Q4 2024 Research Theme: US Tariffs Challenge The Economic Security Of Both Canada & Mexico (And The US)

“A week is a long time in politics”

The first week of March saw the US impose swingeing 25% tariffs on all imports from Mexico and Canada (10% on Canadian energy imports), followed just 72 hours later by an immediate exemption for all imported goods and energy products that qualify and are traded under USMCA (the USA-Mexico-Canada agreement of 2020) rules of origin.

This marks the second volte face in two months for US import tariffs on its two neighbours.

At the time of writing, this latest tariff exemption is no more than a stay of execution until April 2nd, unless good ol’ fashioned diplomacy and negotiations manage to defuse the situation… or Donald Trump decides this may not be the most popular move amongst his biggest supporters / donors.

Despite being inherently eligible under USMCA rules, the majority of Canadian energy exports to the US - most notably the substantial volumes of crude oil - have never been traded as USMCA-compliant for reasons of administrative costs and convenience. As a result, they remain subject to the 10% US import tariff. It’s likely that, for similar reasons, a large proportion of Mexican crude oil exports to the US also face the 25% tariff.

No doubt the race is now on to provide USMCA-eligible proofs of origin so that all such US energy imports can trade hereon as USMCA-compliant and thus avoid tariffs during this temporary one-month reprieve and potentially thereafter if negotiations prove successful.

Needless to say, the current situation remains both tense and fluid.

Energy Security - Are Canada’s and Mexico’s Energy Sectors Too Dependent On The US?

Energy security prioritizes resilience through diversification rather than isolation and thus focusses on ensuring reliable access to affordable energy regardless of source.

The Mexican and Canadian energy sectors have long enjoyed a high degree of integration and mutual dependence with that of the United States. The vast networks of physical infrastructure and bilateral trade flows that bind these three countries appear to be the very epitome of energy security. It’s no wonder that the 25% and 10% import tariffs imposed by the U.S. came as such a bombshell for the two other governments.

The scale of mutual dependence - particularly between Canada and the US - is described below:

• Some 450,000 kilometers of oil & gas pipelines link the Canadian and US energy markets - the result being the world’s most integrated energy market.

• Despite being the world’s largest crude oil producer, the US also imports substantial volumes of crude oil - 6.6 mmbopd in 2024.

• In 2024, Canada supplied 4.1 mmbopd or almost two-thirds of US crude oil imports; Mexico, albeit in second place, supplies ca. 500 kbopd or 7%.

• The US imports account for 93% of Canada’s entire crude oil exports - an obvious and self-inflicted ‘Achilles heel’ due to so few pipelines being built in recent years.

• The recently expanded TransMountain pipeline represents Canada’s only significant non-US export route.

• Likewise, landlocked US refineries in the Midwest and Rockies (PADDs 2 & 4) depend on Canadian crude oil imports (73% and 44% respectively of refinery intake) to meet demand. Alternate Gulf Coast heavy oil imports would require new pipeline construction or reversals.

  
  

Turning to refined products:

• At 1.2 mmbopd, 95% of Mexico’s 2024 refined product imports come from the US. With domestic refining throughput running at ca. 800 kbopd, just 50% of nameplate capacity, Mexico remains highly dependent on such US imports.

• Product imports and exports between Canada and the US are however relatively more balanced.

On natural gas:

• The US remains Canada’s sole gas export market providing 99% of US natural gas imports. However, surging domestic gas production from US shale plays - Marcellus, Haynesville, Permian - has reduced US demand for Canadian gas to ca. 8.5 bcf/d.

• Canada’s first LNG exports should commence mid-2025 with the start-up of LNG Canada’s first two trains (initial capacity: 14 mmtpa or 1.8 bcf/d)

• Mexico is near-100% reliant on the US for imported natural gas via pipeline, which in turn covers almost two-thirds of Mexico’s domestic gas consumption.

What Options Exist For Canada & Mexico Regarding US Tariffs On Energy Imports?

Canada - Short-Term Measures

In the immediate term, Canada needs to demonstrate that all of its energy exports comply with USMCA rules of origin to qualify for the temporary tariff exemption until April 2nd.

Crude oil exports could offer Canada a potential degree of leverage - no doubt the high dependence of US refineries in PADDs 2 and 4 on Canadian heavy oil argued for the lower US import tariff of 10% for Canadian energy imports rather than the 25% for other Canadian imports and all Mexican imports, including energy. But, as discussed earlier, Canada’s paucity of alternate non-US export routes and the sheer scale of crude oil, gas & product exports to the US (23% of 2023 exports, 8% of GDP,1) effectively limit the palette of viable retaliatory options.

