By Dan Cronin and John Auers
“Crazy Train” is an all-time heavy metal classic rock song from British rock legend Ozzy Osbourne that can be found on his solo debut album “Blizzard of Ozz” released in 1980. The song is about the Cold War and the fear associated with a global nuclear conflict. While the current issues with limited takeaway capacity for crude being produced in Western Canada is certainly not as scary as the threat of a nuclear war, there certainly are many industry players in Western Canada who feel the politics associated with the issue echo the sentiment from “Crazy Train.” The seemingly never-ending protests and judicial challenges from anti-oil opponents, together with growing production and demand for that production has led to the logistical constraints and a standoff between opponents and proponents of bitumen development. Unprecedented intervention into the marketplace by the Alberta Government though mandated production cuts injects further uncertainty into the situation. Over the past few weeks we have written about one possible avenue to deal with the constraints while pipeline expansions remain delayed – the conversion of bitumen into PUB. In today’s blog, we look at a more immediate answer (and one in which the Alberta Government has also become directly involved in) – moving the bitumen out by rail. So, in the words of the “Prince of Darkness” – “All aboard! Hahahahahahahaaaa!”
Crude-by-Rail in Western Canada – Who and what’s to blame
It is irrefutable that the safest and most efficient way to transport crude oil out of Western Canada to market is via pipeline. Pipelines also represent the most environmentally friendly transportation method for Western Canadian crude from a Greenhouse Gas (GHG) emissions standpoint. Traditionally, as production continued to grow in Western Canada, pipeline capacity was able to keep pace with the incremental barrels; however, this all came to a screeching halt once the Keystone XL pipeline was successfully delayed by opponents. This watershed event then became the playbook for those looking to stop other pipelines that would service the oil patch in Western Canada.
Crude-by-rail (CBR) has traditionally been associated with a short time window – those investing in CBR typically looked for a payout of that investment relatively quickly as the general consensus was that the rail facility would become uneconomic once the necessary pipeline capacity was inevitably constructed. However, with pipelines continuing to battle through regulatory red tape and judicial challenges, producers have started relying more and more upon CBR to transport their incremental production out of Western Canada. The continuous delays in pipeline projects have created an environment where rail is considered by some producers as a longer-term investment and serves as “insurance” against the incessant pipeline capacity issues that have plagued Western Canada.
Significant rail capacity has already been built in Western Canada – we estimate at least 1.3 million bbls/day of rail-loading capacity is currently in place in the region. While this is well above the actual movements (the National Energy Board estimated ~326 KBPD of Canadian CBR exports took place in January 2019, a drop from the highwater mark of ~354 KBPD recorded in December 2018), other factors, such as the availability of rail cars and locomotives, have been a factor in limiting rail movements at times. Just as with their moves to curtail crude production and provide support for PUB development, the Alberta government has also become involved in the rail market by investing in the procurement of rail cars. As a result, the results of the upcoming elections (where the opposing parties have expressed significant differences on this issue) will be quite important in what comes next in the Western Canadian CBR environment.
The Alberta Government’s CBR Initiative – “I’m living with something that just isn’t fair.”
As we stated in a recent blog that discussed the Alberta election, the New Democrat Party (NDP) led by Rachel Notley has been very active in supporting a CBR initiative, as shown by the following particulars:
- $C3.7 billion investment
- Leasing ~4,400 new rail cars
- 3-year term
- Shipments to start in July 2019 (120 KBPD capacity to be reached by 2020)
- Expected to generate $C5.9 billion in revenue
- Crude will be purchased and loaded onto rail cars at one of the 21 on-loading facilities in Alberta
Notley and the NDP feel that intervening in the market through the CBR program is the best path forward for Alberta. Jason Kenney, the leader of the United Conservative Party (UCP) is adamantly against the CBR deal signed by Notley and vows to cancel that deal if elected (latest polling data suggests that he will win the election, and it won’t even be close). While Kenney continues to indicate that he will cancel the rail deal if elected and we don’t doubt his intentions, the question is whether or not he will actually go ahead and follow through on this campaign promise.
The finer details of the existing Provincial CBR deal remain vague so it will be interesting to see if Kenney (if successfully elected), will go ahead and cancel this contract sight unseen. For a moment, put yourself in the position of the counterparty to the NDP when this deal was formulated and executed. As the counterparty, you know the polling situation that the NDP faces and you also know that if the UCP were to come to power (a likely outcome), that their intention is to cancel the CBR deal. With this in mind, one would expect to find very tough cancellation clauses in the contract and that the only economically rational decision might be to maintain such an agreement. While we are obviously speculating here, a scenario could occur where the UCP forms the next Government of Alberta and when reviewing details of the CBR deal, the UCP realizes that the most economically rational path forward is to actually adhere to the deal and not cancel it; however, rational decisions and political decisions are not always one and the same – it will be very interesting to see how this one key issue plays out.
