Regulated tolls, fully subscribed shippers, 15-20 year guaranteed contracts, demand in Asia and other markets, equals solid business case for Trans Mountain operation

Did Ottawa negotiate a good deal with Kinder Morgan Canada or was the Trudeau Government fleeced by sharp operators from Texas? Political partisans on both ends of the continuum claim the latter. But economists interviewed by Energi News say Canada paid only a small premium for the pipeline company’s assets and when all the reasons behind the purchase are considered, it’s a very good deal for the country.

Prof. Kent Fellows, School of Public Policy.

“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.”

I think it’s best if you look at the layers of how a government would look at this,” explains Kevin Birn, direct, Oil Sands Dialogue, IHS MarkIt. 

The economists suggest there are four “layers” the federal government likely evaluated while doing its due diligence on the purchase.

The Business Case

Once pipelines are built and operating, they tend to be a really stable investment, argues Fellows. 

Shippers (companies that produce the crude oil or the refineries manufacturing refined products) commit to 15 to 20 “take or pay” contracts that require them to pay the pipeline operator even if they don’t actually ship product.

Over 50 per cent of Trans Mountain Expansion shipping capacity was committed to up front, and a percentage is set aside for the spot shipping market, says Fellows.

“That’s regulated by the NEB as well. They can’t sell those volumes in advance. That’s their contingency, but the volumes they can sell in advance, it’s a majority of the shipping volume for sure,” he said.

Tolls (the price paid by the shipper) are negotiated by the National Energy Board so they’re fair to both parties.

And when the NEB reviewed the project prior to approval, the economic case was subjected to consider scrutiny.

The NEB does that “in part to protect incumbent pipelines from the unnecessary competition,” Fellows said in an interview. “Pipelines are a very special type of market, really they’re natural monopolies, so along existing routes it’s often it’s one pipeline or a very small set of pipelines that is the most efficient. The NEB protects these firms from competition, which is part of the reason that the NEB approval carries such significant value.”

An important part of the business case is prospective customers, in this case, Asian refineries. Critics have said there is no market for bitumen anywhere, least of all in China and India, the fastest growing and largest Asian economies.

Darryl Anderson.

Darryl Anderson is the managing director of Wave Point Consulting and an expert on energy policy and markets. He says there is not much chance of Canadian bitumen making its way to India because closer sources of supply from the Middle East are more competitive.

But China has many independent (non-state owned) operations called “teapot refineries,” some of which are kitted out to process heavy crude and would be a natural customer for Canada.

“To suggest that if we had full market access with a pipeline to the West Coast that we couldn’t ship crude oil to China is hard for me to believe,” he said in an interview.

Anderson says he attended an industry conference in Singapore last year and attended a presentation by the CEO of a major Japanese refiner who said that if Canada could provide a stable, long-term supply of heavy crude oil, his company could become a customer.

“Here’s the head of a major Japanese oil refinery basically saying, ‘If we could guarantee long-term supply, then we’ll look at it.’ But the market does want some stability before it’s going to take it. So the challenge for refineries is once you’ve made the upgrade to process the heavier oil, you really want to continue getting a steady supply of heavy oil,” said Anderson.

Birn makes the point that many refineries blend heavy and light crude oils to create an input that works best with their plant configuration.

“They’re going to buy a spectrum of crude oil and they’re going to blend and optimize those crudes to fit as best as possible in their existing infrastructure and then they’ll make decisions on how they want to tailor that facility over time,” he said.

“No refinery in Asia is going to buy all their crude in Canada and that’s the only crude they’re going to process.”

Support for upstream crude oil production

This is a significant issue for both the Canadian and Alberta governments, says Birn.

The historic discount between Alberta heavy crude oil grades and West Texas Intermediate is between $10 and $15, but the Canadian pipeline system is running out of room, which caused the “differential” to recently balloon past $38 (currently sitting at $32.51 as of Thursday morning, according to GMP FirstEnergy).

Even as global oil prices take off, Alberta producers aren’t benefiting because of the large discount they are forced to take.

