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Canada's dearth to deluge

Not long ago the oil sands looked hemmed in by a lack of pipeline capacity. Now they may have too much

It is a prospect that seemed unthinkable for oil sands producers just a few months ago: Canada, which faced a dire shortage of space on its ageing transportation network, might now be over-piped. Two major pipeline expansions have been approved, a third is moving through the regulatory process; throw in a revived Keystone XL (KXL), and suddenly producers may get 2m b/d of new capacity flowing east, west and south.

It started in late November when prime minister Justin Trudeau gave the green light for KinderMorgan's controversial C$6.8bn ($5.2bn) TransMountain expansion (TMX) line, while turfing Enbridge's Northern Gateway proposal at the same time.

TMX will triple to 0.9m b/d the capacity on an existing line linking Alberta's oil sands to Vancouver on the west, providing a much-needed outlet to Asia. Despite protests and fierce opposition, the British Columbia government surrendered necessary environmental certificates shortly after the approval, all but ensuring it will be built. Though it still faces court challenges, construction is likely to start this autumn with the first oil flowing through the pipeline by 2018.

Less controversial was Trudeau's approval of Enbridge's C$7bn Line 3 expansion south into the US. This will replace a link into the company's US Lakehead system that ruptured in 2010, fouling the Kalamazoo River in Michigan. As part of a settlement with the US Environmental Protection Agency (EPA), the company has reduced the pipeline's operating pressure—which effectively cut capacity in half to around 380,000 b/d. Facing a choice from the EPA either to replace the pipeline or pull it out of the ground, it has chosen to replace and expand Line 3. The new investment will restore capacity to its original 0.76m b/d and allow for further expansion to 0.915m b/d.

US president Donald Trump's 24 January executive order aimed at restarting the stalled KXL project could end up adding another 0.83m b/d of capacity. Little surprise, project backer TransCanada refiled its application almost immediately after the ink was dry on Trump's decree, and the Canadian firm is already thinking of expanding KXL to more than 1.1m b/d. The decision now goes to Trump's new Secretary of State Rex Tillerson, who has until late March to act. There is little doubt which side the former oilman will come down on.

Add in more than 100,000 b/d of oil shipped by rail—a number only growing with new investment from producers Imperial Oil, Cenovus and others—and Canadian producers are facing a whole different, but not unwelcome, dilemma: where to send production that is expected to top 6.1m b/d by 2040, according to International Energy Agency forecasts.

Canada sends more than 98% of its oil exports to the US, which has resulted in steep discounts for its expensive barrels. In glutted times—when producers are competing to send oil down the pipeline—the discount can be 50% of global benchmarks.

The rationale for new pipes is obvious from an economic point of view. Presently two-thirds of Canadian barrels go to a handful of refineries in the US Midwest, effectively overloading the market and worsening price differentials. Producers are losing $15 on every barrel at today's prices. When WTI was trading for $100 a barrel, the discount was as high as $45/b.

Barely 10% of Canada's oil lands in the Gulf Coast, the largest refining market in the world and where Canada's heavy grade is preferred over Venezuelan Orinoco and Mexican Mayan crudes. Both Venezuela's and Mexico's state-owned oil companies have refineries on the Gulf Coast, giving them a foothold in the market. By contrast, Canada serves only a dozen refineries scattered across the US. Most of them are outdated and unsuitable for heavy crude.

Cash boost

By some analyst's estimates, Canadian producers would immediately see an extra $5/b premium on the selling price of its crude, a huge source of extra revenue if more crude can find its way to the Gulf Coast.

Yet for all the joy in Calgary, Trump's KXL decision throws the fate of a fourth project oil sands-export project—TransCanada's Energy East pipeline to Saint John, New Brunswick, on the east coast—in doubt and effectively undermines Canada's market-diversification strategy.

Despite being a net oil exporter, Canada imports 0.75m b/d into the Maritime provinces and Quebec, at a cost of more than $1bn a month. A pipeline to the east coast could theoretically ease the import burden, although this would depend on the price of competing grades shipped across the Atlantic. The pipeline could also allow for shipments to Europe and Asia through the Atlantic. For some, this has made the pipeline a higher national priority.

After a rocky start that saw a regulatory panel resign en masse over allegations of conflicts of interest, public hearings into Energy East resumed in January. The delays have pushed the project back until at least 2020.

It probably doesn't matter. It is unlikely that TransCanada will build both pipelines. The company has always had a clear preference for KXL, the more lucrative project, and only turned its attention to Energy East as a backup when it looked like KXL was dead and buried.

For Canada's oil sector, the way to mitigate its Trump risk might be to stick with the drive to find markets

Any pipeline operator knows that the most cost efficient route to market is the shortest distance between two points. Former TransCanada chief executive Hal Kvisle once took out a ruler and drew a straight line on a map from Hardisty, Alberta, the starting point for KXL, to Oklahoma.

Energy East is at a clear disadvantage because the route is longer, traversing two-thirds of the country, and it would compete in a flooded Atlantic basin against imports from West Africa and the Middle East. So, while the politics might favour Energy East, the economics point to the Gulf Coast.

That doesn't mean the path ahead for KXL is easy. After Barack Obama's rejection, Trump's executive order to revive the project has sparked equal parts optimism and consternation complicated by geography, economics and, ultimately, politics on both sides of the border.

KXL became a huge thorn in what is one of the largest bilateral energy-trading relationships in the world. After eight years of intense lobbying, Trump's reversal has been praised by Canadian producers and politicians including the prime minister.

It may yet prove to be a Pyrrhic victory. Trump has also threatened to tear up Nafta and implied some willingness to impose tariffs on imported Canadian barrels—though a summit in Washington between Trudeau and the president in mid-February yielded some conciliatory signals from the White House. Still, it's unclear if KXL is an economic proposition in Trump's realigned market, especially given another idea floated by the new US government, that any construction be done with American steel. Executives in Calgary say this could render the project uneconomic—assuming US steel-makers could even meet the demand. Players north of the border are also troubled by the volatility of the new president's persona. Trump's vow to reduce American reliance on Middle Eastern oil might also open the door for Canadian suppliers—but it also comes alongside the White House's cosiness with Saudi Arabia, which has its own plans to expand in the US. So Canadian producers will be wary of misreading the geopolitics.

For Canada's oil sector, the way to mitigate its Trump risk might be to stick with the drive to find markets. But some of the risk is domestic. Another wildcard for the broader pipeline expansion plans is environmental policy. At the start of the year, the Alberta provincial government introduced a hard cap on oil sands emissions, limiting them to 100 megatonnes a year by 2030. This would allow for continued expansion of about 1m b/d—which is likely to be hit around 2024—without a step change in emissions-reduction technology that would decouple oil sands growth from carbon growth.

That extra 1m b/d is only half of the proposed pipeline-capacity expansions. Suncor Energy, Canada's largest oil sands producer at more than 0.5m b/d, has proposed shutting in higher-cost production to meet those caps, calling into question whether the oil sands will ever need all the new pipeline capacity.

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