Sometime early in the next decade the US will overtake Saudi Arabia as the world’s most prolific producer of oil. That’s according to the US Energy Information Administration.

The key is new technology that’s unlocked vast reservoirs of oil and natural gas heretofore trapped under shale. And it’s spurred a production boom in Canada as well from previously untapped areas such as the Cardium Formation, the Duvernay Shale and the Montney Shale.

The North American energy explosion has the potential to enrich scores of individual companies and their investors as well as to provide an immense economic benefit to the US and Canada.

There’s just one problem: Rising production to date has run well ahead of the ability to get the energy to market.

Simply, most of today’s prime areas of energy production from shale haven’t been drilled in the recent past.

As a result they lack adequate pipelines, gathering systems, processing centers and storage facilities to handle the surging output.

The upshot is a growing amount of North American oil and gas is effectively landlocked.

And until the needed energy midstream infrastructure is built producers’ only recourse will be to ship via more expensive alternative means such as railroads, barges and trucks.

That, in turn, means oil and gas produced in some regions now sells at vastly discounted prices to traditional benchmarks, such as West Texas Intermediate crude (WTI) in North America and global standard Brent crude. And it’s likely to continue to at least through 2013.

Pipeline Shortage

Over the past 12 months WTI crude has traded as high USD110 a barrel and as low as USD77 and change. WTI’s recent level of roughly USD96 is about a USD20 per barrel discount to the price of Brent crude.

This spread has widened in recent years for one major reason: the rapid surge in US oil production coupled with inadequate pipeline capacity to move oil from the Cushing, Oklahoma, hub, where WTI’s price is determined, to the refineries on the US Gulf Coast, where oil can be exported and therefore sold at least closer to the higher Brent price.

The reversal and expansion of the Seaway pipeline–a project run by Enterprise Products Partners LP (NYSE: EPD) and Canada’s Enbridge Inc (TSX: ENB, NYSE: ENB)–promises to alleviate some of the bottleneck. So will the southern leg of TransCanada Corp’s (TSX: TRP, NYSE: TRP) Keystone XL pipeline.

Nonetheless, it will take time to build enough shipping capacity to significantly narrow the spread. And until the spread narrows companies that sell their oil based on the WTI price will profit less than those that produce and sell outside North America.

Price differentials for natural gas are even more extreme. Production has exploded thanks to shale technology. But supply is all trapped in North America, owing to the fact that virtually all the liquefied natural gas (LNG) processing facilities are geared for import rather than export.

Tackling this glut are some 15 projects now in progress to enable LNG exports. Even the most advanced, however, don’t project shipping gas before 2015.

That means North American producers will have to continue selling gas at prices far below those in global markets. This week, for example, natural gas in the UK sold for USD10.37 per million British thermal units (MMBtu) versus just USD3.30 in North America. Gas in Asia routinely sells in the teens.

Most dramatic of all are the differentials between Canadian and global prices for oil and gas. That’s in part because much of Canada’s oil is “heavy.” But mainly it’s because transportation infrastructure is even less adequate.

The vast majority of Canadian heavy oil winds up at the Cushing hub, where it’s bottlenecked with already glutted US oil. And that’s after traversing an even more congested network just to get there.

We’ve already seen some enormous spreads between US and Canadian natural gas prices. Last spring, for example, the benchmark contract on the New York Mercantile Exchange briefly dipped south of USD2 per MMBtu. Alberta gas prices, however, reportedly dipped below a buck.

Now the same thing has happened in the oil market. The price of Western Canada Select (WCS)–the region’s benchmark–recently sank below USD60. That’s USD30 less than WTI and barely half the Brent crude price.

As in the US, there are numerous energy transportation projects underway to move this landlocked energy to market and restore balance to prices. That’s billions of additional revenue for builders and operators of the infrastructure–and ultimately for producers of oil and gas that will be able to sell at much higher global prices. And in the meantime there’s also a burgeoning energy freight business in rail, trucking and transport logistics.

Unfortunately, there’s also danger with this opportunity. So long as price differentials are as wide as they are, they’ll eat into producers’ cash flows.

The most vulnerable will increasingly be faced with three uncomfortable choices: add debt at a time when energy prices are weak, cut back on drilling plans and/or reduce dividends. And their demise will make them less likely to enter the long-term contracts needed to attract pipeline investors.

Here’s my take on the dangers and opportunities presented by Canada’s energy production boom and the current price differentials.

