NAFTA and Canadian Oil

Here’s an interesting tidbit… NAFTA contains a proportionality article (Article 605) that requires a signatory to the article to not reduce the proportion of a commodity that it exports to another signatory country. Currently, Canada exports about 65% of its oil production to the U.S. (about 11% of U.S. oil consumption is Canadian oil). With the recent growth in heavy oil and oil sands development in Canada, the proportion of oil exported to the U.S. is expected to rise significantly, since oil production in Canada is rising faster than the rate of consumption (the inverse of the U.S. situation).

What happens when Canadian oil production peaks? At some future point production will begin to decline, and to meet domestic consumption Canada would wisely want to restrict oil exports. Article 605 is written as a one-way function – signatory governments cannot use policy mechanisms to control the distribution of a commodity. In simple terms, Canada can increase its oil exports to the U.S., but it cannot decrease its oil exports as long as there is a willing U.S. market. This has major economic ramifications for any signatory that exports non-renewable natural resources to another signatory.

Article 605 has no downside for the U.S., so the article was strongly pushed by the U.S. during NAFTA negotiations. Canada may have shot themselves in the foot on this. It is interesting to note that Mexico, another major exporter of oil to the U.S., refused to sign Article 605.

[Update] – I came across this interpretation of Article 605 which tends to refute my interpretation. I can’t say that I agree with Mr. Holden’s interpretation. NAFTA is biased in favor of oil importing countries at the expense of oil exporting countries. I see the key point as being that oil exports, as a percentage of total production, cannot decrease due to government action, such as tariffs, duties, or national policy. My understanding of Mr. Holden’s’ argument is that as long as the same economic price is charged in both Canada and the U.S. everything is OK. The flaw is his assumption that oil, as a global commodity, flows according to free market principles of price, dictated strictly by supply and demand.

The oil industry does not operate in a free market. The major oil companies are more like members of a dysfunctional family than business competitors. They generally operate as a set of intertwined vertical monopolies, constrained more by compacts and market share agreements than by free markets. Mr. Holden notes that

“If shipping terminals and pipelines (with sufficient capacity) exist, then consumers across Canada will have access to world oil supplies (including those in Western Canada) at world oil prices. The only way a local shortage could exist, then, would be because there was a global shortage.”

Nice in theory, but local shortages, and gluts, do exist precisely because all consumers do not have equal access to world oil supplies. Access is constrained by many factors, both economic (lifting cost, transportation and infrastructure costs) and non-economic (wars, national security, environmental issues, political withholding). On a very basic level, Chapter 6 of NAFTA appears to provide the U.S. a hedge against regional/local oil shortages by guaranteeing the U.S. the highest historical proportional access to Canadian oil.

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One Response to NAFTA and Canadian Oil

  1. M.Miller says:

    The US did not live up to NAFTA in the softwood lumber dispute! Why do you think even for a minute we would continue shipping oil which we would need in Canada to the US?
    If we have surplus, we will gladly share it with our FRIENDS. If our FRIENDS are plotting against us now, perhaps we should begin NOW to ship our surplus oil to CHINA…

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