‘Canada’s Folly’ is important not because it’s accurate, but because this is increasingly how investors outside Canada view industry, government policy

Is the Canadian government’s purchase of West Coast pipeline assets from Kinder Morgan Canada “a substantial risk?” A new study argues Ottawa is likely to take a loss when it eventually sells the pipelines under “distressed conditions” and the Alberta oil sands are no longer viable. Is this how the world is coming to think of the Canadian oil and gas industry?

Thomas Sanzillo.

“Canada’s Folly” by Tom Sanzillo, former first deputy comptroller for New York State, and Kathy Hipple, a finance professor, for the Cleveland-based Institute for Energy Economics and Financial Analysis, is critical of the deal – calling it a “problematic investment” – and believes Canada will have to sell in a “distressed climate,” thereby losing money, possibly a good deal of it.

Not everyone agrees. The federal department of finance was not amused and fired back with comments of its own. Prof. Jack Mintz agrees Canada may incur a loss of $1.5 billion on the purchase, but doesn’t foresee a catastrophe. And pipeline industry veteran Dennis McConagy thinks the IEFFA study is completely misguided and wrong (he’s not alone. Canadian economists and industry types were savaging the study on social media after its release).

The IEEFA analysis tries to answer a simple question: did Canada get a good deal?

The IEFFA view

A word of caution. Throughout our interview, Sanzillo said numerous times that his analysis is based upon only those “formal documents” filed with official agencies like the Securities and Exchange Commission, that he doesn’t “speculate” about information not contained in those documents, and that he approached the deal like a private investment banker, one of his competencies according to his bio, which points out that he once managed a $150 billion pension fund for New York.

Kathy Hipple.

“We’re not economists. We are financial analysts and my background is in actually investing money,” he said his interview. “Economists use models. I use markets and I take a very different perspective. Economic information and data is very important, but it is not the basis upon which any investor would make an investment.”

The federal department of finance took exception to the methodology used by Sanzillo and Hipple.

For instance, the study estimates the government “is facing at least $11.6 billion in project-completion costs,” which could add a $6.5 billion unplanned expenditure to Canada’s budget during the 2019 fiscal year, increasing the federal projected deficit of “$18.1 billion by 36%, to $24.6 billion,” the authors wrote in the study: “The transaction risks an increase in Canada’s annual deficit in FY 2020, too, reversing a deficit reduction trend that supports Canada’s strong recovery, sound fiscal position and excellent credit rating.”

In a terse statement emailed to Energi News, Finance said that the “conclusion stated in this report regarding the impact on Canada’s budget deficit is completely incorrect. Upon purchase, the Government would receive an asset of significant value. Consistent with generally accepted accounting standards, an asset would be recorded upon acquisition of the project. As such, we do not expect that the purchase would have an immediate impact on the federal debt or deficit.‎”

Another point of contention is the study’s claim that “Kinder Morgan Inc. and its Canadian subsidiary, Kinder Morgan Canada Limited, will share a profit of $3.89 billion from the sale of the pipeline to the Canadian government. IEEFA estimates that the return on outlay will total 637%.”

In rather strong language for government officials, Finance fired back that the “representation of the financial return to Kinder Morgan based on Government’s agreement to purchase the company’s Trans Mountain Expansion Project and related pipeline and terminal assets is fundamentally flawed.”

Another “flaw” pointed out by Finance: “The report allocates the entire purchase price to the expansion project. It does not take into account the fact that the Government has agreed to purchase the existing pipeline and related assets, which are viable commercial operations with significant financial value, in addition to the expansion project.”

What the bureaucrats are getting at is that the $3.89 billion “profit” actually paid for assets, real stuff that has value and generated revenue for 65 years. Here’s what the actual share purchase agreement, linked in the study very first footnote, has to say:

The sale of these securities will transfer to the Purchaser the ownership of the companies and limited partnerships that hold the Trans Mountain pipeline system (“TMPL”) and related expansion project (“TMEP”), the Puget Sound pipeline system and the Canadian employees that operate the business and assets to be sold.

TMPL is the original, now 300,000 b/d pipeline (built in 1953) that travels 1,150 kms from Edmonton, Alberta to Burnaby, British Columbia on the West Coast. Related assets include the Westridge Marine Terminal where tankers are loaded with Alberta crude oil and the Burnaby tank farm.

The Puget Sound pipeline system ships Canadian crude oil products via the Trans Mountain pipeline system from Abbotsford, BC to Washington State refineries in Anacortes, Cherry Point, and Ferndale.

The related – and unfinished – expansion project is the 590,000 b/d Trans Mountain Expansion, about 70 per cent of which will follow the original right of way.

I asked Sanzillo about this apparent anomoly, identified by other economists and pundits, and he replied in an email:

I take the profit calculations from the company’s statement that is reporting the nature of the transaction. It is their job to disclose to their shareholders the full benefit and costs of a transaction. I assume they did so. (If I could not assume this then we would be saying that our shareholder disclosure rules are meaningless and the market just so much uninformed chaos.) I am fully aware of the full range of the assets involved and would hope that the investigation by the government of Canada and then the company adjusts the asset/liabilities calculations going forward. Why did they report the profit figures as they did? Why did not the Canadian government present the kind of revenue offsets you are talking about…if that is what you are implying should be taken into consideration. I try not to speculate and I try to limit off balance sheet banter when applying disciplined analysis. 

The reader will have to make of that comment what they will.

