July 2016 The Costs of Pipeline Obstructionism Gerry Angevine and Kenneth P. Green www.fraserinstitute.org iii COSTS OF PIPELINE OBSTRUCTIONISM Contents Executive Summary / 1 Introduction / 3 Continued Discounting of Western Canadian Crude Oil in US Market Underscores Need for Market Alternatives / 4 Economic Consequences of Bottlenecks for Producers and Governments / 10 Canadian Crude Oil Production Outlook: Implications for Pipeline Infrastructures / 16 Alberta’s Climate Change Plan: Implications for Oil Sands Investment, Production, and Additions to Takeaway Capacity / 18 Obstacles Faced by Major Pipeline Projects / 22 Changes to the Pipeline Project Review Process / 28 Recommendations for Expediting Pipeline Projects of Strategic and National Interest / 30 Conclusion / 32 Appendix / 35 References / 37 About the Authors / 42 Acknowledgements / 43 About the Fraser Institute / 43 Publication Information / 44 Supporting the Fraser Institute / 45 Purpose, Funding, and Independence / 45 Editorial Advisory Board / 46 www.fraserinstitute.org www.fraserinstitute.org 1 COSTS OF PIPELINE OBSTRUCTIONISM Executive Summary This paper reviews how Western Canadian oil producers are being con- strained by the inability to access new markets via ocean ports and how this constraint, along with the drop in oil prices, the Alberta ceiling on greenhouse gas (GHG) emissions in oil sands operations, and regulatory obstacles are affecting pipeline infrastructure requirements and decisions. Western Canadian conventional and non-conventional (i.e., oil sands) heavy crude oils continue to suffer from price discounts relative to world region crude oil prices such as North Sea Brent (adjusted for quality differentials and transportation cost), and are at risk of being displaced by increasing US oil production. Access to port facilities on the west and/or east coast would allow Canadian producers to access world crude oil prices. If Canada were able to export 1 million barrels of oil per day to markets accessible from ocean ports—with the lion’s share of heavy oil and bitumen exports continuing to flow to US oil markets—substantial incremental rev- enues could result. At a US$40/bbl price this could be as high as $2 billion per year (in Canadian dollars) compared with selling into the flooded US market. At an average price of US$60/bbl, it could reach CA$4.2 billion; and at US $80/bbl, CA$6.4 billion. If higher netbacks from markets accessed from tidewater connections were realized by all Western Canada heavy oil production, at the US$40, US$60, and US$80/bbl price levels the annual benefits could reach CA$8.9 billion, CA$18.5 billion, and $CA28.2 billion, respectively. Both the oil price and the volume of production drive the Alberta and Saskatchewan crude oil royalty formulas. The importance of the price factor is underscored by the impacts of much lower prices on royalty revenues. In the Alberta October 2015 budget, royalty revenues were projected to plunge to $1.5 billion in 2015–16 from $5.0 billion. Royalties from conventional oil production were estimated at $0.5 billion compared with $2.2 billion in 2014–15 (Alberta, 2015a). Saskatchewan’s February 2016 Budget Update projected oil royalty revenue of $347.9 million in fiscal 2015–16—38.5 per- cent less than previously (Saskatchewan Ministry of Finance, 2016a). Understanding the sensitivity of royalty revenues to price changes allows governments to predict how revenues will be affected by improved prices as, for example, access to new markets is achieved. Oil royalty revenues in Alberta and Saskatchewan would increase by about CA$1.2 billion a year if the WTI oil price were to increase by US$7/bbl. A US$5/bbl increase in the price of WTI crude oil would increase Saskatchewan’s annual royalty revenue on heavy oil production by approximately $29.5 million, and total www.fraserinstitute.org 2 COSTS OF PIPELINE OBSTRUCTIONISM oil production royalties by about $94.5 million (assuming an exchange rate of 71.5 cents per Canadian dollar). The capacity to transport crude oil to coastal refineries is insufficient to solve the pricing dilemma that western Canadian oil producers face due to heavy dependence on the US mid-continent region. Oil pipeline projects with a combined capacity of about 4 MMbpd (million barrels per day) have been proposed or conditionally approved. But investors may be less inclined to move ahead with oil sands and related infrastructure projects than before the downturn in prices. With no reduction in GHG emission rates, the 100 Mt limit on GHG emis- sions from oil sands operations will be reached in 2025, at which point total oil sands production is projected to increase by 1.5 MMbpd. If, as the NEB has suggested, Western Canadian conventional oil production will then have peaked, the required increase in pipeline takeaway capacity will be about 1.9 MMbpd (assuming a system capacity utilization rate of 80 percent). Clearly, without significant reductions in oil sands GHG emissions rates, much of the