INDU Committee Report
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CHAPTER 15:
THE PETROLEUM PRODUCTS SECTOR
Economic Contribution and Industry Structure
The petroleum products industry comprises the "downstream" portion of the petroleum sector and includes 18 oil refineries and 13,000 automotive retail stations. Crude oil (approximately 1.6 million barrels per day) is refined into a variety of different petroleum products, principally motor gasoline, diesel fuel, aviation fuel, light and heavy fuel oil, and other products, such as lubricating oils and greases, asphalt and petrochemical feedstock. The Canadian Petroleum Products Institute (CPPI) described its members' activities and economic impact to the Committee as follows:
| The member companies of CPPI have over $6 billion of capital employed in the business. ... We employ directly in the industry 130,000 Canadians ... In addition, we employ indirectly another 100,000 Canadians who supply goods and services to the products business. [Andrew Stephens, Canadian Petroleum Products Institute, 11:15:35] |
The three largest refiners (Imperial Oil Limited, Petro-Canada Ltd. and Shell Canada Limited) control about 56% of refining capacity, while the remaining 44% is controlled by 10 regional refiners.43 Natural Resources Canada estimates that 44% of refinery capacity in this country is Canadian-owned, leaving 56% in foreign ownership, of which the United States accounts for 35% and European companies most of the remaining 21%. Independent businesses own 44% of retail outlets.
Productivity and Competitiveness
Both crude oil and refined petroleum products are produced for an integrated North American market; there is a flourishing cross-border trade in these largely undifferentiated products between Canada and the United States at all levels (i.e. oil and gas producers, refiners, wholesalers, retailers and consumers). By definition, an integrated continental market means that Canadian and American producers are direct competitors. Thus, in the 1990s, both Canadian and American "upstream" and "downstream" industry segments faced market circumstances characterized by little to no growth in demand and both suffered depressed price-cost margins and profitability.
Under current conditions, the industry accepts that refineries must operate at about 85% of crude capacity in order to maintain adequate profitability. Given the relatively flat demand in the 1990s, the industry has had to rationalize its operations from 40 refineries in the early-1980s to 18 in 2000 to achieve this level. Employment was cut even more drastically, so labour productivity in the Canadian petroleum refining industry steadily increased:
| Our employees are very productive. For example, our refinery employees generate $200,000 in annual output per employee, which is significantly higher than the average manufacturing employee output of $55,000 per year. Each refinery employee has an employee multiplier of 7 to 1 -- that is, each refinery employee creates an additional seven jobs somewhere in the Canadian economy. [Andrew Stephens, 11:15:35] |
However, as Figure 1.5 showed, the labour productivity of Canadian refiners is considerably below that of United States refiners.
Oil and gas refining is also a highly capital-intensive industry, requiring $8 of capital for every dollar of output. This far outweighs the average capital intensity of $2.60 of capital for every dollar of output for all manufacturing industries. On these terms, Industry Canada estimated the industry's performance as follows:
| The ratio of capital stock (i.e. value of refinery assets in constant 1986 dollars, which includes machinery, equipment and structures) to refinery daily output represents the industry's capital productivity. Since 1988, capital productivity has averaged approximately $63,500 per cubic metre per day of production.44 |
Beyond the contributions that labour and capital productivity bring to refinery margins and profitability, there are a number of other influences, some of which are beyond the refiner's control.45 The operating factors are access to low-cost feedstock, the ability of a refinery to process lower-cost heavy sour and non-conventional crude -- both of which types are expected over time to become more plentiful and economically attractive -- economies of scale, and cost control. In addition, refineries are price takers for both crude purchases and product sales.
The Canadian refining industry is largely based on light, sweet crude oil feedstock, particularly in Ontario, where it has to compete with northern U.S. refineries that have considerable heavy crude coking capabilities that allow them to run the cheaper crude oil. At the same time, industry rationalization has increased the average size of Canadian refineries to a scale that is more competitive with that of northern U.S. plants. Industry Canada sized up the relative capabilities of Canadian and American refineries as follows:
| Canada's industry ahead in hydro cracking and catalytic cracking capabilities, and the American industry ahead in sour crude desulphurization and heavy crude residual upgrading capabilities. The U.S. refiners are therefore currently better positioned to process the heavier, more sour and cheaper crude. |
| Canadian refiners did not invest in the heavy, sour crude upgrading technology during the 1980s to the same extent as their American counterparts. The reason is that the differential between Canadian light and heavy crude oil prices was artificially set by the federal government rather than by international market forces. The administered (light/heavy) price differential was less than the open market spread, and too low to justify major facility investments. In contrast, the U.S. government did not administer crude prices, and market forces were therefore allowed to encourage U.S. refiners to invest in more complex refining technology.46 |
This suggests that U.S. refiners have a competitive advantage over Canadian refiners partly because of past government interference in the industry. Industry representatives were, however, satisfied with their more recent performance and present competitive status:
| When we started doing these surveys in 1990, we were in the bottom half of our class looking around the world and in North America. But over the 1990s, through process changes, capital investment, and the use of technology, we have changed our competitive position such that we are now in the top half relative to other players in the world. That's even considering some of the disadvantages of the Canadian climate, including the long population expanse, the fact that our plants aren't world-scale economy, and those sorts of things. I think both of those statistics in terms of supply costs and in terms of external benchmarking demonstrate that the industry is competitive with any other player in the world. [Andrew Stephens, 11:15:40] |
In addition to its rationalization initiatives, the industry has invested heavily in computer technologies in order to improve both office and process functions:
| The technology we've been adopting tends to be more information technology as opposed to what I might call mechanical or process technology -- information technology in terms of our business systems, the accounting and so forth ... Also, ... the application of computers to simulate processes and process control -- all that has helped us be both more effective in the way we turn crude into products and more efficient in terms of the cost structure. We are starting to see some new technology being developed that we're very interested in. In general, this is technology associated with taking sulphur out of crude oil or taking sulphur out of products. Because there hasn't been a need in the past to do that, there was some fairly typical technology that required high temperatures and high pressures and was very expensive. But we've seen developed, as a result of some of the legislation that's coming at us, lower-cost, low-pressure, low-temperature technologies, which the Canadian industry would like to use. [Andrew Stephens, 11:16:00-16:05] |
At the retail or marketing end of the sector, Canada has not rationalized the number of service stations to the same extent as has the United States. According to the industry, through most of the 1990s Canada operated twice the number of service stations per capita as the U.S.; hence, sales volumes per station in Canada were about half (5,300 litres per day) of U.S. volumes (10,000 litres per day in 1994). Along with rationalization (from 24,100 stations in 1980 to 13,000 in 2000), came restructuring. Receiving relatively low retail margins on gasoline sales, Canadian retail operators have had to turn to secondary sources of income, such as convenience stores and car washes, in order to remain viable.