According to the experts I interviewed in late May about the sale, Canada paid a fair price plus a small premium, customary in these kinds of sales.

“I think the economic case is really sound,” said Prof. Kent Fellows of the School of Public Policy at the University of Calgary.“I would be very surprised if the government can’t find a suitable buyer following construction, which is their stated plan.”

Jack Mintz, also a professor of economics at the School of Public Policy, thinks the value of existing assets is closer to $3 billion: “The federal government paid for the old assets, but it also paid for the new assets that were currently under construction. So, there’s value to them as well.” 

McConaghy, a former VP with TransCanada who was in charge of the Keystone XL project, says Canada made an investment when it acquired the Trans Moutain assets and the right to complete its expansion project.

“The $4.5 billion is not a current expense,” he wrote to Energi News in an email. “When the expansion is completed, the TransMountain assets will have substantially more value. Substantially. No party is better equipped than the federal government to deal with completion risk on the project.”

Mintz isn’t so sure. He thinks the $1.5 billion paid by the government over and above the value of the assets could be lost.

“The toll charge set by the National Energy Board was based upon construction costs which are not the same as the value that the federal government paid for. The government may not be able to recover that $1.5 billion,” he said in an interview.

Mintz points out there is a range of possible losses, with the billion-plus at the bottom end but maybe as much as $8 billion if construction never finishes and Canada is stuck with a huge white elephant.

“The question is whether they underpaid or overpaid for all the assets and that will be something we’ll judge in the future, but there is a contingency where the project may never get built,” he said.

“And in that case, the expansion will be of zero value and in a sense, the federal government has taken on what’s called a contingent liability associated with new assets. And as I understand public accounting, that contingent liability would have to be included as part of debt and deficit.”

It appears Ottawa and its critics disagree on several important points and presumably those issues will be resolved coming months if federal government does, in fact, complete the deal with Kinder Morgan.

But no Canadian expert I interviewed or talked to took the harsh view of Sanzillo.

Alberta oil sands also no longer viable?

Another reason to doubt the viability of the Kinder Morgan assets, according to the IEEFA study, is that the oil sands are already – or soon will be – uneconomic.

“Oil sands production remains the most vulnerable oil production region in the world due to its high cost structure. Further, while supportive of the government action, the CEO of Suncor [Steve Williams], Canada’s second largest oil producer, does not see the move [Canada buying Kinder Morgan Canada assets] improving Canada’s oil competitiveness on the global market,” write Sanzillo and Hipple.

“Further still, opinion is mixed on whether oil producers in Canada will actually receive a higher price for oil as a result of the pipeline’s completion or if Asian markets will materialize in the way thought by Canadian business and governmental proponents of the transaction.”

Energi News has reported upon and I have written many columns on these very topics and the general view in Alberta is much more optimistic than the study.

For instance in mid-May, a study by the Canadian Energy Research Institute found that most oil sands production could compete with the best of the US shale production. Greenfield (requiring construction of new facilities) steam assisted gravity drainage (SAGD) operations need WTI price of US$60.17/b at the Cushing, Oklahoma transportation hub and only US$51.59/bbl for brownfield (use existing facilities) projects.

As for IEEFA being “skittish” about Asian refining markets, I’ve now interviewed six economists and trade experts and they all agree Singapore, northern China, and India are all excellent prospects for Alberta dilbit and heavy crude once a steady supply is flowing through Trans Mountain Expansion to the West Coast. They also expect continued demand from California, whose domestic heavy crude oil production is in long-term decline.

McConaghy has a different view of Trans Mountain Expansion and market access issues than Sanzillo and Suncor’s CEO: “The cost to Canada of not solving its market access crisis for oil sands volumes is real and  substantial. That is the real cost in play here, that should be understood by Canadians.”

What to make of the IEEFA study?

My experts were mostly dismissive of Sanzillo and Hipple; the lone exception was Mintz, who agreed with a few of their observations, but not all.

Why should the Canadian government – or Alberta government or the Alberta industry, for that matter – care what the IEEFA thinks?

Because the oil sands and the infrastructure it needs to get product to market is under seige.

Crude oil is Canada’s biggest export, clocking in at $66 billion last year, more than a third more than autos. The sector is vitally important to the national economy and that importance will grow as oil sands output grows by as much as two million b/d over the next 20 years.

Canadian producers say they are having trouble competing now for capital in US markets because of the perception that Canada’s regulatory system is in shambles and the industry’s competitiveness is in freefall.

Studies like the IEEFA, because they receive media coverage that is read by decision makers, reinforce that opinion in places like Wall St. and Houston where companies like Suncor try to raise capital.

And to make matters worse, industry groups like the Canadian Association of Petroleum Producers are a big part of the problem. Over the past year, CAPP has released study after study arguing that governments – principally Alberta and Canada – are killing the golden goose with excessive regulation.

The cumulative impact of all this talking down of the industry is a self-fulfilling result: Canada is increasingly viewed as incompetent and a bad place to invest.

The IEEFA study is just another brick in that wall.

Tom Sanzillo says that there are still many questions that need to be answered about Canada’s purchase of the Kinder Morgan assets and he includes 20 in his study.

While many – probably most – of his criticisms of the deal and the oil sands are problematic, this should be a wake up call for Canada, a time to answer the questions that need answering and to regain control over the public debate about the national oil and gas industry.

If Canada continues to abdicate that responsibility, then analysts like Sanzillo will craft the energy narrative for us, with all too predictable consequences.

Someone needs to step up before it’s too late.