Producers: Dealing with Differentials

In the near term energy producer stocks always follow energy prices. Over time, however, shareholder returns depend on how effectively companies build reserves and raise output.

CE Portfolio Aggressive Holding ARC Resources Ltd (TSX: ARX, OTC: AETUF) is one Canadian producer that’s consistently exceeded the standard. The company reported record average daily output of 95,725 barrels of oil equivalent in the fourth quarter of 2012.

That was 7 percent higher than the third-quarter tally and topped management guidance. Oil production was 15.7 percent higher than year-earlier levels, reflecting management’s success in shifting to liquids while natural gas itself is weak.

Natural gas liquids (NGLs) output was 40.8 percent higher. And the company also replaced more than 200 percent of annual output with new reserves for the fifth consecutive year.

ARC too suffered from pricing differentials, with the average realized selling price for its oil slipping 13.3 percent from the fourth quarter of 2011. NGLs prices fell even further, by 29.2 percent.

Nonetheless, the company still covered its distribution by a 2.27-to-1 margin and reduced net debt by 18 percent while setting capital spending guidance of CAD830 million for 2013.

The ability to turn in results like these in the face of severe price pressures is why ARC continues to rate a buy up to USD25, for those who don’t already own it.

I expect to see similarly strong results from my other “core” producer holdings when they report in the coming weeks: Crescent Point Energy Corp (TSX: CPG, OTC: CSCTF), Peyto Exploration & Development Corp (TSX: PEY, OTC: PEYUF) and Vermilion Energy Inc (TSX: VET, OTC: VEMTF).

Like ARC, these companies are growing output and reserves and enjoy low costs as well. Vermilion has the added advantage of selling most of its energy outside of North America. Crescent’s purchase of Ute Energy Upstream Holdings LLC has expanded its reach outside Canada.

Peyto, meanwhile, is primarily a natural gas producer and is therefore not affected by oil differentials. And its ability to produce gas at an all-in price of less than CAD1 means it’s basically competitive no matter what happens in the energy market.

Even if today’s wide oil price differentials last into 2014 and beyond these companies should be able to keep growing and paying dividends this year. That should also be true of the other energy producer in the Aggressive Holdings, PetroBakken Energy Ltd (TSX: PBN, OTC: PBKEF), though the risks are greater as is the yield.

As a light oil producer with an expanding portfolio in the Bakken and Cardium plays–as well as elsewhere in Alberta and Saskatchewan–the company is considerably more exposed to price differentials. Management’s expectation that wide spreads would continue throughout 2013 was the primary reason for a scaled-down capital budget of CAD675 million for this year.

That spending, however, will still result in an 8 percent to 12 percent increase in energy production. PetroBakken is further protecting itself by increasing hedge positions to roughly 35 percent of expected production, up from its customary 25 percent.

Coupled with the very high participation rate in the company’s dividend reinvestment plan–which reduces cash outlays–the strategy shift should ensure the safety of the payout. And cash flow will fund the vast majority of capital spending as well. There’s also ample room under credit lines to ramp up output, should pricing become more favorable.

Like most energy producers, PetroBakken shares had a tough second half of 2012, and that’s continued into this year. Part of that has been due to the deconsolidation with Petrobank Energy & Resources Ltd (TSX: PBG, OTC: PBGEF), which gave stock to shareholders of the latter that many are apparently cashing out. But the decision to control capital spending and favor the dividend also spurred some selling.

What’s important, however, is that assets are good, and for the first time in its brief history management is delivering on development goals.

Though not as safe as my other four CE Portfolio energy producers, PetroBakken is a buy up to USD15 for the more aggressive.

Dividend Watch

Penn West Petroleum Ltd (TSX: PWT, NYSE: PWE) also chose to curtail capital spending in 2013, last month announcing a base budget of CAD900 million.

The company laid out conditions for investing another CAD300 million, the biggest being a reduction in oil-price differentials.

But if that doesn’t happen, production will likely be flat, with an increase in oil output offset by declining gas.

Like PetroBakken, Penn West shares took a hit following the news. But there is a silver lining for income investors: The dividend should be very well supported, even in a volatile pricing environment.

The company has further ensured cash flows by hedging over 80 percent of forecast output of oil for 2013 as well as 45 percent of gas. And the series of asset sales over the past year, though not always at optimal prices, will reduce debt.

That should insulate the company against price differentials in 2013. Former Portfolio recommendation Penn West is now a hold.

