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Can new upgraders solve Alberta’s differential dilemma?

The government wants to help ailing oil sands producers by funding new upgraders

To upgrade or not to upgrade is the question facing Canadian oil producers after the Alberta government committed C$1bn ($780m) in incentives to build new pre-refining facilities aimed at increasing prices for its ultra-heavy oil sands and bitumen.

The crippling differentials between light and heavy oil that reduce the price Canada's crude fetches on world oil markets has long been the bane of Canada's oil sands producers.

Differentials are a function of the oil sands' crude quality compared to lighter grades. The heavier the viscosity, the less it sells for. The discount for Western Canadian Select, a key price benchmark, typically averages 25-30% off the West Texas Intermediate price, but has often exceeded 50%. Some estimates have suggested Canadian oil producers are losing as much as C$20bn annually by selling a partially finished product to American refiners.

The situation is being exacerbated by a worsening shortage of pipeline capacity to take crude from Alberta to key markets on the US Gulf Coast, creating a supply glut at home.

As capacity dwindles and production increases, the huge chunk of the pipeline being taken up by diluents, which are used to lighten the oil sands' bituminous crude for transport, becomes more problematic. Especially because much of the diluent is imported and re-exported, adding no value while crowding out new barrels.

As much as 30% of each barrel of bitumen is comprised of thinning agents. Eliminating them would free up nearly 1m barrels a day of pipeline space and save producers C$13bn a year.

The solution is to upgrade the heavy oil near the field, a pre-coking process which results in a superior product that can meet pipeline specifications without thinners and fetches higher prices. Presently only 40% of Canada's heavy oil and oil sands are upgraded.

It seems simple, but there's a huge Catch 22. Upgrading is a risky business.

The pots and pans are hugely expensive to build and producers are reluctant to take on new upgrader construction without subsidies. Further, the economics are predicated on precisely those differentials-the wider they are, the more attractive it becomes. Conversely, narrowing those discounts quickly erases any fiscal gain. For producers, there is a strong incentive to allow others to make the costly investment and freeride on the economic benefits, which is why the government is stepping in.

However, operators—in this case the public—can lose their collective shirts in a hurry if the market swings or costs get out of control.

To top it off, upgrading will blow Canada's greenhouse gas emissions through the roof at a time when carbon taxes are poised to double by 2020 and the country is looking to reduce emissions.

The industry is leery. The last time the Alberta government built an upgrader—the Bi-Provincial Lloydminster Upgrader in the 1980s—it failed to recover its investment and eventually sold its interest for pennies on the dollar to Husky Energy.

Likewise, an upgrader being built near Redwater is facing similar criticism amid uncertain markets and cost overruns. That facility isn't being directly funded from the public purse, but the province has committed its royalty share of bitumen barrels in kind to supply it under long-term contracts. Ted Morton, a former energy minister (who ironically signed off on the project), has publicly called it a "boondoggle" and a waste of time, effort and resources.

Voters are also questioning the wisdom of corporate handouts at a time when the government's accounts are drowning in red ink, precisely due to those widening discounts and several years of weak oil prices. But without some way to increase profits on oil production, which would in turn increase royalty payments to the treasury, the province faces difficult spending cuts.

So, the question isn't whether Alberta can afford to upgrade at home. The more pressing concern is whether it can afford not to.

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