Policy for Crude Oil

Policy for Crude OilAuthor(s): Anthony ScottSource: The Canadian Journal of Economics and Political Science / Revue canadienned'Economique et de Science politique, Vol. 27, No. 2 (May, 1961), pp. 267-276Published by: Wiley on behalf of Canadian Economics AssociationStable URL: http://www.jstor.org/stable/139150 .

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Review Articles 267

policy was being administered with increasing vigour (a fact not overlooked by United States subsidiaries in Canada); legislation against restrictive busi- ness practices was on the increase in Europe; and proposals to change (some to weaken, some to strengthen) Canada's Combines Investigation Act are perennial. Canadian newspapers were already giving frequent reports on Ottawa's concern over the preponderance of United States subsidiaries in Canada's important industries. The air was charged with policies which, what- ever turn they took, would affect the future of Canadian industry.

The industry studies, by avoiding assessment of the possible impact of such policies, created a policy vacuum in the Commissions' report itself. On tariffs, it recommended stabilization of the rates prevailing in 1956. On United States subsidiaries, it made the modest recommendations that a fraction, perhaps 20 per cent to 25 per cent, of the voting shares be gradually offered for sale to bona fide residents of Canada, and that the withholding tax on dividends pay- able to non-residents be revised.8 The Commission had available to it no analysis which supported even these proposals, but then it had no analytical basis for policy recommendations of any sort. The individual studies proceeded on the assumption that existing public policies would prevail; they laid the basis for a recommendation that they should prevail.

These critical comments are given much more to what the ten industry studies did not do than to what they in fact accomplished. The loss is not irreparable. The body of facts the studies produced would in any case have been a necessary first step in the assessment of how alternative policies would alter the 1980 prospects for particular Canadian industries. Such assessments, if and when made, will owe much to the competent fact-gathering capabilities of the authors of these ten studies.

8Final Report of the Royal Commission, 396-8.

POLICY FOR CRUDE OIL

ANTHONY SCOTT

University of British Columbia

THE first report of the Borden Commission appeared in October, 1958. It dealt with the transmission, export and regulation of natural gas, and with the financing of Trans-Canada Pipe Lines Limited. Very little was said about the transportation and export of crude oil. This second report' is designed to fill the gap. It deals with "the policies which the Commission believes will best serve the national interest in relation to the export of crude oil and the marketing of crude oil within Canada itself."

On the model of their first report, the Commissioners start out by comparing reserves and potential output with future Canadian needs. But while they could regard natural gas as a limited stock of energy avidly desired by the United

'Second Report, Royal Commission on Energy (Ottawa, 1959). References to the report are given in parentheses in the text.

Vol. XXVII, no. 2, May, 1961



268 Canadian Journal of Economics and Political Science

States market, they soon found that Canadian crude, like Canadian coal, had become excessively abundant. The United States and the rest of the world were so far from scheming to get hold of Canadian crude oil that they might even have been relieved if Canada had never found it. Even while the Commission sat, the situation deteriorated further. Those who sought approval of Canada's recently gained export markets along the Transprovincial pipeline in the American middle west, and in the Puget Sound area on the west coast, were replaced by those pleading for new Canadian markets to replace a falling export demand.

Let us first examine the "scarcity" part of the report. The opening chapters present an account of the "probable" reserves, in western Canada, estimated to be about fifteen times actual annual production. "Ultimate" reserves in turn are put at about fifteen times "probable" reserves. Hence there may be enough petroleum underground for two hundred years' requirements.

However, ultimate reserves require proving, and proving depends on exploration and development expenditure by the industry. The report shows concern about the decline in the rate of exploration since 1958, because the loss of export markets had "created the danger that the ability as well as the incentive of the industry to finance new exploration and development may be impaired" (p. 87). The subsequent pages are concerned with avoiding this "danger." I could find no explicit discussion of the adequacy-of-reserve-for-exports question. It was just abandoned. But certainly the impression is left that there is nothing to worry about; among the "Conclusions" we are told ". . . future Canadian requirements will not be jeopardized, in our opinion, if exports of crude oil are permitted and encouraged," since the export of petroleum does not involve a long-range (e.g. twenty years) commitment by the exporter to the purchaser

(p. 125). In arriving at this bald conclusion, the Commission brings more credit on

its research staff than on its own critical faculties. A great volume of information has been assembled in tables, maps and charts. The oil reserve calculations are succinctly explained, and future markets are evaluated as neatly as possible. A good deal of recent history is unobtrusively worked into the text. Contending points of view are fairly represented. Surprisingly, however, the Commission did not feel called upon to develop its own geological information. The oil companies and the provinces themselves contributed the estimates of the reserves, which might have decided whether or not they were to be allowed to export.