Canadian pipeline operator Trans Mountain is exploring options that could add between 200,000 and 300,000 bopd of capacity to the existing pipeline capacity of 890,000 bopd:

Short-term options include the use of drag-reducing agents to boost throughput; longer-term solutions include additional pump stations. Further navigation aids in the Port of Vancouver will also permit the transit of unladen tankers at night, boosting the frequency of loadings.

The ‘nuclear’ option of cutting off US energy exports or even taxing such exports would inflict far more damage on Canadian oil producers and the broad economy than the US.

Production Curtailment May Offer A Swift, Effective Solution

A more subtle option could be curtailment of output - no more than what OPEC+ does. Modest reductions in production would serve to raise the price of Canadian oil, potentially resulting in minimal changes in overall revenues. More of the impact of the US tariffs would thus fall on US consumers rather than Canadian oil producers, with no new, overt tax to incite retaliation.

We’ve seen this movie before - rising Canadian oil production and pipeline constraints resulted in record low WCS pricing and a record high WCS-WTI differential by late 2018. Alberta’s premier ordered a coordinated production cut of ca. 9% across producers - the result being a swift surge in WCS pricing and restoration of its long-term differential to WTI pricing.

Just as pipeline constraints collapsed WCS pricing six years ago, so the US import tariff can also be seen as an enforced restriction on Canada’s oil exports that will inevitably lower pricing for Canadian oil producers. Coordinated, calibrated curtailment may well work second time round. 

Canada - Longer-Term Measures

With US import tariffs the new reality, there is a renewed bipartisan political will to revive previously cancelled pipeline projects to reduce Canada’s singular reliance on the US.

Extraordinary times call for extraordinary measures

Canada’s freshly appointed Prime Minister, Liberal leader Mark Carney, has openly spoken about using federal emergency powers to accelerate major strategic projects: “We as a nation need to build some new pipelines for conventional energy”, but with the caveat: “… in consultation with provinces, with First Nations”. But would a Carney-led government, if elected, actually enact those federal emergency powers should such consultations stall vital pipelines?

‘Twice bitten, thrice shy’

Previous pipeline ventures including the Energy East (1.1 mmbopd) and Northern Gateway (0.5 mmbopd) pipelines would have transported oil from Western Canada to east to New Brunswick and west to British Columbia respectively, thus bypassing US markets entirely. Both projects were cancelled in 2016/2017 in the face of regulatory hurdles, environmental and, ultimately, federal opposition.

Furthermore, Ottawa had to purchase the Trans Mountain pipeline system from Kinder Morgan in 2018 for C$4.5 billion, and it took federal powers and hard-earned tax dollars to complete its expansion in 2024 at a final, eye-watering cost of C$34 billion!

Given this history, the private sector is highly unlikely to participate in future pipeline projects without federal backing and major reforms to permitting, impact assessments etc.

Future expansion of LNG Canada and two further LNG export facilities - Cedar LNG & Woodfibre LNG - that are already under construction offers 2.5 bcf/d of additional gas export capacity. 

However, even if all the above projects come to pass, the US will remain Canada’s largest export market for both oil & gas.

Mexico - Short-Term Measures

In the immediate term, Mexico needs to demonstrate that all of its energy exports comply with USMCA rules of origin to qualify for the temporary tariff exemption until April 2nd.

Unlike Canada, which received a reduced 10% tariff on energy-related products, Mexico's energy exports face the full 25% US import tariff. According to government sources, Mexico will not be offering any discounts to make its crude more attractive to U.S. buyers once the 25% tariff is in place. Instead, Pemex is already in active talks with crude buyers in Europe, India and Asia. There is certainly a growing global appetite for heavy crudes, and Mexico’s heavy crude oil is, beyond US refineries, likely best suited to

Asian refineries’ crude slates.

However, as described earlier, Mexico has become far too dependent on both refined product and gas imports from the United States, so any marked diversion of crude oil exports away from the US could likely prompt a swift, severe retaliatory move.

Mexico - Longer-Term Measures

Significant investment is long overdue to lower Mexico’s dependence on US energy imports:

• Reviving domestic gas production with private sector investment and technology.

• Modernization of domestic refining capacity, currently running at ca. 50% utilisation.

• Improved interconnections with Central American markets to diversify export markets.

• Expansion of LNG import capacity to reduce dependence on piped US gas imports.

• Mexico could also invest in and capitalise on its abundant solar resources. 

When Is Energy Security Truly Secure?

 The North American View

As discussed in the prior section, these draconian US import tariffs on fellow USMCA signatories Canada and Mexico clearly challenge the paradigm of energy security that has long existed between the three nations.

