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Global Outlook

Gas Prices and Russia’s Aggressive Foreign Policies

April 29, 2014, Tuesday, 17:17 GMT | 12:17 EST | 20:47 IST | 23:17 SGT
Contributed by eResearch


If you are Canadian, you may have noticed that you are now paying prices at the pump that are once again flirting with all-time highs. Yet, there isn't a shortage of crude oil; actually, quite the opposite.

U.S. inventories hit a new weekly high last week, with monthly inventories rising to levels not seen since 1931.

Canada, on the other hand, is already an oil-producing powerhouse, but one that is now experiencing a dramatic increase in natural gas production. So why are we getting cheated at the pump and paying extravagant fees for heat?

I have read everything: from the spring time refinery turnover (where refineries shut down for maintenance in preparation for the busy summer driving season), to shrinking storage supplies in Cushing, Oklahoma, the delivery point for WTI futures, where inventories have fallen back to October 2009 lows. While these reasons all add to the rationale behind high (er) gas prices, it is by far not the whole truth.


Canada: An Oil Producing Powerhouse

When we hear complaints of high gas prices, we are generally talking about the stuff we put in our cars: gasoline. Gasoline is derived from crude oil. One barrel of oil generally produces around 19 gallons of gasoline, but there are also costs associated with refining it and transporting it back to market where you pump your gas. For example, in 2011, refining costs made up about 11% of the total cost of gasoline.

Canada exports nearly three million barrels of oil per day. With this much production, you would expect we should all get a little break on prices at the pump. But we don't. That is because all of this oil needs be refined for commercial use.

The majority of Canadian oil (Western Canadian Select, or WCS) is a blend of conventional oil, bitumen, and synthetics, making it heavier and more difficult to process than some other types of oil, like Brent and even WTI (West Texas Intermediate).

In other words, it costs more to refine WCS. Furthermore, there are not many refineries in Canada that can accommodate the amount of oil we produce. As a result, most of the oil from Canada is shipped down to America for processing.

When you combine transportation and refining costs, the profit margins for refiners using WCS is less than they would get from processing WTI. That means if we want refiners to take our Canadian oil, we have to sell it to them for less - a lot less.

The spread between WTI and WCS has recently been in excess of $30 per barrel. Since Canada produces about three million barrels per day, it means we could be losing $90 million in revenue every day. That is why major campaigns backing the Northern Gateway and Keystone XL pipelines are taking place. These pipelines will alleviate the costs of getting Canadian oil more quickly and efficiently to export markets and refineries on the Pacific coast and the Gulf of Mexico.


Why Do We Ship Oil to America?

The simple answer would be for Canada to build more refineries, instead of shipping it down south. However, a recent report by the Conference Board of Canada showed that it would cost up to $7 billion to build a refinery capable of processing Canadian oil; yet, the returns are rather dismal -especially when you consider the lower Canadian Dollar.

Over the past decade, pre-tax returns in the refining industry have averaged only 11% per year. It is no wonder why Canada has lost 50% of its refineries over the last 40 years. Even in oil-rich Alberta, oil refining accounts for only about 0.3% of GDP.

With nearly 60 refineries practically sitting idle on the U.S. Gulf coast, it is pretty hard for investment dollars to filter into Canadian refineries that are likely destined to have diminishing returns. So, while Canada remains an oil-producing powerhouse, most of our oil is sent down south for processing, before it is sent back to us for use.

Since it is easier and cheaper to pipeline product in from the U.S.A., most Canadian refiners have taken the position of exiting the market. As a result, much of the gasoline used in Eastern Canada is not even Canadian at all.

The added costs of transport and refining have all led to higher gas prices for Canadians.

What is worse is that since we have to buy gasoline (refined oil) from America, even if it was ours to begin with, we have to pay for it in American dollars. That is an immediate 10% premium given the recent decline of the Canadian dollar against the Greenback.

Canadians are getting hit both ways; the price of oil we import is going up, while the price we export is going down.

Furthermore, much of our oil requires natural gas to produce. Oil sands companies need natural gas to heat water to create steam, which softens oil-rich bitumen deposits to the point where the bitumen can drain into wells from which it can be pumped to the surface.

As natural gas prices rise (which they have), so do the costs associated with much of the oil produced.

How lucky are we to have significant amounts of crude and natural gas, yet also the highest natural gas and gasoline prices?

