Latest Pipeline Spill Indicates That Canada’s Oil Crisis Has Yet to End

Benefit from higher oil by buying Suncor Energy Inc. (TSX:SU)(NYSE:SU) and lock in a 4% yield.

Matt Smith

Former investment manager and market junkie, Matt has 20 years of experience. He hails from Sydney Australia where he earned a Master of Business Law from the University of Sydney and Master of Arts in International Relations from the University of New South Wales. He has been helping investors achieve their goals for over a decade. When not studying the markets, he can be found relaxing with his dogs and practising Spanish.

Published November 11, 2019 1:30 pm EST

The latest oil spill concerning a Canadian pipeline has brought the spotlight back on the oil patch and the risks facing energy stocks. A spill of more than 9,000 barrels of oil from TC Energy’s controversial Keystone pipeline forced the company to close the pipeline, removing almost 600,000 barrels daily of capacity from Canada’s pipeline network.

This caused the price differential between the Canadian heavy oil benchmark Western Canadian Select (WCS) and the North American benchmark West Texas Intermediate (WTI) to widen sharply last week. By last Friday, the price differential had risen to US$22 per barrel compared to US$17 a barrel two weeks earlier. This will have a sharp impact on the profitability of heavy oil producers in Canada’s energy patch, particularly those with limited refining operations.

Vulnerabilities abound

The spill demonstrates oil patch’s dependence on the limited number of pipelines that connect it to crucial U.S. refining markets and its vulnerability to outages. This couldn’t have come at a worse time for U.S. refineries, which have been seeking alternative sources of heavy oil feedstock because of declining Venezuelan oil production and lagging output from Mexico. The recent drop in the price of WCS highlights what could occur once Alberta ends the mandatory production limits that have been in place since the start of 2019.

Edmonton has been progressively winding back the cuts because of reduced local oil inventories, which have lessened the pressure on WCS prices. It illustrates that the lack of pipeline transportation capacity between the oil sands and vital U.S. energy markets has yet to be dealt with, especially when it is considered that pipelines are the most economic means of transporting bitumen.

A combination of steeper regulations, environmental concerns, and lack of investment means that there is significantly less pipeline capacity than the oil patch requires, meaning that a single shutdown has a marked impact on domestic oil prices. That lack of capacity combined with growing oil production, which was responsible for WCS during the second half of 2018 plunging to record lows of less than US$6 per barrel, despite WTI trading at close to US$50.

There is every reason that WCS will collapse again. The production limits have only been a stop gap measure, which has done nothing to alleviate the key problem: a lack of pipeline capacity. There are claims that the cuts even made crude by rail less profitable, which saw some oil sands operators, including Imperial Oil, throttle back the volumes of bitumen transported. This means if the production cuts are eliminated, it will take time to ramp up crude-by-rail volumes to cover the shortfall in pipeline capacity, potentially worsening the impact on WCS prices. Even record crude-by-rail volumes during the second half of 2018 failed to prevent a supply glut from emerging.

For these reasons, Suncor Energy (TSX: SU)(NYSE: SU) remains a top pick for gaining exposure to higher crude. During WCS’s last price slump, it reported record earnings for its refinery operations, which benefited from cheaper heavy oil feedstock and the ability to sell the refined products at premium that mirrored significantly higher WTI prices. Suncor is capable of refining over 60% of its oil production, allowing it to effectively offset and even profit from a wide price differential between WCS and WTI.

The company has been steadily growing its production, with it rising by 2.5% year over year for the third quarter to 762,000 barrels daily, positioning it to benefit from higher crude. Suncor is also one of the lowest-cost oil sands operators, reporting cash operating costs of $26.60 per barrel for the third quarter. Those costs were $4.60 per barrel higher than a year earlier, which was caused by the mandatory production curtailments and changes in Suncor’s production mix, rather than operational failures.

Foolish takeaway

While Suncor won’t shoot out the lights, it is a solid play for investors betting on higher oil. Its integrated business allows it to weather and even profit from oil price slumps, while the scale of its operations, low costs, and growing production mean it is ideally positioned to benefit from higher prices. Investors will be rewarded by its sustainable dividend yielding 4%, while they wait for Suncor stock to appreciate.