On Monday, April 9, 2018, pipeline giant Kinder Morgan, Inc. (KMI) stated that it would cancel
Interest in constructing a pipeline from Alberta to Canada’s west coast began as early as 1947 when oil was first discovered in Leduc, Alberta. At the time, it was felt that the growing demand for oil in Asia and the Western United States could bring wealth to the region and create
In 2004, Kinder Morgan began work on a second pipeline to parallel the first. The goal of this project was to increase total capacity and thus assist the growing Albertan oil industry. This project was completed in 2008 and increased the system’s total throughput capacity from 260,000 barrels per day to 300,000 barrels per day.
In 2013, Kinder Morgan proposed the Trans Mountain Expansion project to the Canadian National Energy Board. This project would involve the construction of another pipeline, running roughly parallel to the existing system, that would be used to transport diluted bitumen from the Canadian oil sands to the west coast for export. This project would also greatly increase the capacity of the system, taking it up to 890,000 barrels per day from the existing 300,000. This massive capacity increase would thus clearly stimulate production growth in the oil sands due to all the extra transportation capacity.
One of the unfortunate realities of projects such as this is that there are always a large number of stakeholders, each of whom have varied interests. We saw this problem earlier this decade in the United States through disputes over the Keystone Pipeline and we unfortunately see it here with a dispute over this pipeline project.
In 2016, the government of British Columbia objected to the project, claiming that Kinder Morgan did not provide sufficient information about its spill prevention program. Later that same year, Canada’s federal cabinet approved the project as proposed, subject to “157 binding conditions that will address potential indigenous, socio-economic, and environmental impacts.” Kinder Morgan was able to meet these requirements and has begun work on the project.
Despite this, the province of British Columbia continues to fight against this project. To date, seven Federal Court challenges have been filed by the municipalities of Vancouver and Burnaby, and the Tsleil-Waututh, Squamish, Kwantlen, and Coldwater First Nations over various aspects of the pipeline. In addition, in January 2018, the government of British Columbia proposed restrictions on the amount of diluted bitumen that can enter the province from Alberta. About a week later, the Albertan government announced an import ban on British Columbian wine in retaliation.
This appears to be a struggle between governments on ideological grounds. Nominally, Canada has a federalist government just like the United States and so the fact that the project has the approval of that entity should trump the objections of any provincial government. Ultimately however, these issues will be resolved by the Canadian court system, but it is uncertain how long that will take. In the meantime, Kinder Morgan remains in limbo.
As already mentioned, Kinder Morgan stated earlier this week that if these legal issues are not resolved by the end of May, then it will be terminating the pipeline project. The reason that the company gave is that its investors/financial backers in Texas are running out of money and its investors across the board are losing patience as expenses continue to mount as the legal issues drag on.
This is a good sign from a shareholder perspective as it shows that Kinder Morgan is looking out for their best interests. This is due to the willingness that it shows on the part of management to abandon even a potentially profitable and valuable project if the risks begin to outweigh the potential gains as may be the case here. As an investor, I also dislike continuing to fund projects that fail to show results so it is somewhat nice to see in that regard.
With that said, this development will prove to have adverse consequences for Kinder Morgan’s forward growth. As already mentioned, this pipeline project would add approximately 590,000 barrels per day to Kinder Morgan’s capacity upon completion. This additional capacity is expected to add up to CAD$1.1 billion ($873 million) to the company’s adjusted EBITDA, which would obviously be a substantial boost over the company’s existing Canadian operations:
Source: Kinder Morgan
One of the advantages of the pipeline business is that the majority of the industry’s revenue is secured by long-term (5 to 25 year) contracts. In many cases, pipeline companies will secure contracts for new pipelines before embarking on the construction project. This is one way for the pipeline company to ensure that it is not wasting money by constructing a pipeline that nobody wants to use. This was the case with the Trans Mountain Pipeline Expansion. According to Kinder Morgan’s fourth-quarter 2017 earnings presentation, the project has already secured 13 shippers to export 708,000 barrels of bitumen per day on 15- and 20-year take-or-pay contracts from the termination point of the pipeline in British Columbia. This therefore represents 79.5% of the total system’s capacity upon completion. Thus, Kinder Morgan already has a sizable portion of that CAD$1.1 billion ($873 million) in new EBITDA effectively guaranteed.
The fact that these are take-or-pay contracts reinforces the fact that the completion of this pipeline is essentially guaranteed to boost Kinder Morgan’s EBITDA significantly. A take-or-pay contract is a contract that requires the customer (the shipper in this case) to either take delivery of the product or pay a penalty. Thus, Kinder Morgan is going to get paid for transporting the diluted bitumen regardless of whether or not the shipping companies actually take it. The exception to this might be if the oil companies in the oil sands do not actually provide the 708,000 barrels of bitumen per day but they have already committed to do that. Thus, the company’s future cash flows from this project up to the first 708,000 barrels are already guaranteed.