According to the World Bank, Canada ranks 3rd, behind Norway and Australia, in terms of overall natural resource wealth per capita (the US ranks 7th). Despite such resource wealth, Canada largely ceded its energy security due to a singular energy export dependence on the US, greatly limiting its degrees of freedom in the current circumstances. Mexico likewise has allowed its perceived energy security to be supplanted by an overwhelming energy dependence on the US, also limiting its negotiating tactics and strategic options.  

The European View

Broadening the discussion of energy security and energy independence beyond Canada and Mexico to the global stage:

Three years ago, Russia’s renewed invasion of Ukraine upended the geopolitics of energy, ushering in a new realpolitik worldwide. It proved to be a long overdue wake-up call for Europe which had to move swiftly to shore up its energy security. Germany, in particular, had ‘sleep-walked’ into a crazily high 55% dependence on Russian gas. Why? Because it was cheap! With vital Russian piped gas supplies to Europe swiftly cut back by Moscow, USA LNG cargoes provided a crucial and timely substitute back in 2022. US LNG remains vital to Europe, meeting 45% of Europe’s gas needs last year. Yet 11% of Europe’s LNG imports still come from Russia!

Western sanctions on Russian oil and products are, by design, largely toothless. With no immediate substitute for Russia’s pre-war oil & product exports of ca. 7.5 - 8.0 mmbopd, a true embargo would have driven oil prices to record levels, threatening the global economy. Instead, in what is politely called a ‘refining loophole’, Russia’s extensive ‘shadow’ tanker fleet transports its crude to India and Turkey where it is ‘laundered’/refined into products, which are then exported in large part back to Europe. In essence, a global game of ‘Three Card Monte’!

Under Europe’s new energy security paradigm, Russia still meets 15% of its gas demand and as much as 30% of its refined product imports (19% directly with the remainder supplied via India). We would argue therefore that Europe’s energy security remains at risk. Furthermore, Europe increasingly faces both cyber-attacks and the physical sabotage of critical data and energy infrastructure - particularly the many cables and pipelines that lie in the shallow waters of the Baltic, North and Arctic Seas.

These two examples of diminished energy security - on separate continents, an ocean apart and provoked by entirely different catalysts - highlight the need for continued oversight to ensure that perceived energy security does indeed deliver true energy security.

Is Energy Independence The Answer?

Inevitably, there are increasingly vocal demands from many quarters for energy independence - if a country provides all its energy needs from domestic sources, then it surely cannot suffer the vagaries of the global market or interruption of foreign supplies?

Politicians and commentators too often swap the terms ‘energy security’ and ‘energy independence’. But the two concepts remain distinct - different objectives demanding different strategic approaches.

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The primary goal of energy security is a reliable, resilient energy system, affordable and accessible for all consumers, underpinned via diversification of energy sources by type and via international agreements, contracts etc.

The primary goal of energy independence is self-sufficiency in energy production/generation, the desired outcome being limited if any exposure to global markets, import disruptions etc.

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Energy security and independence are not mutually exclusive; indeed, modern energy strategies seek a measure of energy independence to better guarantee energy security.

Renewables Are Far From A Universal Panacea For Energy Security & Independence

Be Careful What You Wish For - Cautionary Tales From The UK And The EU

Proponents of renewables argue they provide ‘true’ energy independence but fail to mention that sufficient economic energy storage capacity and/or standby power generation - typically gas-fired - must exist in tandem to ‘fill the gaps’. With pricing set by the cost of the marginal electron, renewables do not lower electricity prices: indeed, despite significant investment in renewables, UK electricity prices are now the highest across developed nations worldwide - 50% above EU pricing, 4-fold that of the US!

High energy costs have already prompted the closure of several large UK chemicals & refining plants. Marry such energy costs with the impending threat of US import tariffs - the potential result is a hollowing out of what’s left of UK manufacturing capacity. And as for the UK government’s plans to encourage vast data centre and AI investment given their insatiable power needs…!  

The dramatic expansion of renewable energy has now destabilized the EU’s energy market - the growing scale of intermittency requiring substantial power exports from Norway. The resultant spiking of electricity prices in Norway, where citizens have long enjoyed abundant, cheap hydropower, has now destabilized Norwegian politics: the government recently collapsed given the impact that full adoption of EU energy policy would have on domestic energy prices. Were Norway to restrict energy exports, the impact on EU energy security would be significant.

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Oil and gas will play an important role in energy markets for many years to come and, alongside renewable energy sources, will ensure that countries possess a diversity of energy sources - yielding both energy security and, where necessary and feasible, energy independence.

PillarFour Capital will continue to seek out and invest in innovative, scalable technologies that deliver improved revenues and/or lower costs alongside lower carbon intensity for the oil and gas industry - upstream, midstream to downstream.

1 Statistics Canada 2023

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