A Socratic Dialogue: The Impact of U.S. Tariffs on Canadian Oil Exports

2 February 2025

S: So, in todays news (announced 1 Feb 2025, technically yesterday), we have a newly announced 10% tariff on Canadian oil exports into the USA.   

Who is going to bear this cost?  All I am reading is that tariffs are counterproductive because they just increase prices to the end consumer? Is it going to lead to higher gas prices?   Will that then feed into higher inflation generally?

MC:  Ok, hold up, there is lots in that, so let’s break that down. I'm going to start the analysis on Tax Incidence Theory. You may recall that Tax Incidence Theory analyses how the burden of a tax—or in this case, a tariff—is divided between buyers and sellers based on price elasticities of supply and demand.

S: Ok, lets apply this to Canadian oil. Canadian exports are dominated by heavy sour crude (Western Canadian Select, or WCS), which trades at a discount to lighter benchmarks like West Texas Intermediate (WTI). Hang on, why does this discount exist, could that be relevent to better understand the price elasticities involved?

MC: WCS is heavier and requires more refining, and Canada’s oil sands face transport constraints. Limited pipeline capacity forces producers to rely on costlier rail shipments or accept lower prices to remain competitive. Historically, the WTI-WCS spread has fluctuated between 10–10–30/barrel due to these factors.

S: Good. Now, if the U.S. imposes a 10% tariff on Canadian oil, how might this interact with existing price dynamics?

MC: On the face of it and based on economic 101 textbook, tariffs increase the cost of production, leading to costs being worn by buyers in the form of higher prices.

owever However, tax incidence theory breaks down whether the producers (Canadian oil companies) or buyers (US refiners, then consumers) will absorb the cost depending on elasticity of response.   In short, if U.S. refiners can easily switch to alternatives, Canadian producers would have to lower their pre-tariff price to keep total all-in cost to their buyers competitively neutral relative to alternatives.

S: Let’s dissect that. What substitutes exist for WCS in the U.S. market?

MC: Some reasonable minority* proportion of U.S. Gulf Coast refineries are configured specifically to deal with heavy crude within their feedstock mix, but generally can accept other feedstocks albeit with an efficiency detriment or some costs of reconfiguration.  Alternative heavy crudes include Mexican Maya, Venezuelan oil (currently sanctioned), and Saudi Arabian heavy crudes, while sub-optimal lighter feedstock alternatives are abundant.    Noting that a majority of northern American crude (and value chain) is light-sweet centric.  

S: So, does this mean U.S. refiners would bear the tariff?

MC: Not necessarily. Even with some constraints on substitutes, Canadian producers have even fewer options. They can’t easily pivot to Asia or Europe due to pipeline and other infrastructure bottlenecks – there is no path to market. Their supply to the U.S. is highly inelastic. If the U.S. is their only viable market, producers might absorb the tariff by lowering prices to remain competitively neutral to non-tariffed alternatives

S: Precisely. This reflects the “incidence” falling on the party with the least strategic flexibility (technically, the party that faces the least favorable economic elasticities to respond).  Now, consider transport constraints. How do they amplify Canada’s vulnerability?

MC: Pipeline bottlenecks and costs to transport to market are a key driver in Canadian discount relative to US benchmarks, as reflected in the WTI-WCS benchmark spread (simplified, the spread does reflects multiple factors).   A tariff will widen the WTI-WCS spread further, as buyers will buy the Canadian product at the total all-in price inclusive of the tariff (plus transport cost netback and quality discounts), while capped at near substitute prices.  

S: What if Canadian producers refuse to lower prices?

MC: Then U.S. refiners would pay the tariff-inflated price…. but only if they lack alternatives . Given the Gulf Coast refineries are tuned towards heavy crude, they might tolerate some of the price increase before they can reconfigure for feedstock mix or realign supply to other heavy crudes.  However the refiners cost for marginal changes are relatively modest, so the maximum they would bear is limited. 

S: Let’s quantify this with a roughly worked example. Suppose the pre-tariff WTI price is $70, WCS price is $55/barrel ($15 discount spread), and the tariff is 10%/$5.

The ultimate benchmark here is WTI.   Let’s say a refiner base benchmark is willing to pay WTI for its feedstock, but also happy to accept lower quality heavy crude in a worse location for a suitable discount.   WCS already trades at $15 discount reflecting location and quality discounts.   These have not changed (in the short term) from the tariff.    The cost sharing of the $5 tariff between the producer vs the buyer depends on who has the best alternatives to avoid the cost.

MC: Given US refiners have multiple alternatives and Canada’s lack of alternatives, producers will likely concede most of the tariff. This would predict that the WTI-WCS spread could widen from, say, $15 to around $20 to accommodate majority of the $5 tariff.

In other words, the importer (US refiners) will directly pay the cash for tariff, but the Canadian producers will wear the majority of the true economic incidence, reflected in the form of a lower prices for their product.

S: Is this a short run effect only?  How might this influence long-term investment?

MC: A tariff whose ‘incidence’ is worn majority by the Canadian oil companies does ultimately increase cost base and reduce profitability.  In the very short term, most producer’s marginal cash operating costs are low enough that supply response will be muted.  However, should the tariffs remain in force as a new permanent reality, fewer new projects or expansions will be viable to be built at the new all-in cost base (capex and opex), reducing supply over the longer term, and eventually slowly changing the tax incidence towards buyers at the margin.   