Enerplus Corp (TSX: ERF, NYSE: ERF) and Pengrowth Energy Corp (TSX: PGF, NYSE: PGH) both affirmed their commitment to current dividend levels as well as capital spending plans.

I’ve upgraded Enerplus to a buy at USD14 and Pengrowth to a hold.

We’ll get a better read on both when they report earnings later this month. Enerplus is still on the Dividend Watch List. And if energy prices did drop enough, Pengrowth, Penn West and even PetroBakken could join it there. But at their current prices the bar of expectations is extremely low, and current yields are high.

Enerplus and Pengrowth have cut their dividends in the last 12 months. So have AvenEx Energy Corp (TSX: AVF, OTC: AVNDF), Bonavista Energy Corp (TSX: BNP, OTC: BNPUF), Talisman Energy Inc (TSX: TLM, NYSE: TLM) and Zargon Oil & Gas Ltd (TSX: ZAR, OTC: ZARFF).

All have been affected by weak oil and gas prices in Canada. All of them chose to save cash by cutting dividends. AvenEx is attempting a three-way merger, as I detail in Dividend Watch List, with the goal of scaling up.

Dividend cuts remain the easiest lever for cash-strapped companies to pull. And the longer price differentials last at these levels the more likely we’ll see even more dividend cuts in the coming months.

There’s one more way that producers can stick to capital spending plans without cutting dividends or rolling up debt, even if energy prices remain weak. That’s to attract deep-pocketed and patient strategic partners, whose financial support can keep plans on track.

Two large investments have come in the form of outright takeovers. The all-cash buyout of Progress Energy Resources Corp by Malaysia’s national oil and gas company Petroliam Nasional Berhad, better known as Petronas, is now complete. The purchase of Nexen Inc (TSX: NXY, NYSE: NXY) by China-based CNOOC Ltd (Hong Kong: 883, NYSE: CEO) is still waiting on approval from US regulators.

Sometimes the investment has come in outright purchases of assets. Super Oil Chevron Corp (NYSE: CVX), for example, acquired a 50 percent interest in the Kitimat LNG export project and related producing properties by buying out EOG Resources Inc (NYSE: EOG) and Encana Corp (TSX: ECA, NYSE: ECA). That deal jump-started the stalled project and provided needed cash for struggling Encana.

The most popular form of strategic investment is basically a cash infusion in return for a share of ownership in a particular asset, which the Canadian energy producer continues to own and run.

An investment by China Petroleum & Chemical Corp–better known as Sinopec (Hong Kong: 386, NYSE: SNP)–provided badly needed cash to Talisman last year.

Last month Bellatrix Exploration Ltd (TSX: BXE, NYSE: BXE) announced a CAD300 million investment from a South Korean company to accelerate development of its Cardium lands.

The investor will get a 33 percent working interest, and the company will boost its CAD180 million capital budget for 2013 to the CAD230 million to CAD240 million range.

The investment makes refinancing CAD101 million of a CAD220 million credit line maturing Jun 2014 suddenly a whole lot less daunting. And it’s another good reason for aggressive investors to buy Bellatrix Exploration up to USD5.

MEG Energy Corp’s (TSX: MEG, OTC: MEGEF) fourth-quarter 2012 production hit a record of 32,292 barrels a day. Annual production was up 8 percent over 2011 levels, the fourth consecutive year of production gains.

Operating costs were just CAD8.95 per barrel, by far the lowest for any oil sands producer and topping the company’s target of CAD10 to CAD12 a barrel.

Low costs and production growth kept the company’s “netback” steady at CAD34 and change, despite the impact of oil-price differentials. MEG also maintained the robust pace of capital spending, keeping the company on target to meet its production goal of 260,000 barrels a day by 2020. Proved bitumen reserves were increased by 80 percent during the year.

MEG’s ace in the hole is investment by CNOOC, which owns 13 percent of the company and is dedicated to seeing the company complete its projects. Coupled with these solid numbers, that makes MEG the highest potential pure play in the tar sands. Note that the company doesn’t currently pay a dividend, which may turn off some investors.

I expect to see more such investments in Canadian energy going forward, as cash rich outsiders take advantage of low asset prices. But that’s not a good reason to go chasing after sector weaklings such as Advantage Oil & Gas Ltd (TSX: AAV, NYSE: AAV). But it is a sound basis for sticking with buy-rated companies in the Canadian Edge Portfolio and in How They Rate.

Keystone Controversy

If Canadian producers are suffering from record price differentials, energy midstream companies are lining up to ease their pain by launching massive construction projects.