proposed increase in pipeline capacity from Western Canada (Appendix A) will not be needed. The Energy East Pipeline, the Trans Mountain Pipeline Expansion, and the Northern Gateway Pipeline project would enable about 2MMbpd of Western Canadian crude to access coastal US and overseas markets. But all three proj- ects face serious challenges, mostly environmental, from First Nations, and from various communities. Further, the federal government has imposed new consultation obligations and upstream GHG emission assessment requirements on the Energy East and Trans Mountain projects that will prolong the review process. Every effort should be made to expedite pipeline project review and assess- ment processes before windows of opportunity for access to new markets are largely pre-empted by competitors. If the legislated regulatory review process with regard to a particular project is unduly delayed, the federal government may need to help resolve impasses or, in the case of projects that are truly in the national interest, introduce special legislation to allow a project to proceed. www.fraserinstitute.org 3 COSTS OF PIPELINE OBSTRUCTIONISM Introduction In 2013, we reviewed the challenges that Western Canada’s crude oil pro- ducers face by not having pipeline transportation access to potential mar- kets in Eastern Canada, parts of the United States, and overseas (Angevine, 2013). That review indicated that producers were suffering from substantial discounts vis-à-vis prices in the US because of increasing supplies in the mid-continent region, where limited pipeline capacity was constraining crude oil shipments to refiners in the US Gulf Coast. Further, the inability to access markets in Eastern Canada and overseas and to expand exports to refineries in some US market regions, especially the Gulf Coast, threatened to seriously constrain the growth of crude oil exports. Also constrained was much of the anticipated growth in production from Western Canada’s oilfields, especially the oil sands. Events since that paper was written compel an updated review of Canada’s crude oil transportation bottleneck dilemma. This study examines whether and to what extent producers and governments continue to suffer from widespread price discounting on account of the bottlenecks noted in the earlier paper. We review changes in the outlook for investment in oil sands bitumen recovery operations, where Western Canada’s potential for oil pro- duction growth lies, and the implications that this may have for infrastruc- ture requirements. In addition, we examine the extent to which the Alberta Government’s recent decision to limit GHG emissions from oil sands bitu- men production to 100 megatons per year could limit production growth and affect infrastructure requirements. Finally, we review progress that has been made towards putting proposed new pipeline transportation infra- structure in place, and the various obstacles that are being encountered. We conclude by putting forward several suggestions for governments to consider when they review important pipeline project proposals. www.fraserinstitute.org 4 COSTS OF PIPELINE OBSTRUCTIONISM Continued Discounting of Western Canadian Crude Oil in US Market Underscores Need for Market Alternatives Failure to build pipeline capacity to transport crude oil from western Canada to port facilities on the east and west coasts (which would facilitate export to overseas refineries) means that Canada’s exports continue to be limited for the most part to US inland refineries. Substantial increases in US oil production in recent years (figure 1) as the result of technological improve- ments in horizontal drilling and multi-stage fracturing techniques, as well as increased crude oil supplies from Western Canada, have put downward pressure on crude oil prices in the mid-continent region. With completion of its “MarketLink” crude oil pipeline facility (the south- ernmost leg of the proposed Keystone XL Pipeline) in 2014, TransCanada Corporation now has the capacity to move crude oil from Cushing, Oklahoma to the Houston, Texas vicinity. However, the rejection of the company’s Keystone XL Pipeline proposal by President Obama in November 2015 means that the ability to ship 825,000 barrels of crude oil per day from Western Canada and North Dakota to the US Gulf of Mexico via Keystone XL and Cushing has been thwarted, at least for the time being (President Obama, 2015).1 Figure 1: US field production of crude oil 4.0 3.5 els 3.0 arr b of ns o Billi 2.5 2.0 1.5 1965 1970 1975 1980 1985 1990 1995 2002 2005 2010 2015 Source: US Energy Information Administration, 2016a. 1. There is no indication that the recent downturn in prices has altered price expectations sufficiently to weaken would-be shippers’ support for the proposed Keystone XL Pipeline. www.fraserinstitute.org 5 COSTS OF PIPELINE OBSTRUCTIONISM For its part, Enbridge has been expanding its US Mainline pipeline capacity from North Dakota to Cushing via the upgrading and addition of pumping stations