So the discounts we saw the first quarter, the government would obviously factor that into their calculus,” said Birn. “The biggest challenge facing the upstream sector in Western Canada is that pipelines have not been moving into actual physical construction.”

Lost tax and royalty revenue

Michael Burt is the executive director, Global, Industry, and Education Economics at The Conference Board of Canada. He supervised the economic impact studies of the Trans Mountain Expansion project for Kinder Morgan.

Total government revenue over the life of the pipeline is estimated to be $46.7 billion. Total federal revenue from taxes and other sources is estimated to be $24.6 billion.

He said there are two ways governments could see their tax and royalty revenue shrink if Trans Mountain Expansion is not built.

One, higher differentials means less sales revenue for producers, which translates into less direct tax and royalty revenue.

Two, lower profits and employment translate into fewer jobs and less income, leading to lower indirect tax revenue.

“There are impacts from the higher net-backs that are expected to be associated with the pipeline. If oil companies are earning higher profits, they pay higher income tax. Then you’ve got knock-on effects. We expect them to do different things with the higher profits, for instance pay more dividends and undertake new investments,” Burt said in an interview.

Investor confidence

While cynics may argue with some justification that investors are losing confidence in the Canadian regulatory regime precisely because Trudeau has mishandled the issue on many fronts, including the fight with BC over Trans Mountain Expansion, nevertheless allowing the project to fail would have proved catastrophic.

The Alberta-based oil and gas industry has argued this point repeatedly over the past year or more.

“…the dispute that has arisen between Alberta and BC cannot be allowed to fester. Especially not when the resulting impasse threatens both the livelihood of thousands of workers and Canada’s solid reputation as a good place to invest,” Finance Minister Bill Morneau said in his Tuesday speech announcing the purchase.

“To investors who are considering Canada as a place to build big, important, transformational projects like the Trans Mountain Expansion – know that you have a partner in Ottawa. One who not only respects the rule of law, but who understands the challenges you’re up against, and who will work with you to find solutions that work for everyone.”

Even the Canadian Association of Petroleum Producers was on board, albeit reluctantly.

“Ottawa’s investment in Trans Mountain demonstrates confidence in Canada’s energy sector,” CEO Tim McMillan said in a release Tuesday.

Not surprisingly, the midstream industry (in the form of the Canadian Energy Pipeline Association) was pleased that Trans Mountain Expansion will be constructed, but skeptical that alone would lure back gun shy investors.

“CEPA is deeply concerned that the government needed to purchase the project for it to be built and to assert federal jurisdiction. We do not believe that this outcome will instill investor confidence in Canada,” the organization’s CEO, Chris Bloomer, said in a statement.

But Fellows says the small premium paid by the Canadian government will actually be reassuring to investors.

“The premium they’re paying is also a thing because part of this is to try and placate investors and make Canada look like it’s still an attractive place to invest. So, you really don’t want to bargain them down too far otherwise that’s a negative signal to investors as well,” he said

“I think they actually get a really really fair deal and I think to the extent that they could come up with a good signal to potential investors for their projects they have.”

How certain is the business case for Trans Mountain Expansion?

The viability of the $7.4 billion pipeline project is, to a large extent, predicated upon Canadian bitumen and heavy crude oil being competitive once it’s loaded on an oil tanker at the Westridge Terminal in Burnaby.

“The pipeline toll costs are certainly not exorbitant and as oil sands producers lower their cost of production, why wouldn’t they be able to get a better net back than selling into an already over-supplied US marketplace?” asks Anderson.  “You don’t have to have a guaranteed sale. If you have the chance to compete by getting to tidewater, you can figure out how to organize logistics and your supply chain to lower costs.”

“Once it’s on tidewater, once it’s on a vessel, it’ll go to the market that is going to make the highest value return off that crude,” says Birn. “If it goes to Asia, it’s more likely that the buyer is going to cut up that cargo and sell it to three or four facilities.”

“I find it really hard to take seriously any argument that there isn’t a business case here when the shippers are willing to commit, the pipeline proponent is willing to build, the National Energy Board is willing to give them the approval to do so,” concludes Fellows.