More disappointing is the failure of the Commissioners to develop a philoso- phical view of the place of oil in our economy. Various parts of the country are exercised about coal, water-power and uranium policies. Latter-day Malthu- sians are predicting ultimate world scarcities of energy that may bring economic progress to a standstill. After all, this was a Royal Commission on Energy, but the report belies its title. A few years ago Professor Johnson complained that the preliminary report of the Gordon Commission failed to provide what



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Canada could conceivably contribute to the rest of the world, a consistent philosophy of economic development based on natural resources...."2

The Borden Commission also fails. Neither in its report on natural gas, nor in the present report, are we given any hint of principles to be followed. The reader can only wonder why the reports go to the trouble of estimating reserves; no guidance is given on what reserves might conceivably be too small, or too large. Only when it appears that the industry may be unable to sell its product are we offered a few general remarks.

(a) Protection. Forcing Alberta crude into the Montreal market is likened to the traditional National Policy, already followed in the building of the railways and, allegedly, in some of the earlier gas and oil pipelines. (pp. 128-9)

(b) Security. "Oil is a vital requirement of modern industry and is the most important source of energy in Canada. . . . Canada must have oil at all times and it is undoubtedly in the national interest that it should at least be in a position rapidly to make itself as independent as possible of imports, whicl may be subject to interruption." (p. 130)

(c) Conservation. "It has at times been suggested that a country conserves its resources of crude oil by importing foreign crude and utilizing it instead of domestic production. However, the effect of such imports of foreign crude on exploration for and development of Canada's resources must be considered. The primary ability to make expenditures for exploration and development comes from the actual and anticipated revenues from production.... Finding and developing oil fields is a process which commonly extends over many years.... If imports of foreign crude displace domestic production ... there is bound to be a decrease in the revenues of the industry and a consequent slackening of the incentive and initiative needed for exploration and development." (pp. 130-1)

(d) The American example. The Americans are keeping their industry healthy by government intervention, so Canada should too. (p. 132)

Only on (a) is there very much urgent argument. The other points are paid out like knots on a rope, hopefully, one after the other. But they should not be allowed to pass unchallenged.

(a) This is the subject of the latter half of the report, and I will discuss it in part III below. Would it be like the National Policy? The report argues that it would, in that it would help Canada to defy its economic geography, moving goods and services east-west instead of north-south. But this was not the spirit of the National Policy. The true parallel, it seems to me, is in coal policy. Coal is the chief raw material that Canada has protected, in the same way that the National Policy has attempted to protect manufacturing by tariffs and by market development. Otherwise, the National Policy chiefly attempted to aid the export of raw materials, such as grain, timber, pulp, and minerals. So, to force Canada to consume its own raw materials would be, apart from coal, a new National Policy. The coal policy has not worked, and is being dis- mantled. The invocation of the National Policy seems to me misleading; to do the Commissioners justice, the analogy is not pressed very far.

2H. G. Johnson, "Canada's Economic Prospects" in this JOUIRNAL, XXIV, no. 1, Feb. 1958, 109.




(b) Very little evidence is advanced to show that national security depends on there being no interruption in the supplies of Canadian petroleum to the whole of the country. The obvious counter-assertion, that Canada's regions would do best, in emergency, to trade oil with the adjoining American regions (thus reducing vulnerability to a cut pipeline), is not even mentioned. One cannot believe the argument was meant to be taken seriously.

