WCS is among the cheapest crude oils in the world. On average, WCS traded with a discount of US$17.2 relative to the WTI. In November 2018, WCS discount relative to WTI reached a record of US$46/bbl. This significant discount pushed the Alberta provincial government to impose production limits in the province. A limit of 3.6 million barrels per day was set at the beginning of 2019 and slowly increased to 3.8 million barrels per day by the end of 2019. Implementation of these limits ceased at the end of 2020.
Oil price is significant for Canadian investors. Some investors use Canadian ETFs to speculate on oil prices. For example, HUC-Horizons Crude Oil ETF replicates the crude oil price performance. More importantly, a substantial portion of the S&P/TSX Composite index is composed of Canadian oil stocks. Upstream Oil stocks, companies engaged in the exploration and development of oil and gas reserves, are often leveraged to the price of oil.
Upstream oil companies are good long positions in an oil bull market, while they can be good short positions in an oil bear market. Midstream oil stocks engage in storing and transporting oil and natural gas. Midstream oil stocks can make good dividend stocks. Oil is often traded in US dollars, and for historical reasons, its price is quoted per barrel (bbl). Each barrel is 159 litres. The effect of oil prices goes far beyond oil stocks; changes in oil prices are often an important component of the inflation rate.
Oil is composed chiefly of hydrocarbons. Hydrocarbons are organic molecules made up of carbon and hydrogen. The larger the hydrocarbons' average molecular weight, the greater the oil’s specific gravity.
Oil with higher specific gravity is considered heavy oil, while oil with lower specific gravity is regarded as light oil. Lighter oil is easier to refine into desirable products, and thus, it often commands a higher price.
Oil with higher sulphur content is considered sour, while oil with lower sulphur content is considered sweet. Burning sour oil would put poisonous oxides of sulphur into the air, which is forbidden by environmental regulations. Since removing sulphur from oil is expensive, sour crude often commands a lower price than sweet crude.
|Light Crude||> 31.1||< 870 kg/m3|
|Medium Crude||22.3-31.1||870-920 kg/m3|
|Heavy Crude||10-22.3||920-1000 kg/m3|
|Extra Heavy Crude||< 10||> 1000 kg/m3|
API is an ad hoc measure of density created by the American Petroleum Institute. It is defined as API = (141.5/Specific Gravity) - 131.5. In this formula, Specific Gravity is defined as oil density/water density.
Western Canadian Select (WCS) is a specific crude oil product used as a benchmark for most Western Canadian crude oil blends. WCS is a heavy sour blend of bitumen blended with synthetic sweet crude and condensate. WCS is mainly produced by Cenovus Energy, Canadian Natural Resources, Suncor Energy, and Repsol. These four companies created the WCS stream in 2004. WCS is primarily traded in the Husky oil terminal in Hardisty, Alberta.
WCS often trades with a sizable discount to WTI. This discount is partly because of the higher cost of refining heavy oil compared to light oil and sour crude compared to sweet crude. But a more significant portion of this discount is because of limited transportation capacity from northern Alberta to oil markets.
Over the past two decades, Alberta oil production has grown fast, but NIMBYism has made it very difficult to either build new pipelines or expand the existing pipelines. NIMBY is an acronym for “not in my backyard,” which refers to residents' objections to development projects in their local area. In addition to NIMBYs, environmentalists also object to developing or expanding pipelines from Alberta.
Environmentalists hope the lack of pipeline capacity would prevent the development of oil sands. They prefer oil sand resources to stay in the ground because oil sands are among the most carbon-intensive oil reserves in the world. But in practice, even in the absence of pipeline capacity, oil sand reserves are developed, and the oil is transported by train, which has a much lower safety record than pipelines.
Conventional oil production in Alberta has been ongoing since the middle of the last century. Over the past two decades, increased bitumen extraction from oil sand has dramatically increased Alberta oil production.
Price of sweet light crude oil at Cushing, Oklahoma (WTI), from 1986 to present. The most exciting feature in this graph is the price of WTI on 20 April 2020, when the oil price was -$37/bbl. A negative price is a very rare occasion. In April 2022, the US oil market had high production and low consumption. The remaining oil farm capacity in Cushing was mainly reserved, and traders who had no place to put their oil had to pay someone to take it off their hands. Data from Energy Information Administration.
North America's most famous crude oil benchmark is West Texas Intermediate (WTI). WTI is a light sweet crude delivered to Cushing, Oklahoma.
WTI serves as a benchmark for oil prices in the US because many tank farms surround the tiny town of Cushing, and it is an oil pipeline hub. Pipelines connect many producing regions (basins) and a train unloading terminal to Cushing, while outgoing pipelines connect Cushing to large refineries in the US.
These factors ensure that producers and consumers of crude can arbitrage away price differences from WTI. The position of WTI as a benchmark is further cemented by the enormous volume of trade in futures contracts for WTI.
Oil prices are cyclical because predicting the oil demand is incredibly difficult, and so is predicting oil production. Forecasting demand is challenging because it requires predicting consumer behaviour, and predicting supply is difficult because there are so many producers. The Toronto Stock Exchange (TSX) alone has 50 oil and gas companies with a market cap close to or more than 1 billion dollars. 18.5% of the S&P/TSX Composite index is composed of energy sector stocks.
But the largest source of uncertainty in oil prices is due to politics. Some oil-producing countries have troubled relations with the most powerful state in the world order. These producers could be pushed out of the market by US sanctions, thus changing oil supply and demand dynamics. Currently, Iran and Venezuela, both members of the oil-producing countries cartel OPEC, are forced out of the oil market by US sanctions. Anybody who carries, insures, or buys their oil will be sanctioned by the US.
More recently, due to Russia’s action in Ukraine, she has faced Western sanctions. According to the International Energy Agency, as of August, these sanctions have reduced Russian crude oil exports by about 600k bbl/day. Also, nearly 1.5 million bbl/day of Russian oil is forced to reroute. All these complexities cause the oil market to be, on most occasions, out of equilibrium.
Fortunately, there is much commercial oil storage capacity available, and also oil tankers can be rented to store oil. A small surplus or deficit in the supply vs. demand for oil is generally ironed out by investors who buy and keep extra oil when there is a surplus and sell stored oil when there is a deficit. Long-duration or large deficits create an oil bull market, while long-term or extended excesses create an oil bear market.
Up to 1960, oil prices were determined mainly by large international oil companies or at least it seemed to be determined by them. They were known as the Seven Sisters.
In 1960, representatives from Iran, Iraq, Kuwait, Saudi Arabia and Venezuela founded the Organization of Petroleum Exporting Countries (OPEC). These countries aimed to collaboratively manage supply and prevent their national wealth from being sold too cheaply.
Over time, other countries have joined OPEC. Its membership currently includes Algeria, Angola, Equatorial Guinea, Gabon, Iran, Iraq, Kuwait, Libya, Nigeria, the Republic of the Congo, Saudi Arabia, the United Arab Emirates and Venezuela. OPEC is a classic example of a cartel and presents a real-world example of how cartels cannot succeed.
OPEC has no mechanism to impose quotas on its members, who often cheat on their allotments. Moreover, every short-term success in increasing oil prices has reduced OPEC’s market share. In 2016 there was a glut in the oil market, and OPEC was unwilling to reduce production and stabilize the market because its market share had already diminished. Following extensive international negotiations, a group of non-OPEC oil-producing countries (Russia was the most critical member of this group) agreed to participate in reducing production with OPEC members. This more powerful cartel which includes OPEC, is known as OPEC+