The venture most often in the news is TransCanada Corp’s proposed 1,700-mile Keystone XL pipeline. The southern leg of the pipeline to run oil from the Cushing hub in Oklahoma to the Gulf Coast is already 45 percent completed and should continue rapid progress now that the company has settled its disputes with protesters. The northern leg has won approval from the state of Nebraska and is waiting on a ruling from the US State Dept.

Keystone appeared to be steaming along to approval before running into election-year reality. It seems clear that President Obama didn’t want to risk alienating either environmental groups that oppose the pipeline or labor unions that support it. With the election in the rear-view mirror, I expect approval to follow, despite the fact that new Secretary of State John Kerry is seen as a hawk on global warming.

If Keystone is approved, it will still be several years before the pipeline system begins to bring oil south and thereby alleviate the bottleneck that’s behind oil-price differentials. If it’s rejected there will no doubt be a negative reaction in TransCanada’s stock price.

That, however, will be a golden time to buy the stock.

TransCanada is an invest-to-grow story, and it has myriad projects that could take the place of the USD5.3 million northern Keystone project. One of these is a plan to convert an existing natural gas pipeline to carry 850,000 barrels of oil a day from western to eastern Canada. That will keep cash flow and the dividend growing for years to come.

TransCanada is a buy under USD45.

Another alternative to Keystone XL is the Northern Gateway pipeline proposed by Enbridge to carry Canadian oil to the Pacific Coast, for export to Asia. The company has also made less dramatic enhancements to its system, investing CAD15 billion over the next three years. And Kinder Morgan Energy Partners LP (NYSE: KMP) is ramping up its Trans Mountain pipeline, with the goal of expanding capacity from a current 300,000 barrels per day to 890,000.

So long as Canadian oil is selling at such a deep discount these and other projects will move forward. Canada’s National Energy Board has proven to be willing to approve new pipeline systems and to reward investment with strong and reliable regulated returns.

Potential roadblocks include a group of First Nations representatives and possibly the government of British Columbia. One way or another, however, infrastructure will be built to bring currently landlocked Canadian oil to the global market place in coming years. And those who do the job will realize powerful and reliable returns.

Exporting Gas

The same holds for currently landlocked natural gas. As Ari Charney points out in the Feb. 5 edition of Maple Leaf Memo, Canada Continues Its Pivot Toward Asia, Canadian natural gas exports to the US have fallen every year since 2007. But development of LNG facilities for export is well under way to more than pick up the slack with the Asian trade.

Canadian regulators approved their second project this week, the LNG Canada facility near Kitimat, British Columbia. Another LNG facility in the area, dubbed Kitimat LNG, got a major shot in the arm when Chevron bought out the interests of EOG and Encana. It too has won approval from regulators. The project proposed by Petronas-controlled Progress Energy is expected to start up in 2014. And finally, the BC LNG Export Co-Operative was granted a 20-year license for export in early 2012.

These are major projects that will take years to build at great cost. But they will eventually unlock Canadian gas to global pricing. And in the meantime Canadian midstream companies will reliably and robustly grow earnings and dividends as they invest.

AltaGas Ltd (TSX: ALA, OTC: ATGFF) had already positioned itself to profit from LNG exports by acquiring a west coast Canada gas system adjacent to Kitimat LNG and other projects. The system will allow the company to take advantage of storage opportunities, as well as customer growth in the primary area where facilities are built.

In late January the company announced a partnership with Japan’s Idemitsu Kosan Co Ltd (Japan: 5019, ADR: IDKOY) to build an LNG facility for export to Asia. The pair plan to have studies completed by early 2014, with exports of LNG to begin in 2017. The venture may also export liquefied petroleum gas as early as 2016.

AltaGas is an invest-to-grow buy up to USD35.

Other midstream companies likely to benefit from pipeline expansion include Inter Pipeline Fund (TSX: IPL-U, OTC: IPPLF) and Pembina Pipeline Corp (TSX: PPL, NYSE: PBA).

Pembina is slightly cheaper. It’s also the best choice for US investors, as Inter Pipeline has maintained in the past that it’s off limits to all but Canadians. Buy Pembina Pipeline up to USD30 if you don’t already own it.

Alternative Shipping

While all these facilities are being built, producers are increasingly turning to other means of shipping their energy. Both Canadian National Railway Co (TSX: CNR, NYSE: CNI) and Canadian Pacific Railway Ltd (TSX: CP, NYSE: CP) are now doing a brisk business shipping oil by rail.