Here is quick average look at the per litre gas prices across the country as of last week:

Victoria - 142.9 cents
Vancouver - 151.7 cents
Calgary - 128.9 cents
Edmonton - 125.9 cents
Regina - 128.9 cents
Saskatoon - 132.9 cents
Winnipeg - 127.9 cents
Toronto - 140.3 cents
Ottawa - 139.3 cents
Montreal - 151.4 cents
Quebec City - 141.4 cents
Fredericton - 140.5 cent
Moncton - 140.5 cents
Saint John, NB - 140.5 cents
Charlottetown - 139.7 cents
Halifax - 143.3 cents
St. John's - 147.3 cents


America: The World's Largest Producer of Natural Gas and More

Canadians can blame the high costs of oil on the high costs of importing oil back into our country, but what about Americans? How come Americans are also being hit with high oil and gas prices?

America's oil production has risen nearly 50% since 2008 and domestic production is finally climbing after almost twenty years of decline.

See the chart on the next page.



Basic supply and demand fundamentals would suggest that, since inventories are now back to alltime highs, oil prices should be much cheaper. But they are not. Why has not the cost of oil and gas come down for Americans?

Sure, drills are turning everywhere and fracking has made oil much more available domestically. But much of America's newly found production comes from shale formations or in deposits under the ocean floor, which is hard to access and, thus, expensive. Places like Montana and North Dakota's Bakken Shale may contain major oil deposits, but individual wells tend to produce little oil, so you have to drill many wells and that takes a lot of investment dollars.

So, yes, it costs much more to produce oil now than it used to - just as it is for mining. Still, the increased costs of oil production are far from the main reasons why oil and gas prices remain so high.


Who Sets the Price?

Violence did not drive the price of oil up, as many media sources will tell you - speculative traders did.

A couple of years ago, there was a great article from New York Times talking about this exact scenario. It explained how traders were the primary reason for increased oil prices:

"...By 2008, eight investment banks accounted for 32% of the total oil futures market. According to a recent analysis by McClatchy, only about 30% of oil futures traders are actual oil industry participants."

That means speculative trading exceeded actual supply and demand fundamentals.

Furthermore:

"According to Congressional testimony by the commodities specialist Michael W. Masters in 2009, the oil futures markets routinely trade more than one billion barrels of oil per day. Given that the entire world produces only around 85 million actual "wet" barrels a day, this means that more than 90% of trading involves speculators' exchanging "paper" barrels with one another.

Because of speculation, today's oil prices of about $100 a barrel have become disconnected from the costs of extraction, which average $11 a barrel worldwide. Pure speculators account for as much as 40% of that high price, according to testimony that Rex Tillerson, the chief executive of ExxonMobil, gave to Congress last year."

The upstream price* (total costs) of oil production in America currently averages $33.76.



Yet, oil prices remain above $100 per barrel. Go figure.


Natural Gas Prices Rising

Canada and the U.S.A. are producing more natural gas than ever.

Canada is the world's third largest producer of dry natural gas with production of 13.9 billion cubic feet per day.

America is now the world's largest producer of natural gas (see chart below), surpassing Russia last year:



While natural gas prices (see chart below) have fallen dramatically over the last decade because of rising production, it does not explain why prices have doubled in the two years since May 2012 from $1.94 to today's price of $4.65.

Yes, we had a harsh winter and used more gas, but that does not account for the rise in price prior to the summer:




Making Money at Our Expense

The USA is a net exporter of natural gas. It is estimated that over 60% of all natural gas production leaves the country. Take a look at the dramatic increase in natural gas exports:



Canada is no different.

Canadian gas supplies earmarked for LNG exports continue to rise. The total export license volume for LNG is now up to 238.33 Tcf (trillion cubic feet), while reserves sit at 68 Tcf.

Annual allowed volumes for LNG export is now at 9.48 Tcf, while Canada currently produces just over 5 Tcf per year and consuming around 3 Tcf per year.

You can do the math.


Battling Russia

As I mentioned in my letter, "Will America Save Europe?" LNG is part of Obama's plan to pay for all of the massive deficit spending that has taken, and continues to take, place in America. This strategy is essentially mirroring Russia's, which has been exploiting its natural gas resources for many years, and succeeding.

If the price of gas drops, America would not make much money exporting gas supplies to Europe via LNG, since it has to compete with Russia, whose gas can be sent to Europe at a much lower cost via pipeline.

The added revenue from exploiting oil and gas could prevent America from its financial destruction.

Oil and natural gas companies pay a lot of taxes. In 2012, the effective tax rate for the industry averaged 44.0%, compared to 26.6% for other S&P Industrial companies.

