PUB – “The Producers”

By Dan Cronin and John Auers

“The Producers” is a 1967 satirical film written and directed by the incomparable Mel Brooks (his directorial debut) which later was made into a Tony award-winning Broadway musical and remade into a 2005 film.  The story focuses on a scheme to oversell shares for a musical that is designed to fail and close the same night it opens.  The idea is that investors will not audit the books of a failed musical and the producers will pocket the investment money.  However, the perfect plan fails as the musical turns out to be a huge success.  In one of the more memorable lines, one of the producers says, “I was so careful… I picked the wrong play, the wrong director, the wrong cast… where did I go right?”  Unlike in the movie, producers of Partially Upgraded Bitumen (PUB) are looking to develop a sustainable business model that will allow more Canadian bitumen to make it to markets in a pipeline constrained environment by reducing the need for diluent while at the same time increasing its netback value. As discussed in last weeks’ introductory blog on this subject– the Alberta Government has established a major program to incentivize the development of projects to produce PUB, backed by C$1 billion in grants and loan guarantees.  One award from this pot has already been announced (to Value Creation, Inc.) and more are expected in the coming days and weeks.  In today’s blog, we profile some of the producers and technology developers which are pursuing PUB strategies and discuss (in a broad way) some of the economics which are incentivizing these projects.

What’s a Producer to Do?

The first question a producer must ask themselves is if they will remain with the status quo and continue to blend bitumen with light diluents, or if they will try to reduce or even eliminate this cost by investing the necessary capital to produce a PUB.  In the current pipeline limited environment, an even more important driving force is the prospect of “stretching” the existing logistics capacity through the reduction of the required diluent volume.

The known producers[1] that are investigating PUB include Cenovus, CNOOC (formerly CNOOC Nexen), Husky, and MEG.  Other players also include the merchant upgrader Value Creation Inc (VCI), and the technology companies Auterra Inc., Field Upgrading, Fractal Systems, Fluid Oil Ltd, JGC Corporation, EXT System Inc., Expander Energy Inc., Honeywell UOP, and Sherrit International.  These companies all see the positive attributes associated with PUB – each company has its own technology and business plan that it will execute.  Below, we assess two companies in more detail – Value Creation Inc. and Fractal Systems.  These companies directionally represent “bookends” of the publicly reported information from known PUB players (in terms of project costs and upgrading complexity) and will most likely occupy different niches in the marketplace.

[1] ENI has partial upgrading technology but is not currently present in Canada

As you can quickly see, the VCI merchant upgrader has numerous advantages with respect to its output and the avoidance of condensate all together; however, the cost, while relatively inexpensive compared to a full-scale upgrader is relatively high compared to Fractal Systems.  The advantage Fractal Systems has is the associated lower capital cost; however, it faces the challenge of marketing a heavy crude that still requires diluent for pipeline transport.  VCI and Fractal Systems represent two different ways in which to solve the same problem – VCI is betting on the fact that higher capital costs are justified by the premium it should receive in the marketplace for its output, while Fractal Systems is betting on the low-cost approach.  Again, these companies will most likely occupy different niches in the marketplace.

What will be the Price of PUB?

Predicting relative crude prices is extremely challenging for existing crudes and such a task is an even greater challenge for crudes that do not yet exist, as is the case for these new PUB streams.  Some may point to the fact that some PUBs are already being produced in Alberta (Pine Bend Special [PBS] and Suncor Cracked C [OCC]), and we could simply look to these crudes for a price reference.  However, with one producer selling to one consumer (as is the case with these streams) it wouldn’t be prudent to extract a broader market price from this for future PUB production; not to mention the fact that these existing PUBs and each of the prospective streams are each very unique in quality and character.

To answer the question of price, one would need the crude assay for each PUB.  With a crude assay in hand, one would then need to look at a variety of quality factors (distillation yields and both whole crude and individual cut properties), and through refinery modeling determine how the refining values of the PUBs differ from those of competitive crudes (perhaps Mars or ANS for VCI and WCS for Fractal Systems).  The refinery modeling process itself requires a significant amount of judgment to determine a “price setting” location and refinery configuration and of course there are a lot of factors which can’t be effectively modeled, but which are important in valuing crudes which also have to be considered.

The challenge for any new crude brought to market is the length of time required for the necessary price discovery to take place.  Generally, a new crude brought onto the market will face an introductory price discount.  Recall when DilBit was first introduced – there were worries about refineries not being able to process a “dumbbell crude” and as a result, DilBit initially faced a discount versus its refining value.  However, the combination of a price discount and the increasing volume of DilBit incented more and more refineries to utilize this crude source.  As refineries started running more DilBit, the introductory discount disappeared – in fact WCS (which is primarily composed of DilBit) has now become the heavy crude marker for Midwest refineries.  Eventually, DilBit gained such an acceptance that many refineries in PADD II invested in the necessary coking capacity to process this crude.

When PUB is introduced into the market, it will face a similar dynamic that DilBit faced with respect to an introductory price discount and a price discovery phase; however, PUB is expected to have two major advantages that DilBit didn’t.  The first advantage for PUB is that refineries are already very familiar with DilBit and as a result, PUB might be viewed as a crude with only minor differences.  The second advantage is that PUB could potentially be run at more refineries than DilBit, and a “thicker market” could result in a shorter price discovery timeline and potentially a smaller introductory discount.

One of the key marketing events that took place with respect to Canadian heavy oil was the formation of the WCS stream.  One of the driving forces behind the WCS stream was to serve as a tool to help protect the producers against refineries from employing a “divide and conquer” strategy.  The WCS concept has worked well for producers and this could be a potential template for future PUB marketing efforts.

PUB properties will differ based on the technology employed and the source bitumen.  As more PUB streams enter the market, a possibility exists for the introductory discount to be extended for all PUB streams.  To avoid this fate, PUB players could create their own blended stream similar to what occurred with WCS.  As more PUB crude comes online, a blended PUB stream could be created to allow PUB players to gain market acceptance more rapidly.  The obvious challenge with such a strategy is not only determining the equalization payments among the participants but also to minimize the fluctuations in the stream’s quality as new PUB producers are incorporated into the blended stream.  How big that stream is depends on how well PUB producers can get along (i.e., agree on equalization payments) and the inherit advantages associated with PUB.

Cost Side Economic Benefits of PUB

The potential economic benefits of PUB are enormous based on diluent reduction/elimination alone.  For illustrative purposes, lets work through an example using the VCI parameters.  In the table below, we assessed the incremental cost for VCI to move the same bitumen volume to market as a DilBit instead of as a PUB (i.e., the cost savings associated with condensate avoidance).  We assumed that condensate will be sourced at Kankakee, IL, via the Cochin pipeline, and that DilBit will be sold into the Houston market via the Keystone pipeline.

The annual cost savings associated with no condensate usage and the above inputs is as follows:

As you can see, the savings on avoiding diluent is significant.  This in addition to the fact that VCI is producing ULSD and a medium sour synthetic crude which will receive a premium over WCS, the case for PUB becomes very persuasive.  This calculation is obviously a simplified example; however, the merits of PUB are potentially very compelling especially when you layer in pipeline constraints and how PUB will save on pipeline capacity.

In the next PUB blog, we will focus on some of the challenges facing PUB such as potential capital cost overruns, the willingness of midstream providers to transport/store PUB, and the challenges refineries will face in processing PUB.

Due to the time and space limitations of a weekly blog, we have included only a high-level discussion of PUB here.  If you are interested in more information about PUB and how it could/will specifically impact your company’s future plans or strategies, please call or email us  at 214-754-0898 or jauers@turnermason.com and dcronin@turnermason.com