In fact in November a majority of oil produced in the Bakken region was shipped by rail rather than pipeline. That’s up from 23 percent in December 2011, and the figure looks set to rise sharply going forward.

Canadian National is targeting CAD1.9 billion in capital investments this year, in part to take advantage of what management sees is a “huge” opportunity to ship energy. And Canadian Pacific forecast 40 percent earnings growth in 2013, as its crude-by-rail effort has ramped up to 70,000 carloads per year with more to come.

The problem with both of these stocks now, however, is everyone already knows the good news. And however much oil-by-rail volumes increase in the next few years it’s unlikely to compete with pipelines in the longer term. Canadian National raised its dividend a hefty 14.7 percent in late January, and Canadian Pacific looks set for another big boost in July.

I have recommended both of these stocks as buys in the past. But at these levels Canadian National and Canadian Pacific are clearly holds.

Anyone who’s made a particularly big profit may consider taking some money off the table. Nothing grows to the sky, and unbalancing a portfolio is a formula for trouble in a market where even the biggest companies can stumble.

As for trucking, TransForce Inc (TSX: TFI, OTC: TFIFF) is seeing some expansion in the energy transport business. But Mullen Group Ltd (TSX: MTL, OTC: MLLGF) has the larger presence.

TransForce is a buy on dips to USD17. Mullen Group is a buy up to USD25 after its recent 25 percent dividend increase.

Parkland Fuel Corp’s (TSX: PKI, OTC: PKIUF) acquisition of Elbow River Marketing from AvenEx will add CAD0.16 per share to annual distributable cash flow initially.

More important, however, the deal adds rail car logistics to Parkland’s product and services mix, with a managed fleet of 1,200 rail cars.

This business has operated in the petroleum products sector for 30 years, matching purchases and sales under contracts to eliminate commodity-price exposure. Combined with the rest of Parkland’s Canada-wide fuel marketing network, there’s considerable opportunity for growth.

My only problem with the stock is price. But Parkland is a buy on any dip to USD18 or lower, or when management at last raises its dividend.

Suffering Services

If there’s a real loser from Canada’s oil-price differentials, it’s the long-suffering energy services group. As producers have cut back on drilling plans demand for rig rentals and other services has shrunk as well. That’s on top of the reduced activity drilling for natural gas over the past year.

These stocks are cheap, to be sure, as investors have abandoned them in droves. And if they do find a path to holding their own now their stocks will be huge winners as differentials decline and drilling bounces back.

Differentials and the demise of smaller producers were the primary factors behind the disaster that struck Poseidon Concepts Corp (TSX: PSN, OTC: POOSF) last year.

Management has restored some since of order by declaring it will pay the January dividend after all. But until they’ve had a chance to go through the numbers–which may be as late as March 22–there’s too much uncertainty here to do anything but watch.

Note the stock hit a new low this week. Sell Poseidon Concepts if you haven’t already done so.

Trinidad Drilling Ltd (TSX: TDG, OTC: TDGCF) has been rumored as a preferred player for the Progress-Petronas natural gas venture. If true, that would be a major plus for the company. Until a deal is struck, however, I’m rating Trinidad Drilling a hold.

The only driller I currently favor is PHX Energy Services Corp (TSX: PHX, OTC: PHXHF), the former Aggressive Holding I disastrously swapped for Poseidon Concepts last year.

The company’s ace in the hole is its global reach, which to date has more than made up for weakness in North America. PHX is expected to report earnings on or about Feb. 28. At that point I may consider adding it back to the Portfolio. PHX Energy Services is a buy under USD9.

I also remain a fan of both Newalta Corp (TSX: NAL, OTC: NWLTF) and Bird Construction Inc (TSX: BDT, OTC: BIRDF). Both could see earnings impacted negatively to the extent that oil-price differentials affect oil sands development in the coming year.

In fact Bird announced last month that a tar sands customer had terminated a contract, which will be removed from backlog when the company reports results on or about March 7.

Bird also announced the award of what’s likely to be a much larger contract at a giant hydroelectric project in Labrador. And it acquired Nason Contracting Group Ltd as well, adding expertise in water and wastewater construction in western Canada. Bird Construction is a buy up to USD14.50.

Newalta’s Feb. 13 earnings release will no doubt speak volumes about how it’s being affected by energy patch activity trends.

But if one thing is true about this company it’s that it is a survivor, thanks to conservative financial and operating policies and a wide reach in an essential industry, industrial and energy cleanup.