| I think in general what we've been seeing over the last 10 or 15 years, as I mentioned earlier, is an increased trend toward efficiency and effectiveness. As you look at retail service station throughputs in Canada, you can see they have been increasing steadily over time. We are still lagging, the average throughputs in Canada relative to the U.S., and I think we'll continue to see a rationalization of facilities going forward. [Andrew Stephens, 11:16:35] |
Industry studies suggest that the failure of the Canadian industry to achieve the same efficiency gains through rationalization as the U.S. can be attributed to government. In Canada, the more stringent environmental regulations govern the decommissioning or removal of station fuel tanks mean that it costs more to exit the industry. This leads to excessive numbers of retail outlets in a period of decline and, in turn, to higher pump prices (or is it that the United States is providing an "environmental subsidy" to retailers?).
Industry Outlook and Policy Issues
The industry's future will largely depend on two factors: demand and environmental constraints. Demand has been flat over the past 15 years and forecasts are not much more promising. When environmental concerns are added to this equation, the picture becomes very uncertain. Take, for example, the industry's forecast of the impact of the Kyoto Agreement:
| If a Kyoto type of scenario unfolded, we would see probably a 30% to 35% reduction in demand for fuels that we make in our refineries, whether they're transportation fuels or heating fuels. A 35% reduction means tremendous surplus capacity. It would mean an environment where refiners were unwilling to invest in new technology because there would be no expectation that they would ever get such a return on that investment. [Andrew Stephens, 11:16:15] |
On the cost side of the ledger, the most pressing environmental challenge over the next decade is the need to produce more environmentally friendly transportation fuels (i.e. reformulated gasoline and diesel fuels). While the technology for producing reformulated fuels does exist, the investment costs are prohibitive. From society's perspective, the health and environmental benefits must be carefully weighed against these costs to ensure cost effectiveness. Efficiency through the right choice of economic instruments is essential.
There is also the issue of how implementing environmental measures will affect the relative competitiveness of Canada and the United States in an integrated North American market.
| I'll start with the standardized specification question. The example that most comes to mind currently is sulphur in gasoline. Canada currently has a regulation requiring various levels to be met over a certain timeframe. The U.S. is in the process of developing that legislation but does not yet have it in place, and it could be that we will be inconsistent. Another example that comes to mind is southern California, which has a different legislative environment and has more stringent requirements for gasoline than anywhere else in the world. The one place where refining has been profitable over the last several years happens to be California, because there are barriers to entry for product coming in. [Andrew Stephens, 11:16:05] |
The Committee, however, wishes to take a more innovative approach to this problem by advocating that Canadian regulations of gasoline characteristics be on the forefront of tough and rigorous environmental standards to provide industry the incentive to innovate and remain ahead of its U.S.-based competitors. In this way, California's tougher environmental regulations will not be a barrier to entry for Canadian gasoline. The Committee recommends:
28. That the Government of Canada ensure that any future environmental regulations imposed on the formulation of petroleum products, particularly gasoline, be at least as rigorous as those of the state of California in terms of both the standards set and the industry's timetable for compliance.
43 Regional refiners include: Irving Oil, Ultramar Canada Inc., Novacor Chemicals (Canada) Inc., Newfoundland Processing Limited, Suncor Inc., Husky Oil Operations Limited, Chevron Canada Limited, Consumers' Cooperative Refineries Limited, Saskatchewan Asphalt and Parkland Industries Limited.
44 Industry Canada, Sector Competitiveness Frameworks: Petroleum Products, Part 1 Overview and Prospects, p. 38-39.
45 Profitability in the petroleum products industry is a function of two margins: (1) the refining margin measures the difference between the refinery's crude costs (i.e. inputs) and the value of the products (i.e. outputs) at the refinery gate; and (2) the retail margin measures the difference between the refinery gate price (usually taken to be the wholesale rack price) and the pump price (net of product taxes) at the service station. The industry's gross margin is the sum of the refining and retail margins and profitability is the gross margin less operating costs, labour costs and income taxes.
46 Industry Canada, op.cit., p. 38-39