(c) The Commission's proposition is true but quite irrelevant. It amounts merely to saying "If Canada does not want to use Canadian oil, investors will not waste their money providing unwanted capacity." One would have expected the report to say instead: "If Canadians do not keep up a steady exploration for oil, they will not be able to find it when they finally do wish to consume it." This point is so often approached, then so studiously not made, that one supposes it is not true. Again, it would have been relevant to the subject of conservation to assert: "If Canadians do not make a sacrifice to sell their oil at a small profit now, they will never be able to sell it in the future, for oil is becoming steadily cheaper on the world's markets." But this matter is not really studied, except in a brief dissent by Professor Britnell (p. 149). The irrelevant argument, coupled with the omitted arguments, leads to the conclusion that if the Commissioners were really thinking about the conservation question at all, they decided that raising it would not support their wish to help the petroleum industry in its present difficulties.

(d) American policy is explored, and on page 63 it is shown to depend chiefly on security considerations. But in (b) above I have argued that Canadian security does not obviously benefit from depending on a single source of petroleum.

II

While failing to guide Canada in its attitude to its resources, the Commis- sion does nevertheless help its readers to understand the world oil industry. If one pieces together points that are made at various stages in the exposition, an interesting picture emerges.

Canadian oil is expensive (p. 125): ". . . Canada has large reserves of crude oil but they are far from tidewater and landlocked in Western Canada. This crude must move long distances overland in order to reach the most important market areas. Costs of exploration, development and production of crude oil in Canada are, in general, higher than in Venezuela and the Middle East." But oil is not a scarce commodity (p. 61): ". . . the proven oil reserves of the Middle East as now established are sufficient to support the present level of production for more than a century." Even though Venezuela gave no new oil concessions from 1943 to 1956, she had in 1957 sixteen years' supply on hand. New sources of oil are appearing in Africa, Asia, and in the north, and many of them are near tidewater. Furthermore, because of political problems, the international owners of the eastern hemisphere's sources are very anxious to exploit them soon, a matter hinted at on page 54.

More important, the major oil companies "own" the supplies from their con-



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cessions abroad, whereas they merely buy oil from prorated fields in North America (that is, they must buy oil from other companies as well as from their own wells). We are told (p. 54) that this means that ". . . it might prove more profitable, for the production and refining operation as a whole, to import and use company-owned crude in its United States refinery even if the per barrel cost were somewhat higher than that of crude obtained from an alternate North American source." Presumably this profitability of the crude end of integrated firms arises from the depletion allowances and other encouragements to oil production that both Canada and the United States have granted with an open hand, though the Commission does not pause to enquire. One would have hoped, however, that it would have taken time to question whether Canadian crude actually is "competitive" when its price merely matches the posted price abroad plus transport costs. The refineries transmit the world price back to Alberta, where it becomes the field price. The provinces, emulating the Texas Railway Commission and other state bodies, offer crude at that price. But the American states, acting in concert, are able to maintain the domestic price (with the help of prorationing and of import quotas). Hence the offshore posted prices are based on Gulf (American domestic) prices, not the other way around. If the Canadian producers wish to get into the American and foreign markets, they must meet the price that implicitly exists within the integrated major companies, and is lower than the posted American prices. Some of this is admitted when (discussing whether Alberta oil would be helped into the Montreal market by imposing a tariff on foreign oil) the report (p. 130) notes that the "vendors of the foreign crude to the Montreal refiners might well be prepared to make, either directly or indirectly, substantial reductions in posted prices in order to preserve the Montreal refinery area as a market for their crude oil. It is impossible to estimate how high a duty would be required in order that it might be prohibitive." It is difficult to believe that estimation is impossible; but the implication is clear: the posted price now paid, to which is related the field price now charged in Alberta, is well above the world's "competitive" price.

The structure of prices, it seems to me, is a topic that we might have expected the Royal Commission to have investigated thoroughly. Instead we are given only tempting allusions to the matter. In his Memorandum of Reservations, Professor Britnell does point out that field prices are more likely than the main report admits to absorb much of the impact of import competition. But only Mr. R. M. Hardy, in his Addendum, really stresses that the 'economics of the international petroleum industry is extremely involved." "Availability of supply and price" are far from explaining the direction of international trade. But Mr. Hardy goes on merely to argue that such special characteristics justify strong government intervention. He does not analyse the effects of the world oil marketing situation on Canada in particular.

