Spatial Price Dynamics: Implications for Investment Decisions and Energy Policy in Canada
This thesis, entitled Spatial Price Dynamics: Implications for Investment Decisions and Energy Policy in Canada, studies the long-run relationship between crude oil prices in different geographical areas and evaluates the impact spatial price differences have on the value of oil sands investments in Alberta. The impassioned debate surrounding the approval of new crude oil export pipelines has been the primary motivation for this research. Beginning in 2011 a larger than normal spread emerged between crude oil prices in Alberta and the rest of the world as constrained transportation capacity has meant excess supply could not be transported from production regions in Northern Alberta to those markets that would yield the highest return. This has led many participants in Canada's energy sector to advocate for expanding Canada's pipeline transportation system, meanwhile, opponents argue the benefits do not justify the direct and indirect economic and social costs of new pipeline capacity. In the first chapter a two-factor real options model is developed to examine the impact spatial price differences have on the value of an oil sands project and the incentive to invest. Spatial arbitrage theory shows that large, volatile price differences between locations can emerge when demand to ship exceeds capacity limits. This may have a significant impact on production, investment, and policy in exporting regions. I assume the price difference between two locations follows a stationary process implying prices in different locations move together. The investment decision is formulated as a linear complementarity problem that is solved numerically using a fully implicit finite difference method. Parameters for the stochastic processes are estimated from monthly spot price data for West Texas Intermediate (WTI) and Western Canadian Select (WCS). Production parameters for the oil sands project were selected to represent a typical steam-assisted gravity drainage project. Results show the value of an oil sands project and the incentive to invest in a new project will increase when price differences decrease. Surprisingly, the standard deviation of the price difference has very little impact on project value or the incentive to invest. The second chapter studies the co-movement of weekly crude oil spot prices from different geographic regions for the period from May 2008 to February 2016 using a cointegration approach that allows for endogenously determined structural breaks. The emergence of large, persistent price differences between land-locked North American crude oil prices and international benchmarks has cast doubt on the `one great pool' hypothesis which holds that crude oil prices in different geographical regions move together. Results indicate crude oil prices, for similar and different quality crude oils, are cointegrated with a structural break suggesting oil markets are still integrated. Estimated break dates range from the July 30, 2010 to December 16, 2014, with break dates for price pairs including a land-locked North American crude oil and an international benchmarks occurring in December 2010 and January 2011. These break dates correspond to the beginning of the unconventional crude oil production boom in North America. The results of the second chapter suggest that crude oil markets are integrated but indicate that capacity constraints may have a significant impact on the relationship between crude oil prices. The third chapter builds on the second by considering the impact constrained transportation capacity has on the WTI-WCS spread. The WTI-WCS spread is modeled as a two regime Markov-switching model where one regime corresponds to normal times when there is sufficient transportation capacity and the other regime corresponds to times when there is insufficient transportation capacity. The results of this chapter confirm predictions in the spatial arbitrage literature. When there is sufficient transportation capacity the spread reflects transport costs and quality differences between WTI and WCS. During periods of tight capacity the spread becomes more volatile and on average exceeds transport costs and quality difference.