As the chart below shows, that is the highest tax rate in the USA for any sector.



In addition, oil and gas companies also pay the federal government significant rents, royalties, and lease payments for production access.

Overall, America's oil and natural gas industries supply over $85 million a day to the U.S. Treasury in the form of income taxes, rents, royalties, and other fees. That adds up to more than $30 billion a year.

With pro-energy development policies taking place, the oil and gas sector could produce at least $800 billion in additional cumulative revenue to the government by 2030, according to a study by Wood Mackenzie.

Without proceeds from LNG exports, America seems doomed to financial failure.


A New Energy Partner?

The battle in Ukraine, Syria, or simply Russia vs. the West, all stems from energy (see The Real Reason for War in Syria).

This is where Russia has been sticking it to America. Not only does Russia already control the flow of gas into Europe, it is about to strike a deal with one of the largest consumers of energy on the planet: China.

After a 10-year series of talks, Russian President Vladimir Putin is expected to meet with China in May to finalize the agreement. I told you about this last month and we will soon see what happens.

If Russia can negotiate a gas agreement with China next month, it will have an upper hand in the battle for energy dominance.

Pipelines are already being built through Mongolia, which likely means it is only a matter of time before gas starts piping through.

This could also affect anticipated LNG shipments from Canada, as LNG costs more than pipeline gas.


Aggression Rising

America is feeling desperate and has finally persuaded other Western nations to follow.

Within the past few days, there have been rumours of Washington sending additional troops to Poland and the Baltics for NATO exercises; this is the front line of the former Soviet periphery.

Meanwhile, American financial services company Standard & Poor's downgraded Russia's credit rating from BBB to BBB -, which is considered the lowest investment grade by market participants. This was clearly a political blow to Russia.

But, more importantly, the G7 have agreed to intensify sanctions against Russia over the Ukraine crisis, with a U.S. official warning some punitive measures could be imposed as early as Monday.

As a result of the intensifying aggression between both sides, Russian presidential adviser Sergei Glazyev proposed a rather radical plan of 15 actions to protect Russia's economy if sanctions were to be applied:

1. Translation of state assets and accounts in dollars and euros from NATO countries to neutral ones.

2. Returning all state-owned assets (precious metals, works of art, etc.) to Russia.

3. Begin selling NATO member sovereign bonds before sanctions are imposed.

4. T ermination of export of gold, precious, and rare earth metals.

5. Monetary swap with China to finance critical imports and transition to settlements in national currencies.

6. Creating own system of exchange of information for interbank payments and settlements

7. Creating a payment settlement system of bankcards like Visa and MasterCard.

8. Limiting foreign exchange position of banks, the introduction of preliminary declaration of major non-trading foreign exchange. Introduction to future tax on capital outflows and financial speculation.

9. Russia should use national currencies in trade with customs Union members, other non-dollar, non-euro partners and conclude new contracts for the export of hydrocarbons in rubles.

10. Monetary swaps with countries to finance trade.

11. Rapidly decline reserves dollar instruments and debt obligations to the countries supporting sanctions.

12. Substitution of state corporations and state banks loans in dollars and euros ruble

13. Advocate citizens to expedite the transfer of euro and dollar deposits into rubles, just in assets of state banks in the U.S. and the EU are frozen.

14. In response to the trade embargo - the implementation of critical operations through Belarusian and Kazakh enterprises.

15. Converting offshore ownership of strategic enterprises, subsurface objects, and properties to national jurisdiction.

Many of these points, while radical, make a lot of sense.

Despite sanctions, there will be many nations who will accept the ruble in payment, which is why monetary swaps with countries can combat much of the sanctions imposed. Think China, for example.

The battle between Russia and the West continues to heat up and it is not going away anytime soon. I have mentioned this over the past year, and it is very real and not something to take lightly.

Just over a year ago, I received a letter from a reader saying that I was a fear-monger for explaining the situation with Russia and the current financial/energy battles around the world. Today, it is slowly unfolding.

As I write this, Ukrainian Prime Minister Arseniy Yatsenyuk just told the world that Russian military aircraft had crossed the country's airspace seven times "to provoke Ukraine to start a war".

NATO estimates that 40,000 Russian troops are massed on the Ukraine border, and appear to be in a state of readiness to invade.

I can say with confidence that this will not end well. Something drastic will happen out of this battle that will significantly affect our money and our portfolios.

Look for traders to create big swings in the market in the coming months on the progressive aggression overseas.