It is admittedly somewhat uncertain what would happen to these contracts should Kinder Morgan follow through on its threats to cancel the project. While it is possible that the contracts would simply be cancelled, it is also possible that Kinder Morgan, or its subsidiary Kinder Morgan Canada (TSX:KML), would be the targets of lawsuits, arbitration proceedings, or similar legal actions. It does seem rather unlikely that court proceedings would be involved as contract disputes in the energy industry are usually resolved out of court, but this is nearly impossible to predict. While it is a safe bet that Kinder Morgan’s management has already considered this in the decision to potentially cancel the project, it is a very real risk.
Impact on the Oil Sands Story
In the introduction to this article, I stated that the cancellation of this project could have a deleterious effect on the Canadian oil sands growth story. This is due to the fact that the Trans Mountain Pipeline is the only pipeline connecting the Albertan oil fields to the West Coast of Canada. The oil producers here need access to Canada’s west coast for two reasons. The first is that this gives them easy access to the rapidly growing oil markets of the Asia-Pacific region. According to the IEA, the Asia-Pacific region as a whole is expected to increase its oil and refined products demand by 2% annually over the next five years, more than double the expected 1.1% growth rate worldwide over the same period. This continues on a growth trajectory that has been going on for several years and has made China the top worldwide oil importer in 2017. The region as a whole is predicted to account for 60% of all global demand growth over the next half decade, ultimately reaching a consumption level of 38.1 million barrels per day in 2023. Given this, it is understandable why companies operating in the oil sands region would want and need easy access to the market.
A second reason why oil sands companies would need access to the Canadian west coast is to access world oil market pricing. One of the biggest problems that has plagued the Albertan oil industry since its inception is that its oil consistently sells at a discount to world benchmarks, primarily WTI and Brent. For example, as of the time of writing, West Canada Select sells for $37.72 per barrel while WTI trades at $62.33 per barrel. While the differential between the two has varied over time, WCS is usually $10-30 cheaper than WTI.
Source: Government of Alberta
There are a few reasons for this, including the limited number of refineries that can handle Albertan crude, but the reason that we are concerned with is the limited oil transportation infrastructure in Alberta. By far the most cost effective way to transport crude oil is by pipeline, but since Alberta does not have nearly enough pipelines to transport its crude oil production, its producers are forced to use much more expensive rail transport to get the oil to market. This increased cost is reflected in the discount compared to other blends of oil that do not have such high transportation costs. The expectation is that this new pipeline will reduce these transportation expenses and thus narrow the WCS discount to WTI.
The various producers in the oil sands are expected to grow their production going forward, thus making the increase in transportation capacity that the Trans Mountain Pipeline Expansion would provide to the region ever more vital. In 2017, the region produced just under 2.7 million barrels of oil per day. This is expected to increase to approximately 3.67 million barrels of oil per day in 2030.
In order to accommodate this growth, the Canadian Association of Petroleum Producers estimates that an additional 1.3 million barrels per day of pipeline capacity will be needed. The 590,000 barrels per day capacity of the Trans Mountain Pipeline Expansion would go a long way towards accomplishing this. Obviously, the industry would still need the full 1.3 million barrels per day of capacity to facilitate this growth should Kinder Morgan cease work on the pipeline expansion.
There is, however, a second problem. That is that the cancellation of this pipeline project could discourage other pipeline companies from building the infrastructure needed to facilitate the oil sands’ projected growth. The political infighting that will have led to its cancellation will undoubtedly cause many if not most companies to decide that constructing pipelines to transport diluted bitumen out of Alberta is not worth the risks of legal problems. Oil sands producers would then be forced to either suspend or curtail their growth plans, disappointing investors, or rely on an ever growing number of freight trains to transport their crude oil to market, with the added expense of that solution. Neither option is particularly good for the industry or for the companies in it.
The company that would be most affected by this is Suncor Energy (SU), which is the largest producer in the Canadian oil sands. Other major companies that are active in the region include France’s Total (TOT), and China’s Sinopec (SNP) through its partial ownership of Syncrude Canada Ltd. Several other companies like Statoil (STO), BP (BP), and Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B) have since sold off their projects in the region for various reasons. I include these last three on the possibility that they may return someday due to their already demonstrated interest in the region (although Royal Dutch Shell seems highly unlikely to do so due to its recent push to become a more environmentally-friendly company). Of all these companies, Suncor is perhaps the most exposed to the oil sands as nearly all of its future growth depends on its projects in the oil sands.
Kinder Morgan has clearly stated its intent to cancel the Trans Mountain Pipeline Expansion Project if the political problems surrounding it are not resolved by the end of May. There is no reason to doubt that the company will follow through on this threat. Kinder Morgan itself would be the first casualty as it would sacrifice the estimated CAD$1.1 billion ($873 million) annual adjusted EBITDA that the completed pipeline is expected to generate as well as the approximately CAD$1 billion ($794 million) that it has already spent on the project. Additionally, we could see the oil sands growth story curtailed due to a lack of transportation infrastructure, which would have a negative effect on the growth plans of the region’s operators, especially Suncor Energy.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.