Oilweek - March 2008

Production volume and contracts are hardly now at the level to justify a formal mechanism. However, I am of the opinion that both will reach sufficient levels within the next five to seven years.

Much of this increasing extraction will initially rely upon Russian and Venezuelan production, but the Alberta oilsands are unquestionably the driving force for both future pricing and market supply. The about one million barrels a day now produced are insufficient to require a formal market, but supply will increase substantially in the very near term.

Once Alberta production begins to reach the market in sufficient volume, neither producers nor consumers will settle for a continuation of indirect pricing, or artificially established discounts to tradable crude. Unfortunately, unless Alberta moves to establish a formal trading environment and a benchmark price, the province (along with its producers) runs the risk of having the market price determined by other suppliers.

A market expects that the primary source of reliable supply sets pricing

This is equivalent to an interest free loan to the U.S. economy. So long as the dollars remain out of circulation, they cannot contribute to inflation in North America.

A corollary development involves the investment of dollars used to purchase oil back into the American economy— primarily in both sovereign and corporate bond investment. To the extent that the dollars return as investment in treasury bills or corporate notes, there is no direct inflation. This is how the U.S. has subsidized an expanding balance of payments deficit without experiencing significant inflation. The Saudis have even been allowed to buy U.S. treasuries without going through the normal auction process.

However, all of this is about to change. Given the weakness of the U.S. dollar and the emergence of the European Union as a major unified energy player, pressures are building to denominate contracts in euros.

Both Iran and Russia in introducing their new benchmark crude rates will move to denominate contracts in euros not dollars. A few OPEC consignments sold on the Dubai Exchange have already

How Alberta determines bitumen development
as well as the current royalty structure debate
will have profound impacts well beyond the
borders of the province.

parameters. Otherwise, previous experience in commodities markets indicates the primary producer loses market flexibility while overall trading stability is compromised. When it comes to bitumen, the primary producer will be Alberta. To protect both return and producer position, it needs to be setting the market price.

There is a parallel consideration in the broader oil market that likewise dictates an early move by Alberta. It is in Canada’s interest to set the bitumen price since U.S.-dollar-denominated contracts are under increasing pressure. This dynamic will have several major results for North America, obliging a response to protect the Canadian producing sector.

All global oil contracts have been transacted in U.S. dollars. This has meant that a considerable amount of U.S. currency at any given time is off the table, remaining in foreign banks as petrodollars to secure consignments and finance future contracts.

gone forward in euros. A de facto euro discount is in force.

Reviewing the past three years of sales, crude oil has increased 87 per cent in dollar terms but only 73 per cent in euro terms. The market is already factoring in the strength of the euro and the likelihood of euro-denominated oil contracts.

When these emerge in regular transactions, fewer petrodollars will be retained in foreign banks. The dollars will be exchanged back to the U.S. to fuel a significant resurgence of inflation. And when that happens, it will quickly move north.

This means insulating Canadian production revenue from repatriated petro-dollar pressure obliges a pricing strategy. Given the increasing position of bitumen in the resulting calculations, such a strategy requires a benchmark rate and a Canadian “inspired” exchange mechanism.