In light of Keystone delays, is NAFTA becoming obsolete?

“There’s no question – at least at that time – that U.S. policy toward Canada was aimed at security of supply”

June 23, 2014

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Allan Gotlieb remembers the years leading up to the Free Trade Agreement, the forerunner to NAFTA, in the 1980s. He was Canada’s ambassador in Washington from 1981 to 1989 and one thing that sticks in his mind today is how important Canadian oil and gas was to the Americans.

“There’s no question – at least at that time – that U.S. policy toward Canada was aimed at security of supply,” he recalls. “This was particularly as a result of the OPEC shocks, so that was a major objective of the U.S.”

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1992: The original three amigos sign the North American Free Trade Agreement, ushering in a new era on the continent
Photo by Dirck Halstead/Time Life Pictures/Getty Images

It was a time of energy anxiety. The Arab oil embargoes and crude oil price shocks of the 1970s were still fresh in the minds of Americans, U.S. crude imports had quadrupled in the decade to 1980 and domestic production stagnated. Canada had instituted its National Energy Program (NEP), which U.S. president Ronald Reagan viewed as directly aimed at the U.S.

There were several aspects to the FTA and NAFTA negotiations, and each had its own objectives. On the energy side, the U.S. had its eye on tapping Canada as a long-term friendly supplier and wanted a deal following the 1980 NEP. “Reagan and many in his administration saw the NEP as aimed primarily at the United States and so they were determined to use the FTA, which Canada had asked for, to get concessions that would prevent anything like that from ever coming back,” says Christopher Sands, senior fellow at the Hudson Institute, a domestic and foreign policy think-tank based in Washington, D.C. “They just wanted to make sure Canada never did that again. Canada’s oil was something that mattered a great deal.”

Washington came away happy. NAFTA went into effect on January 1, 1994, after ratification by the governments of Canada, the U.S. and Mexico. The final energy provisions, in Chapter 6 of the document, basically stipulated that Canada may not restrict exports to the U.S. below a historic percentage of its production.

 

This year marks 20 years since NAFTA came into effect, and neither country seems to care about this provision anymore. Instead, a momentum of unilaterally negotiated exports from each to destinations outside the continent has taken over. Although Canada remains America’s largest foreign supplier of crude and existing south-directed pipelines are consistently full, natural gas exports have drastically slowed. Both countries are racing, indeed competing, to construct LNG liquefaction and export terminals for world export. Prime Minister Stephen Harper has signed a free trade deal with the European Union and discussed supplying Germany with energy. ­Canada has three major crude pipeline projects under application aimed beyond North America: Northern Gateway and Kinder ­Morgan to the West coast, and the Energy East pipeline system partly for ­export of Canadian crude from the East coast. Although U.S. legislation prohibits American crude exports, the U.S. is re-exporting crude that has been imported; much of that is even going to Canada. The U.S. Department of Commerce has approved 52 crude oil re-export licenses in the past six months to destinations other than Canada. And Mexico, whose production has been sagging, pushed through new legislation to allow foreign investment into its oil and gas sector, will likely be looking to export as well via Acapulco.

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2014: Current leaders are exploring ways to update NAFTA’s relevance, such as integrating it into the trans-Pacific partnership

How did this about-face happen? “I think the first thing is that NAFTA was for the U.S. just a step on the road,” Sands says. “It was part of a long effort at trade liberalization. We [the U.S.] also didn’t create an EU set of institutions that were a permanent alliance. And the U.S., which has never been as trade-dependent as Canada is on the U.S., just kept looking for new partners.” Ottawa may have been a bit miffed by that, but the U.S. never saw NAFTA as the end of the debate.

The global oil market then stabilized and went through a period of low prices, and a big concern for the U.S. became environmental as low prices encouraged the use of fossil fuels. At that time, climate change came to occupy a larger place at the table. “So again things started to shift and the U.S. was less interested in places like Canada and started to think about alternative energy,” Sands says.

“The point is, Keystone XL has cast such a negative image and a poison injected into the Canadian energy investment environment that who benefits is U.S. energy companies and their shareholders.”

September 11, 2001, then drew American attention back to energy security, though Canada remained a friendly and secure source of hydrocarbon energy. Other suppliers like Nigeria and Venezuela were becoming less reliable and it was felt that Mexico would never get its act together. This boosted prices a just as a then-new technology, steam-assisted gravity drainage (SAGD), was poised to help double Canadian oil sands production. The U.S. market beckoned; new south-flowing pipelines were launched and more planned.

The plans, however, attracted other attention. “It also mobilized environmentalists who said this is the thin edge of the wedge; we’ll be drowning in oil and climate change will never be reversed if we start buying into Canadian oil,” Sands says. “And so the battle lines were drawn. Obama wanted to address climate change – that was his pledge.” To that end, Obama’s first big effort was the Copenhagen followup on climate, where he disappointed American environmentalists by not committing to near-term emissions targets, thereby compromising his supposedly tough stance on climate change. As a result, they seized on blocking TransCanada Corp.’s Keystone XL as a way to slow development of Canadian oil sands.

Sands reckons that’s why Obama has been foot-dragging on a Keystone XL decision. “He sees approving the pipeline as offending his environmental base in a way that, after having failed them in everything else, they’ll never forgive.”

Even if he’s been foot-dragging on Keystone XL, doesn’t the American president see LNG exports as acceptable within the environmental movement? Not so fast, Sands says. “The environmental supporters say the problem with the gas revolution is that now gas prices are cheap in the U.S. And that’s great if it’s substituting for coal but still it is a non-renewable fossil fuel and to the extent that we become addicted to this cheap gas, it hurts us.” The environmentalists however are OK with exporting gas to China to replace coal there. The hope there is that gas exports will raise the North American price to a point that it’s affordable but not so low as to discourage development of non-renewable sources.