in Wisconsin and Illinois. Combined with the company’s Seaway Pipeline expansion, this will provide an alternative path to the Gulf for Western Canadian crude oil.2 Heavy crude oil and bitumen (non-upgraded) account for almost half of estimated 2015 Western Canadian crude oil production, while conventional heavy crude and upgraded and non-upgraded bitumen (including bitumen blends) represent approximately 81 percent of total Canadian US-bound oil exports (NEB, 2016a). Canadian light and heavy crude oil producers are both subject to substantial penalties in US markets, but the heavy crude oil and bitumen blend labelled as “Western Canada Select” (WCS) that is mixed and priced at Hardisty, Alberta suffers more than light, sweet crudes. This is because the price of WCS is affected not only by relatively long distances to refinery destinations and the higher transportation costs that the shippers must absorb for that reason, but also by quality differences. WCS is heavier than West Texas Intermediate (WTI) crude (an API of 20.5 degrees versus 34.3 degrees) and contains 3.5 percent sulphur by weight versus WTI’s 0.9 percent (BNN News, 2013). Being heavier, WCS is more costly to transport by pipeline (as it takes longer to move it a given distance). Further, the heavier the crude oil (i.e., the lower the API gravity rating), the lower its value to a refiner as it will either require more processing or yield a higher percentage of lower-valued by-products such as heavy fuel oil. Complex crudes containing more sulphur also generally cost more to refine than low-sulphur crudes. For these reasons, oil refiners are willing to pay more for light, low-sulphur crude oil. If it were not for the quality differences and the effect that this has on refinery demand for competing crudes, the difference between the price of WCS at Hardisty AB and WTI crude oil at Cushing OK would boil down to the transportation cost. According to the National Energy Board, “the tolls to ship oil from Edmonton/Hardisty to Cushing are about US$5 to $6.55 per barrel, depending on the type of oil and which pipeline systems are used.” It costs approximately another US$3 per barrel to reach the Gulf Cost from Cushing (NEB, 2014). The insufficient pipeline capacity available to transport Canadian crudes to US destinations has resulted in increased shipment by railway in recent years.3 Of course, the producers that have resorted to shipping by rail have 2. As indicated later in this report, Enbridge is also taking steps to increase the takeaway capacity of the Canadian Mainline (table 2). 3. At 96,065 barrels per day in January 2016, Canadian crude oil exports by rail were ten times greater than in January 2012 (NEB, 2016b). www.fraserinstitute.org 6 COSTS OF PIPELINE OBSTRUCTIONISM had to absorb the higher transportation cost.4 The more that producers have to depend on rail because of insufficient pipeline capacity, the greater will be the average WCS transportation cost and the spread between the WCS and WTI prices. Deducting the transportation cost from Hardisty to Cushing from the price of WTI crude at a given point in time provides an indication of the approximate value of WCS to US refiners in the Cushing area. Figure 2 illustrates that the widely referenced West Texas Intermediate light, sweet crude oil price marker established at Cushing, Oklahoma has mostly continued to trade at a discount relative to the marker established for similar (though slightly heavier) Brent North Sea crude since 2012.5 Consequently, WCS has generally continued to be substantially below the prices of both WTI and Brent. As indicated, WCS has also been trading below the average price of crude oil in Japan. Figure 2: WCS vs. crude oil reference prices 140 Brent 120 100 Japanese price WTI 80 bl b S$/ WCS U 60 40 20 0 Jan-11Apr-11Jul-11Oct-11Jan-12Apr-12Jul-12Oct-12Jan-13Apr-13Jul-13Oct-13Jan-14Apr-14Jul-14Oct-14Jan-15Apr-15Jul-15Oct-15 Sources: Alberta, 2016d; US Energy Information Administration, 2016b; Petroleum Association of Japan, 2015. 4. According to one source, the cost of transporting crude oil from Hardisty, Alberta to the Gulf Coast by rail is as much as US$10/bbl greater than shipping by pipeline (Hussain, 2015). In 2014, the National Energy Board indicated that “rail costs are roughly double or triple the pipeline tolls” (NEB, 2014). 5. The differential between the WTI price and other world region oil prices at any point in time reflects the crude oil supply and demand situation in each region, crude oil quality differences, and transpor- tation costs. When comparing particular prices, one must recognize that the differences between them are affected by these factors. In recent years, the ban on US crude oil exports along with the increase in US oil production has served to suppress the WTI price relative to Brent. With the US export ban lifted, the difference between the WTI marker price and other world region markers can be expected to narrow barring other developments. www.fraserinstitute.org