U.S. Senator John Hoeven (R-ND) made headlines this week when he said that President Barack Obama planned to strike down the Keystone XL pipeline in August during the Congressional recess. The pipeline, with a capacity of 830,000 barrels per day, would carry Canadian oil sands to the Gulf Coast, the key refining center in the U.S. While it is far from clear if Sen. Hoven has access to the inner workings of the White House, what is clear is that the pipeline project has become an over-hyped political symbol increasingly detached from reality.
That said, Keystone also symbolizes the struggles that Canadian oil sands producers have had in getting their product to market. And while environmental groups have been criticized for latching onto a single pipeline project to back their cause, they did so because of the important role that the midstream sector plays in oil markets.
Wile environmental groups have been criticized for latching onto a single pipeline project to back their cause, they did so because of the important role that the midstream sector plays in oil markets.
Without pipelines, oil flows by rail
Canada increased its oil production by 1 million barrels per day between 2009 and 2014, topping 4.3 mbd. Prior to the crash in oil prices, some analysts expected Canada’s oil producers would reach 6 mbd by the end of the decade. In order to move that oil, more pipeline capacity is needed, thus the impetus for Keystone XL and other pipelines like it.
But the inability to build enough pipeline capacity has led to a dramatic surge in oil shipments by rail. Canada’s oil exports by rail jumped from around 0.016 mbd in early 2012 to 0.166 mbd in the third quarter of 2014, a more than nine-fold increase. Exports have since fallen back quite a bit due to the glut of oil in the U.S. and the collapse in oil prices.
The same phenomenon has been even more pronounced in the U.S. Railways have been overloaded with American crude in recent years as U.S. drillers managed to boost oil production from 5.6 mbd in 2011 to near 9.7 mbd as of mid-2015. That amounts to an increase in output of nearly 75 percent in just four years. With the long lead times needed for new pipeline construction, midstream operators were unable to respond quickly enough. Against this backdrop, the flood of oil spilled over onto the railways, and crude-by-rail shipments skyrocketed in the U.S.
Pipeline shortages lead to price distortions
Shipping crude by rail adds $5 to $10 per barrel of oil for delivery when compared to moving oil by pipeline, which causes price distortions between different crude grades. Put another way, oil producers have to provide a discount for their oil to ship by rail when they can’t find enough pipeline capacity.
The long delays for Keystone XL has some Canadian oil hitting the trains, but it also has forced Alberta operators to look at pipeline alternatives. However, those other pipelines have also run into roadblocks. For example, Enbridge has had trouble pushing its proposed Northern Gateway Pipeline, which would connect oil sands to the Pacific Coast for export.
Inadequate pipeline capacity is forcing Canadian oil to trade at a discount, which has been pretty hefty at times.
Inadequate pipeline capacity is forcing Canadian oil to trade at a discount, which has been pretty hefty at times. For example, Western Canadian Select, a marker for Canada’s heavy crude, sold for $19.40 less than WTI on average over the course of 2014, although the wide spread also takes into account differences in quality.
The collapse in oil prices has narrowed the discount, only because the U.S. is facing an oil glut too. While Canadian producers are happy to see the discount shrink, current price levels could prevent marginal projects from moving forward.
In its Final Supplemental Environmental Impact Statement in 2014, the U.S. State Department concluded that pipeline constraints would shut in oil production to a certain degree, especially if oil prices stayed within a range of $65 to $75 per barrel, the breakeven range for many oil sands projects. “Assuming prices fell in this range, higher transportation costs could have a substantial impact on oil sands production levels—possibly in excess of the capacity of the proposed” Keystone XL pipeline, the statement said. In other words, without enough pipeline capacity, some of Canada’s oil sands are not economically viable, especially when oil prices are low.
An oil spill in Alberta in July 2015 by oil operator Nexen, a subsidiary of Cnooc, could bring about more scrutiny for the industry. Nexen’s ruptured pipeline spilled 31,500 barrels of bitumen, sand, and water—a mixture known as “emulsion.” Alberta’s government has said that new regulations on pipelines are not something they are considering at this point, but the accident gives more fuel to the fire of pipeline opponents fighting Keystone XL or other controversial projects.
The co-head of equity and advisory for the Bank of Nova Scotia, Adam Waterous, thinks that Alberta producers are focused too much on tax increases from the new Alberta government, a development that matters much less than the shortage of pipeline capacity. Writing in The Globe and Mail on July 15, he argues “lack of market access is costing the energy industry about $14 billion a year.” By way of comparison, Alberta’s energy industry is up in arms about the latest increase in corporate taxes from 10 to 12 percent, which Waterous says amounts to about $800 million per year, or “a near rounding error compared to what lack of market access is costing the industry.”
Texas finds a way
While Canada has struggled, oil-producing regions south of the border have managed to resolve pipeline constraints. For example, in August 2014 crude oil from the Permian Basin in and around Midland, Texas sold for a $21 per barrel discount to WTI, the largest spread dating back to the start of data collection in 1991. The industry blamed the wide discount on a shortage of pipeline capacity to the Gulf Coast as well as to the key storage hub of Cushing, Oklahoma. According to Platts, the Permian was producing 1.7 mbd in August 2014, but the region only had enough pipeline capacity to move 1.27 mbd.
However, several pipeline projects have come online since then, erasing the discount for Permian crude. Magellan Midstream Partners and Occidental Petroleum brought the BridgeTex Pipeline into operation in September 2014, adding 0.3 mbd in new pipeline capacity (Occidental has since sold its 50 percent stake to Plains All American for $1.1 billion). Plains All American also brought its Cactus Pipeline online earlier this year, adding another 0.25 mbd of capacity for Permian oil to reach the Gulf of Mexico. Furthermore, the Permian Express 2, a pipeline by Sunoco Logistics, will add another 0.23 mbd in capacity.
Furthermore, Plains, Magellan, and Anadarko Corp. are jointly building a 600-mile pipeline between Cushing and the Rocky Mountains with a capacity of 0.4 mbd, which will allow Rocky Mountain oil to fetch a higher price. That is expected to come online in mid-to-late 2016.
The pipeline buildout in the Permian has eliminated the discount that producers had to offer, putting them on stronger footing in this low pricing environment compared to their Canadian counterparts.
The pipeline buildout in the Permian has eliminated the discount that producers had to offer, putting them on stronger footing in this low pricing environment compared to their Canadian counterparts. According to Bloomberg, Permian oil traded at a 78-cent premium to WTI in July 2015. Andy Lipow, president of Lipow Oil Associates LP in Houston, told Bloomberg that all the new pipelines were responsible for the higher price. “Had these pipelines not existed, you’d see Midland differentials at an $8-to-$10 discount to WTI.”