Key Industry Players: Cenovus, Imperial Oil, Suncor – “You gotta listen to my words”
Cenovus, Imperial Oil, and Suncor are not only some of largest producers of Western Canadian crude, but also are among the most actively involved in the CBR game. Despite these similarities, there are also some significant differences in their positions and strategies regarding the production cuts and the CBR initiative. Imperial Oil and Suncor have come out against government intervention and have cut back CBR shipments while Cenovus was one of the companies to lobby the Alberta Government for production cuts and has stepped up its investment into CBR.
Cenovus continues to believe strongly in CBR and has put its money where its mouth is by increasing its investment in this take-away option. This increased investment in CBR comes in the face of upcoming competition against the Alberta Provincial Government’s CBR program and the Alberta Government’s mandated production cuts (both initiatives are bearish for CBR). Despite the uncertainty caused by the Provincial Government, Cenovus has promised to raise CBR shipments five-fold from 20 KBPD to 100 KBPD in 2019. Right now, the light/heavy differential is too narrow to make CBR economical; however, the feeling at Cenovus is that the current light/heavy differential is unsustainable (heavy crude refineries situated in the Midcontinent and USGC sure hope so), and they view their rail initiative as an investment that will pay off long-term.
As Cenovus steps up, others like Imperial Oil have stepped away from the rail market. In a recent webcast, the Imperial CEO indicated that in November, Imperial was shipping ~153 KBPD via rail; in December this value increased to 168 KBPD; in January this value dropped to ~90 KBPD; and in February this value was essentially zero. Imperial pointed to the production cuts and the resulting narrowing of the light/heavy differential for its move away from CBR. The uncertainty in the Western Canadian oil industry (government-imposed production cuts, the government CBR program, Line 3 delay) has also caused Imperial to slow the development of its $C2.6 billion Aspen Project. The Aspen Project has a nameplate capacity of 75 KBPD of bitumen and was initially scheduled to come online in 2022; however, Imperial has ordered work to be slowed and expects the project to be delayed by at least a year.
Suncor has a very similar mindset to that of Imperial Oil when it comes to government intervention and is against the imposed production cuts. Suncor has partially blamed the production cuts on its recently reported fourth quarter loss and points to the “unintended consequences” associated with the government initiative that has made CBR economics unfavorable. The company has come out and asked for an end to the mandated production cuts but with both the NDP and UCP in favor of such a program and with a delay in Line 3 completion until at least next year, the prospects for such a decision by the new government are certainly in doubt.
The Future of CBR – “I know that things are going wrong for me”
The uncertainty surrounding CBR has never been higher. Investing in a rail facility is always risky as it has traditionally been a temporary measure until incremental pipeline capacity is constructed. In today’s world, permission to build incremental pipeline capacity in Western Canada is far from certain. We have had an opportunity to speak with many clients and heard a wide rage of views on a wide range of topics facing Western Canada, but midstream solutions to midstream constraints is the most contentious. Some feel it is only a matter of time before enough incremental pipeline capacity comes online to clear the market and these players are obviously not inclined to invest in CBR. But we have also spoken to clients that feel incremental pipeline capacity will never get constructed and that CBR is the only answer to transport incremental barrels out of Western Canada.
A decision to invest in a rail facility is difficult under normal circumstances. Now layer in the wildcards associated with predicting the in-service date of pipelines that have a history of being delayed, the Alberta Government playing the role of OPEC in terms of mandated production cuts and even entering into the CBR market as direct competition and one has an exponentially harder decision when it comes to investing in CBR. Should I invest in CBR? Should I increase, maintain, or shrink my existing CBR footprint? Should I take a wait-and-see approach? Should I depend on the Alberta Government to provide the CBR service to move my incremental barrels? All these are key factors that a CBR investor must assess when reaching a decision on a path forward.
Producers that have a CBR position have seen both good times (last fall when the Canadian light/heavy differential was north of $50/bbl) and bad times (the current narrow Canadian light/heavy differential). A wait-and-see approach might be best at least until after the dust from the Alberta election has settled and some clarity on production cuts and the Provincial CBR initiative is provided. Many producers take on a “portfolio approach” when marketing crude oil – in some months pipeline transport might provide a better netback than rail and in other months this relationship could be reversed. By staying in both rail and pipe a producer may not be able to maximize their netback on a monthly basis; however, over the longer time period due to a portfolio approach, they expect to be ahead in the game. We might currently be in a situation where a producer must simply “take their lumps” as it pertains to CBR and wait for more direction post-election and act accordingly – “Crazy, but that’s how it goes.”
Due to the time and space limitations of a weekly blog, we have included only a high-level discussion of Western Canadian CBR here. If you are interested in more information on our views regarding the economics and future prospects of CBR and how it could/will specifically impact your company’s plans or strategies, please feel free to call or email us at 214-754-0898 or email@example.com