The report does mention several times the oil industry's peculiar willingness to be pushed by provincial and state governments into heavy exploration and drilling programmes even when it does not wish, collectively, to acquire more reserves. The rights to explore and drill are given by the provincial govern-




ments, and the right to produce is given by the conservation boards. The latter's prorationing arrangements, for example,

encourage the development of new reserves by giving the newcomer to the industry, among others, a market allowance at the expense of the allowance formerly given to existing wells. Because the total market allowance has to be allocated among all producing wells and every well is given a minimum production allowance, marginal wells and newly-drilled wells in effect are able to produce only because the share of the market assigned to all other wells, including those of the most efficient and low- cost producers, is simultaneously reduced. Under these arrangements even those producers who own a great deal of "shut-in" production, if they are to maintain their share of the market, must also drill and develop new wells on all lands under lease. This inevitably leads to excess drilling capacity. (p. 122) A similar point is made on p. 115.

My own investigations have suggested that similar policies are followed by most foreign governments. They succeed in hurrying both large and small companies into paying bonuses for rights, and, later, royalties for production. This situation evokes an academic "Why?"

Why do the major companies submit to being thus goaded along by the provinces and states? All over the world they are attempting to keep their "'share of the market" (that is, of the "allowable" for each field or province). Yet they have more oil abroad than they know what to do with. Even in new territories where they have no market and no share of the existing production (Alaska, Africa, Yukon, etc.), the major companies tumble over each other in an attempt to get new reservations and new wells. As far as one can see each firm's chief motive is to maintain its share of the entire industry's reserves, even if these are not needed. One suspects that there is some cultural lag here; the companies' producing departments are so accustomed to racing their rivals that they cannot endure sitting still and making the best of their existing reserves. Still less can they endure the idea that they might some day buy their crude more cheaply on an open market. This cultural lag, once again, is encouraged by the generous tax arrangements for the oil industry. One would have been interested to have seen an analysis of it by Messrs. Borden and Ladner, two of the Commissioners who have some reputation in the tax field.

III

By the end of chapter iv the reader is left in no doubt that tlle real conlcern of the Commissioners has become that of finding a market for Alberta oil. Repeatedly he is told that capacity has outrun demand; that the United States is a difficult market to break into (because of quotas and because of the "commercial preference" of the refiners for their "own" oil); and that the oil boom, which has been of immense importance to the over-all Canadian boom (a hard case to make, apart from investment; the probability that most of the equipment was imported and so may not have been part and parcel of the rest of the Canadian boom is not investigated), is over unless new markets are found.

Two markets are examined: existing Canadian markets, and the American market. Existing Canadian markets are thought to be very promising. It is



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suggested that the demand for Canadian crude will rise from about 400 thousand barrels per day in 1958-9 to nearly 800 thousand barrels in 1967. Most of the increase will be found in Ontario. To this total should be added about 100 thousand barrels which it is hoped may be exported to the United States. It was felt that Canada could not altogether rely upon a continued willingness of the Americans to accept Canadian crude; since the existing controls are intended to prevent the discouragement of domestic United States production, they might be made to apply stringently to Canada if Canadian crude seriously threatened to become such a discouragement.

The resulting 900 thousand barrels by 1967 is estimated to be less than 64 per cent of the "producibility" of the industry at that time. We are then subjected to a question-begging argument (pp. 132-3) leading to the conclusion that the Alberta industry should be encouraged to keep on looking for more reserves by having additional markets put at its disposal.

The producers (other than the "majors" with refineries in Montreal) pointed to the Montreal refinery market, where a pipeline could deliver Alberta crude in substitution for Venezuelan and Middle Eastern crude. Some champions of the pipeline claimed that it would give rise to little or no extra cost. But the Commission seems to agree that to deliver the oil from Alberta would cost about 35 cents per barrel more than the average laid-down price which the Montreal refineries are paying for offshore crude. The quotation above from p. 130 in the report suggests they are now paying the posted price. Some government pressure on these refineries might reduce this arbitrary posted price to something less than the present payment to their parent companies abroad. If so, the extra cost to Montreal of the pipeline oil would be more than 35 cents.