S: So what about the U.S. consumer? Could they ultimately bear costs at the fuel pump?   Could this lead to more inflation?

MC: Firstly, the tax incidence analysis framework indicates that the proportion of the tax cost that will be worn by refiners and then consumers even further down the chain is low.  

Secondly, the crude commodity oil price at the pump is only fraction of the total pump price, which also reflect various taxes (largest component of pump price), refined product costs & margins, distribution costs and retailer margins.   At extreme, if the above incidence analysis is completely wrong and consumers wear a 100% full pass through of the $5 tariff onto all US consumers equates to approx. 17c per gallon, equivalent to around about 5% increase in the pump price (very roughly).   This is within 1 standard deviation of existing daily pump price volatility. 

Under the alternative scenario of pass through, it would feed directly into CPI as a consumer cost (noting 7-8% of cpi basket is energy, inclusive of all consumer energy use, not just fuel) and indirectly via PPI effects where transportation costs feed into every product cost.       Remember that this scenario only applies if the incidence analysis is incorrect, and the

S: What what strategic options might Canada pursue?

MC:  Accelerating pipeline projects (e.g., Trans Mountain Expansion to the Pacific) to diversify markets.

S: What are some other nuances that drive different outcomes here?

MC: The energy products market is extremely complex but also very efficient in its relative trade-offs and substitutes.   Probably the most important nuance to recognize as having more material impact is the sub-market for diesel.  

The other big impact will be on financial market anticipating or speculation regarding further tariff or regulatory action on other countries, products or components of the energy complex, inclusive of speculating on the duration of this new tariff remaining in place.

Also want to recognise the macro force of increased regulatory and tax uncertainty that could apply to a very wide set of industries or trades. Increasing uncertainty leads (at the margins) to higher risk discount factors.

But this analysis is going to stay at first and second order impacts, with further order impacts or speculation being recognized but a limitation.  

S: So, lets conclude: Who will bear the new tariff’s cost?

MC: Canadian producers.  This due to inelastic supply and lack of strategic alternatives or markets. However, U.S. refiners and consumers might absorb a small portion at the margin depending on substitutability constraints and costs.  

Ultimately, the big proximate winner is U.S. government gaining tariff revenue at Canadian oil companies expense (as the biggest proximate losers). Other players in the value chain will be impacted at various margins , though relative impact is diluted compared to the first order impacts of the big winner and big losers.

S: Excellent. This interplay of elasticity, infrastructure, segmentation within commodity markets underscores the nuances of tax incidence theory and application.

--------------------------------------

Laboratorium Decisorium Principles

Caveat & Scope Limitation: The scope of the article is to apply a directionally accurate short form insight at the intersection of the economic theory of tax incidence applied to an energy products submarket. The author has specific expertise and experience in both these areas and believes this take is different to the consensus reaction (which seems to be that the tariff is counterproductive and that US consumers will simply bear the incidence via higher prices at the pump).

The article scope is strictly limited to just the tariff on the energy products and recognises that the news involved wider tariffs on general goods as well as impacting both Mexico and Canada, within a wider macro and geopolitical context. The

The analysis makes predictions that could influence the following business decisions:

Prediction 1: Canadian oil producers are the big losers from this. 

o   Probability = high (70%)

o   Impact = high. A (roughly) $5 reduction in operating margins on operators with already high operating costs is a significant dent in asset / corporate profitability.

o   WTI-WCS will widen as evidence they are ‘tax incidence’ eating the majority of the tariff.

o   Opportunities for speculation in energy sub-markets

o   “Short” Canadian oil producers (hedged against macro forces such as oil price)

Prediction 2: No impact on inflation as the impact on the pump price will be minimal. 

This has low pressure on CPI with the relevant downstream marginal impacts on interest rates futures, bond prices, FX markets.

o   Probability High (80%*)

o   Impact: Low

§  Confidence Level of 80% is higher confidence than Prediction 1 because even if Prediction 1 is wrong and US refiners and then consumers wear some or all of the cost, crude product costs are only a real but still modest fraction of final pump prices (overestimated and overinflated in common discussion due to crude being the most volatile component, triggering noticeable changes) , and thus the percentage pass through into end prices is diluted.

o   Caveats:

§  Energy markets are volatile with hundreds of forces at work all the time, and this will be very difficult to measure or attribute directly to see if it happened.

§  Bond market / inflation expectation market dynamics are the same with marginal changes in probabilities baked into futures markets extremely quickly and most single news events are difficult to attribute or decompose in price action.

o   Ultimately, high confidence but no clear trade due to low impact and noisy, ultra fast markets

Prediction 3: Canadian infrastructure value chain will ramp up consideration of alternative paths to market, likely with various projects and consultants ramping up, refreshing or positioning feasibility studies for alternative pipelines and export infrastructure.  

o   Probability: Near certain

o   Impact: Low

§  Business development opportunities for relevant players active in these sectors.

END NOTES

Mind Map Link: https://bra.in/5qVXbJ

Keywords:  Oil, WTI, WCS, Tariffs, Tax Incidence Theory