The Fuse

Canada’s Oil Industry Faces Long-Term Challenges Without Key Pipelines

by Nick Cunningham | April 11, 2018

Kinder Morgan announced on April 8 that it would suspend all non-essential work on the Trans Mountain Expansion pipeline, a major setback for Canada’s oil sands. The company said that ongoing legal and permitting disputes present too large of a risk to shareholders, and the pipeline would be permanently scrapped unless a deal can be reached to overcome outstanding issues by May 31.

The end result of the project being canceled could lead to large price discounts for Canadian oil for years to come.

Should the project be cancelled, it would significantly hurt oil sands producers in Alberta, which have struggled for a decade to build a major pipeline to move crude out of the province. The end result could lead to large price discounts for Canadian oil for years to come. However, at the same time, the loss of the Trans Mountain Expansion would aid the business case for the Keystone XL pipeline, which is also facing an uncertain future.

Trans Mountain Expansion stalled

Kinder Morgan Canada put the blame squarely on the provincial government of British Columbia for its decision to halt the Trans Mountain Expansion. The company said in a statement that “under current circumstances, specifically including the continued actions in opposition to the Project by the Province of British Columbia, it will not commit additional shareholder resources to the Project.”

The Trans Mountain Expansion has the backing of the Canadian federal government as well as the provincial government in Alberta. In fact, in 2016, the government of Prime Minister Justin Trudeau approved Kinder Morgan’s pipeline, while also nixing a competing project—Enbridge’s Northern Gateway pipeline—that would have allegedly caused large environmental damage by traveling through the Great Bear Rainforest. His attempt to balance the interests of both the oil industry and environmentalists did not succeed, and Trans Mountain has faced strong opposition ever since.

Trudeau’s attempt to balance the interests of both the oil industry and environmentalists did not succeed, and Trans Mountain has faced strong opposition ever since.

Kinder Morgan’s pipeline took on even greater importance last year when another competing project, the Energy East pipeline, which would have carried Alberta oil to refineries and export terminals in eastern Canada, was abandoned by its owner, TransCanada.

The federal government and Alberta placed a lot of faith in the outcome of the Trans Mountain Expansion. The path forward appeared assured, but the 2017 provincial election in British Columbia resulted in a new government led by the left-leaning NDP in a coalition with the Green Party. That proved to be pivotal in the case of the Trans Mountain Expansion. BC’s opposition led to a trade war of sorts with the neighboring government in Alberta and ultimately caused too many problems for Kinder Morgan Canada. “[S]ince the change in government in June 2017, that government has been clear and public in its intention to use ‘every tool in the toolbox’ to stop the Project,” Kinder Morgan Canada said in a statement.

“If we cannot reach agreement by May 31st, it is difficult to conceive of any scenario in which we would proceed with the Project.”

“A company cannot resolve differences between governments. While we have succeeded in all legal challenges to date, a company cannot litigate its way to an in-service pipeline amidst jurisdictional differences between governments,” Kinder Morgan Canada CEO Steve Kean said in a statement.

Kinder Morgan Canada said that the project now faces “unquantifiable risk,” with BC threatening “unspecified additional actions to prevent Project success.” The company already spent C$1.1 billion since it was initially proposed in 2013, and the beginning of construction would have significantly ramped up spending in the months ahead, greatly heightening the financial risk to the company if the project hit political roadblocks. “If we cannot reach agreement by May 31st, it is difficult to conceive of any scenario in which we would proceed with the Project.”

Midstream bottlenecks

It is difficult to overstate the importance of the Trans Mountain Expansion to Canada’s oil industry. Alberta oil sands producers have had to sell their oil at a discount for years due to midstream bottlenecks. Those discounts have fluctuated significantly over time, and have widened in recent months as new oil sands production has come online while pipeline capacity has remained stuck. The discount for Western Canadian Select (WCS) hit $30 per barrel versus U.S. benchmark WTI a few months ago when the Keystone pipeline suffered a temporary outage after a leak, although the discount narrowed more recently to just under $20 per barrel. The WCS-WTI differential could widen once again with an additional 400,000-500,000 barrels per day (b/d) of new supply coming online in Alberta through the end of 2019, with little chance of additional midstream capacity available to offload that product over that timeframe, according to Scotiabank.

While Trans Mountain is one of the few options for the industry, there are two other pipelines that could receive a boost from the absence of Kinder Morgan’s project.

While Trans Mountain is one of the few options for the industry, there are two other pipelines that could receive a boost from the absence of Kinder Morgan’s project. Enbridge’s Line 3 replacement and expansion is the most likely, which would increase volumes from Alberta to Wisconsin in the U.S. The project is hoping to clear the last few regulatory hurdles, and could come online by the end of 2019, although that timeline could slip into 2020. The inauguration of Line 3 would ease a portion of the bottlenecks, likely reducing the WCS discount—but it won’t be enough to entirely resolve the midstream problem. “[W]e anticipate that Line 3 alone will be insufficient and that the market will require either the [Trans Mountain Expansion] or [Keystone XL] before Canadian crude discounts fall back to levels associated with sufficient takeaway capacity,” Scotiabank analysts wrote in February.

TransCanada’s Keystone XL also faces regulatory uncertainty in the U.S., even though it has the backing of the Trump administration. TransCanada has held off on making a final investment decision on the project as it assesses its options. Even if the company moves forward with construction and does not run into additional delays, the project will not come online until the early 2020s.

Long-term vulnerability without new pipelines

Over the long term, Canada’s oil production could bump up against a ceiling if both Keystone XL and Trans Mountain Expansion are shelved. “If either KXL or TMX do not move forward, Canadian production will outstrip pipeline takeaway capacity indefinitely,” according to Scotiabank.

“If either KXL or TMX do not move forward, Canadian production will outstrip pipeline takeaway capacity indefinitely.”

Crude-by-rail shipments are rising, but new capacity from rail companies tend to require long-term contracts, to which oil producers are typically unwilling to agree because of the higher cost of transport. As such, rail shipments flare up when the WCS discount is sufficiently large. It is unlikely that rail would solve Canada’s midstream woes.

Over time, as new crude barrels come online from oil sands and Canada’s emerging Montney Shale, the pipeline bottleneck will likely worsen in the 2020s without Trans Mountain or Keystone XL. “Canadian crude will have an increasingly difficult time getting to market absent this essential infrastructure, which will manifest as ever-wider WCS discounts,” Rory Johnston of Scotiabank said in an April 9 research note.