On other assumptions, the pipeline's extra costs would be less. For example, a rival project, by another route, would seem to have promised to deliver oil at prices comparable to those at which they are now landed from abroad. But the Commission does not appear to have accepted this estimate. Another scheme examined was a Crown-owned line, which would have saved on income tax (since, being a public utility, its return would be regulated) and on depreciation requirements (a Crown asset apparently is assumed by engineers to have a longer financial life than a private asset). Consequently, its permitted charge per barrel, as computed by the usual fair-return-on-costs method, would also have allowed Alberta oil to be delivered to the Montreal refineries at the same price per barrel as offshore oil, though a subsidy would of course be implicit in the income-tax exemption. The Commission shied away from this alternative, noting (p. 107) that public ownership "involves considerations beyond the question of securing lower transportation costs.

If not by subsidy, how then would the line be financed? The Commissioners favour keeping out the foreign crude, thus creating a closed market for Canadian oil. They reject a tariff because it might fail to keep foreign crude out, since, as noted above, the foreign shippers might cut their posted price in order to duck under the tariff barrier. Such price-cutting might be viewed as an advantage by some, but not by the Commissioners.

They add (p. 130) that a nation-wide tariff would "have the effect of raising,




unnecessarily in our view, the internal cost [of petroleum] . . . to Canadian consumers." They do not explain the word "unnecessarily," but it may mean that they feel the incidence of the extra costs of the Montreal project should lie on the Alberta producers, rather than on the consumers in the Montreal district or on the refiners. This interpretation is fortified by their citation of some estimates (made by Imperial Oil Ltd.) on the rate of return earned by oil producers. The calculation, which is not fully explained, suggests that a decline in the field price between 25 and 50 cents per barrel would reduce the rate of return from its present range of 7 to 12 per cent to about 5 to 8 per cent. The report seems to accept this estimate but notes that there would be an offsetting benefit to the producers in the larger volume of sales.

In any case, the Commissioners are probably wrong in attributing a higher nation-wide price to the tariff, but not to their preferred licensing scheme. On the one hand, the tariff might not raise the internal price everywhere in Canada by the amount of the tariff, if production continues to be prorated and if Alberta exports continue to meet world posted prices. On the other hand, as Professor Britnell warns in his Memorandum of Reservations, the import restriction scheme would encourage non-competitive price-setting within Canada. Professor Britnell believes this would in turn lead to government price-fixing throughout the industry.

It is difficult indeed to decide just how the Commissioners thought the reservation of Montreal for Canadian crude would work out. Many important details are not discussed. This uncertainty may explain why they recommended that the government defer its decision on policy until early 1961, thereby providing a breathing spell during which the industry, especially the major companies, might attempt to export more to the United States. But it seems un- likely that even the best efforts to break into the United States can overcome the barriers of a slow growth of American demand, the threat of import quotas, and the "commercial preferences" of the American major companies for their "own" overseas crude. Since 1958 exports have indeed increased, but to the Alberta industry Montreal must still look like the promised land. Since 1958 its imports from overseas have actually increased by twice as much as all Canadian exports.

IV

In my opinion, the Commission's analysis of the reasons for and the probable results of opening up the Montreal market to Alberta crude is illogical and short-sighted. It suffers on logical grounds from the absence of any set of principles about Canada's proper energy policy. In default of such general principles there was a need for an examination of oil as an ordinary commodity- producing industry. But this more restricted concept is precluded by the absence of a clear estimate of the gains to Canada of protecting the producers. Neither is there an estimate of the burden Canada would have to assume to ensure this protection, nor of which groups the burden would fall on most heavily. Moreover, the analysis is short-sighted since there is little or no attempt to master the intricacies of the world oil-pricing system; no mention of the ability of Canada's rivals, Venezuela and the Near East, to retaliate



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(through the United States major producers and through the American quota) if Canada should close its market to their crudes; and no discussion of the consequences of Canada's becoming a closed economy so far as oil is concerned.

Events since 1958 have made this last point the most important of all. Even within the text of the report there are signs that witnesses were transmitting to the Commissioners some sense of the changing situation in the world's energy-resource markets. Briefly, oil is following in the path of the other raw material industries. No longer has it that special character which has been wrongly attributed to the fact that it is an "energy resource." Its special characteristics have actually derived from the fact that until recently oil has been so scarce that almost any source of oil has been able to earn a rent over its costs of discovery and exploration. As with the early development of uranium, copper, zinc, or gold, production of oil has apparently always been profitable. Differences in location and cost contributed to differences in profitability, but they did not push many locations outside the margin (apart from those fields that had been exhausted).