All of these different factors are forcing Canada to diversify its energy exports. Gotlieb thinks this is good and in fact was on the table long ago. “I remember in the ’60s the third option was to diversify our trade partners and that was the leading foreign policy posture of the Trudeau government for 15 years or so,” he says. “Instead we got more and more dependent on the U.S. So the policy that has been advocated for a generation now is that diversification is necessary to our economic prosperity.”

As ex-Suncor CEO Rick George put it in a recent Report on Business interview, “We should not have energy policy in Canada dictated by a dysfunctional Washington.” And Bruce Heyman, the new U.S. ambassador in Ottawa, said in an April Globe and Mail interview that Canada was too focused on Keystone XL anyway.

 

So are the Americans pursuing U.S. energy independence instead of NAFTA’s continental energy independence and interdependence? Paul Michael Wihbey, president of Washington-based GWEST (Global Water & Energy Strategy Team), who often advises sovereign governments on energy policy, says yes and no. “They are pursuing energy security, which is different,” he says. “They are well on their way to energy security not because of any grand policy formulation but because of shale technology coming on the scene, which very few people had anticipated. That changed the whole landscape.” With U.S. natural gas production high and prices low, it’s clearly a major achievement in terms of U.S. energy security, he says. “In terms of crude, the U.S. is still importing about eight million bpd so it is not achieving energy independence but energy security.” With U.S. consumption at its lowest since the mid-’90s and domestic crude production now the world’s highest, American energy security is at a high point not seen in decades.

It is possible that these developments could render NAFTA obsolete. “A number of issues that would have been dealt with by NAFTA a decade or so ago are now being dealt with in the Trans-Pacific Partnership (TPP) or other forums, and more bilateral agreements,” Gotlieb says. “NAFTA may not be the principal forum, although it will be the beneficiary if agreement is reached in another forum, for deepening our relationship.”

Some political analysts think a NAFTA-style bloc could even exist within organizations like TPP. “Canada, the U.S. and Mexico are all negotiating at the same time in the TPP,” Sands says. “It doesn’t include China yet but does include a lot of big Asian markets that want our energy. I think there’s a huge opportunity to use that negotiating table to get some things straight amongst ourselves – kind of like a NAFTA II buried inside the TPP. It would open up those markets and get us thinking about how we move things along our respective infrastructures.” He figures an energy provision in TPP on investment and market access could allow Canadian oil to be exported through ports in Alaska or California. After all, a unified North America would be a formidable energy powerhouse.

Indeed, former prime minister Brian Mulroney, under whose watch the original FTA and NAFTA negotiations advanced, said at a Canada 2020 speech in Ottawa in April of this year that “North America working together as a dynamic, coherent player would be much stronger engaging with China and the rest of the world. Energy sufficiency gives us greater independence to chart our own course and can be a source of real leverage with others. Standing together, North America can lead the world.”

Wihbey thinks that for now this looks like a pipe dream. “I’ve always been in favor of a continental policy,” he says. “But conditions have changed rapidly over the last few years and I don’t see the political will or the political leadership right now in any of the three countries to resuscitate this thought. I think the relationship with the White House is really poisoned. It’s so bad that in the short term there is not much that one can do; the damage has been done over Keystone. It should have been de-politicized from the get-go; and the Harper administration has such a different foreign policy agenda than Washington.”

 

In the meantime, it appears that a lot depends on Keystone XL flowing crude, which may be some distance down the road. “I think at some point the Obama administration is likely to approve it, but there will be all sorts of conditions attached that would allow for legal challenges to be brought against it, so it will never be built and operational during Obama’s term of office,” Wihbey says.

There’s another reason Wihbey reckons the delay will be protracted. “The failure to approve Keystone XL has resulted in Canadian energy companies having their shares depressed because of negative investor sentiment relative to their counterparts in the U.S.,” he says. “The point is, Keystone XL has cast such a negative image and a poison injected into the Canadian energy investment environment that who benefits is U.S. energy companies and their shareholders.”

The 1994 NAFTA energy promises – like approvals for projects like Keystone XL – grow increasingly irrelevant as the U.S. landscape evolves. “I see that there will be a real push, if Republicans win the Senate, to open up the LNG export market,” predicts Wihbey. “The ban on crude exports I think will be harder; right now it’s very beneficial to U.S. crude producers to keep the oil in the domestic market.” He looks at American producers who are having a field day in shale plays and earning profits with limited government interference. He forecasts a continuing ramp-up of U.S. domestic crude production and declining consumption; with perhaps increased deliveries to Canada.

 

Opportunities For Increased Crude Exports

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Source: Canadian Association of Petroleum Producers

With Canada’s total crude oil production set to increase to 6.7 million barrels per day by 2030, the country’s oil and gas industry is urgently seeking to grow market share in established and new demand markets. Growth in light oil production on both sides of the border is replacing offshore imports to refineries on the Eastern Seaboard, including the U.S. PADD I district.

The largest potential growth markets for growing oil sands production may lie primarily in the U.S. Midwest and Gulf Coast where over 2.2 million bpd of heavy crude imports, primarily from Venezuela and Mexico, were processed in 2012. New infrastructure builds could boost Canada’s current crude exports to this refining hub from current volumes of 100,000 bpd to 1.1 million bpd. Conversion projects at several PADD II refineries are set to increase that district’s demand for Canadian heavy oil by 460,000 bpd by 2020. Refineries in the highly populous PADD V district may prove an important future market opportunity as many of their traditional supply sources are going into decline.

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