Thomas White Global Investing
Canada
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May 25, 2012
A Postcard from the Americas
Canada: Untangling pipeline projects to realize energy export potential

Canada Energy

Production facility for oil from oil sands in Alberta, Canada. Oil production in Canada is set to increase to 6 million barrels a day by the end of this decade, but the country lacks pipeline infrastructure to facilitate exports.

For a country richly endowed in natural resources, and with growing energy production, Canada has been facing a perplexing problem in recent years. While its producers are supplying oil and gas to U.S. refineries at prices below the international market, Canadian refineries on the east coast are paying higher international prices for the oil they import. It may seem odd that a major energy producer like Canada imports oil at all. But for Canada, it’s unavoidable. Truth be told, the Maple Leaf lacks the necessary infrastructure to transport oil from its domestic fields in the central part of the country to markets on the east coast.

With more than 175 billion barrels of proven deposits, in oil and oil equivalents, Canada has the third largest energy reserves in the world. Most of the reserves are in the Alberta province, which has traditionally shipped most of its oil exports to the Midwest U.S. Oil output in Alberta has steadily increased in recent years, the result of large investments to extract crude from oil sands. At the same time, oil and gas output in American Midwestern states such as North Dakota has also gone up substantially as improvements in fracking technology have allowed for increased energy production from shale deposits. This has led to a supply glut to refineries in the area, with average prices realized by oil producers dropping. For instance, when the West Texas Intermediate (WTI) crude oil benchmark was trading well above $100 a barrel, Canadian oil fetched an average of $75 a barrel in the U.S. By some estimates, Canadian oil producers who export 1.55 million barrels of oil and equivalents a day to the U.S. Midwestern states lose nearly $15 billion annually because of this price differential.

Until recently, Canadian oil producers were banking on the expansion of a major pipeline project that would eventually stretch from Alberta all the way to the Gulf Coast of Texas, where prices are set by the WTI benchmark. The first phase of this project, completed in 2010, currently brings Canadian oil to the U.S. Midwest. The second leg of the pipeline connects to Cushing, Oklahoma, where the world’s largest oil storage facility is located. The final stretch of the pipeline, which is expected to be completed by the end of next year, will drain the excess supplies from Cushing to the Gulf Coast. To accommodate the increasing oil output in Canada, a second pipeline from Alberta to Nebraska, which will join the existing pipeline, has also been planned. When completed, this project will potentially reduce the oversupply in the Midwest, and lift average prices for Canadian producers.

However, the pipeline expansion project from Alberta to Nebraska is now on hold after the U.S. government delayed permission on environmental concerns. The project will be reviewed again next year, only after a comprehensive environmental impact study is completed and alternate routes are evaluated. Nevertheless, the Cushing to Texas stretch of the pipeline was approved by the U.S. government earlier this year and is expected to be completed by the second half of 2013. In addition, an existing pipeline that now brings oil from the Gulf Coast to Cushing is being reconfigured and expanded to carry oil in the opposite direction.

Stung by the delays in the Alberta-Texas pipeline expansion, the Canadian government has been trying to speed up approvals for the $5.5 billion Northern Gateway Pipelines project connecting Alberta to British Colombia on the Pacific coast. The new transport project will seek to open new international markets for Canadian oil and thereby reduce the dependency on the U.S. market. What’s more, from the port of Kitimat in British Colombia, where the pipeline will end, the oil can then be easily transported to markets in Asia where demand remains high. Still, this project too has also been delayed on concerns over its impact on the environment and on the Native Indian population along the pipeline’s proposed route.

Another project to significantly expand the capacity of the existing Trans Mountain Pipeline System, which connects Alberta to refineries in the Vancouver area, has so far not faced much opposition. And the proposal to build a pipeline from Alberta to Montreal in the east, called the East Coast Pipeline Project, is at a very early stage and may take several years for the necessary approvals.

Nevertheless, lower energy export price realizations have become a drag on the country’s economic growth, as acknowledged by the Bank of Canada in its recent Monetary Policy Report. The central bank said ‘the price of oil that Canada exports has declined’ and the ‘deterioration in the oil-related terms of trade reduces Canada’s real gross domestic income’. Earlier studies by the central bank estimated that for every 10% increase in crude oil prices, real GDP growth gains by up to 0.3%.

The significance of the energy sector to the Canadian economy should only increase in the future as oil output expands, making it all the more important that these pipeline projects are completed without further delay. It is estimated that oil production in Canada will increase from the current 3.6 million barrels a day to more than 6 million barrels by the end of this decade. The Canadian Energy Research Institute expects that this increase in oil output will generate 700,000 jobs and add $3.3 trillion to economic output over a period of 25 years. The only apparent bottleneck that may prevent Canada from achieving this potential growth is the insufficient pipeline capacity. Promoting major infrastructure projects without ignoring environmental concerns demands a fine balance that most governments and policy makers find extremely difficult to manage. But it appears that Canada must find a way to untangle its energy pipeline projects and expand its export markets for energy. The alternative is living with the economically painful paradox of exporting cheap oil and importing the same commodity at higher prices.

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