But reduced costs of finding oil, and the consequent increase in reserves (all arising basically from technical and geological strides) have reduced the real price of oil. Fields in unfavourable locations, or with what the report obscurely but correctly calls high replacement costs, have been unable to cover costs. Today the industry would just as soon neglect altogether certain fields, regions and, indeed, countries. The oil "problem" has been aggravated also by technical changes. New discoveries of natural gas, the working out of means of trans- porting it and the very rapid development of new techniques of using it have meant the rise of strong competition for oil. The costs of raising steam from coal have fallen drastically. Atomic power is a threat always in reserve. Hence a scarcity of crude may never return; other sources of energy may be ready, one hundred years from now, to take over permanently.

Just as she has marginal sources of coal, base metals, uranium, paper, and gold, Canada now finds that she has "untold" amounts of marginal oil. Canada cannot hope to cash in on absolute scarcity for long; her receipt of economic rent attracts new entrants to resource markets just as readily as profits attract competitors in the manufacturing world. How to deal with this cyclic rise and fall of new resource products is Canada's own particular adjustment problem. Tariffs and import quotas have shown themselves powerless in the long run to shield Canada's weaker manufacturing industries from the competition of stronger producing regions. Surely it must also be obvious that she cannot long protect her oil industry by such imperfect techniques. Ultimately, she will have to specialize in exploiting only her richer fields, just as she now depends only on her richer copper mines and her low-cost forests.

The real problem, to which the Borden report does occasionally address itself, is how to find these richer fields without at the same time providing a subsidy to all the high-cost producers. Such devices as the public geological survey, and the "expensing" of private exploration, suggest that there are already a few ways by which exploration and development can be assisted. It is certainly not a tested proposition that prospecting for good sites must




always require the wholesale subsidy of an entire industry. Some countries have shown that there is some further role for public participation in thle orderly development of resources. In my opinion, the state might emphasize highly intensive exploration and geological surveying, rather than final development and production. The merits of this plan, which may fall to the provinces or to the federal government for execution, will probably become more obvious in the next few years. For no longer are the great integrated resource companies so willing to spend money anywhere in the world to find their scarce raw materials. Better scientific "control" over their exploration allows them to develop more convenient sources. But citizens of remote lands -and much of Canada is very remote-must look under their own rocks, or leave the minerals there for ever, "untold."

CENTRAL AFRICAN ENQUIRY

JOHN S. CONWAY

University of British Columbia

THE Report1 of the Advisory Commission on the Review of the Constitution of Rhodesia and Nyasaland, the Monckton Commission, will undoubtedly be a document of historic significance. Not only will its findings be certain to affect the destinies of the seven and a half million inhabitants of Rhodesia and Nyasaland; not only does it form yet another in the long series of stepping stones of liberal imperialism leading to the creative abdication of imperial responsibilities; but the assumptions it starts from and the appeal it makes for a partnership between the races will also be important for the future relations between black and white in all Africa.

The Monckton Commission was established in 1959 at the instigation of the British government, to advise that government, the federal government of the Central African Federation and the three territorial governments of Southern and Northern Rhodesia and Nyasaland on future constitutional developments. Led by Lord Monckton, a distinguished former British cabinet minister, the Commission was composed of members appointed by these governments. The importance of the constitutional review was emphasized by the selection of a Canadian and an Australian to sit on the Commission. Professor D. G. Creighton of the University of Toronto was invited by the British government to serve as the member from Canada.

The Central African Federation was created only seven years ago in unprece- dented circumstances. Instead of granting sovereignty, as had been done with other overseas territories since the Statute of Westminster, the United Kingdom stipulated that the favourite form of association of the nineteenth rather than the twentieth century should be preserved. The United Kingdom would still retain overriding authority, and the Colonial Laws Validity Act, 1865, would remain in force. However, the relation of the British government to both the

'Cmd. 1148 (London, HMSO, 1960), pp. 175. References to the report are given in parentheses in the text.

Vol. XXVII, no. 2, May, 1961



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Policy for Crude Oil

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