. As of January 4, the Henry Hub spot price was US$3.03 per million British thermal units (MBTU), whereas the AECO spot price was almost a third, trading at US$1.02 per MBTU.
A lack of takeaway capacity because of infrastructure bottlenecks and pipeline constraints has caused Canada’s natural gas inventories to surge. According to the Canadian Gas Association, domestic natural gas stocks reached over 700 billion cubic feet by October 2018, which was 69% greater than in January 2018 and well above the five-year average, weighing heavily on AECO prices.
The deep discount is having a significant financial impact on Canadian natural gas producers. Painted Pony Energy (TSX:PONY), which is focused on the Montney, reported a third-quarter 2018 net loss of almost $19 million compared to net profit of over $19 million for the equivalent period in 2017. That can be blamed on weaker AECO pricing with the natural gas benchmark averaging $1.19 for the quarter, which was 18% lower year over year and a third of the average NYMEX natural gas spot price. The only reason Painted Pony’s netback for the period grew compared to the same quarter in 2017 was significantly higher prices for natural gas liquids and the positive effect of the hedges held by the driller.
There is every sign that Canadian natural gas prices will remain weak for the foreseeable future with no sign of the deep discount against Henry Hub or NYMEX prices easing anytime soon, because the lack of pipeline transportation capacity can’t be addressed overnight. It takes a considerable amount of time and capital to plan and construct new pipelines or expand existing pipelines. The strict regulatory environment can make it a very lengthy process to construct new pipelines. The situation is being further exacerbated by natural gas producers ramping up production.
Pembina Pipeline (TSX:PPL)(NYSE:PBA) is a major player, providing natural gas transportation, storage, and processing infrastructure in Western Canada. The existing supply glut and growing production have created considerable opportunities for infrastructure providers to grow earnings. Pembina is targeting significant expansions of its existing gas infrastructure. This includes expanding its Peace pipeline to support ongoing production growth in the Deep Basin and Montney plays, which are experiencing natural gas booms. The company anticipates that once phase six of this project is completed in 2020, the pipeline system will have capacity of 1.1 million barrels daily.
Pembina is also developing the Jordan Cove LNG project in Coos Bay, Oregon, which is a liquefaction and export facility that is forecast to have LNG production capacity of 7.8 million metric tonnes per annum. The midstream services provider has applied for approval to the Federal Energy Regulatory Commission and a response is expected in November 2019.
Are natural gas producers attractive investments?
The wide differential between AECO and U.S. Henry Hub as well as NYMEX prices for natural gas makes drillers like Painted Pony that are focused on natural gas production unattractive investments. There is no sign of the pipeline bottlenecks easing for the foreseeable future, which means that weaker prices are the new normal.
It does, however, make energy infrastructure providers like Pembina attractive investments, because there is already considerable demand for the new projects currently under construction. The energy infrastructure provider has a $3.1 billion portfolio of assets under development that come online between now and 2020 and will significantly boost earnings.
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Fool contributor Matt Smith has no position in any of the stocks mentioned. Pembina is a recommendation of Dividend Investor Canada.