Who is the most unpopular American citizen in Canada? It depends on whom you ask. The average Canadian citizen would almost certainly say Gary Bettman, commissioner of the National Hockey League. He has been criticized for “Americanizing” hockey by expanding into non-traditional markets in the South and Southwest at the expense of more traditional markets in Canada and the Northern U.S., as well as his role in three labor stoppages. At this writing, the 2012-2013 season is in danger of being canceled (à la the 2004-2005 season) – it may be a long cold winter for hockey fans.
If you asked the same question to political leaders or management teams within the Canadian energy sector, however, they might respond, somewhat surprisingly, President Barack Obama (with Bettman likely not far behind). The reason: Obama’s unexpected delay of a presidential permit for the Keystone XL pipeline in November 2011.
It has been more than a year since President Obama’s controversial decision to delay approval for the permit for the construction of TransCanada’s Keystone Pipeline. At the time, President Obama suggested the delay was necessary to ensure all environmental issues would be properly addressed and understood, though we and others believe the “no-decision” was motivated primarily by the administration trying to maintain the favor of sections of the Democratic political base ahead of the November 2012 election.
Additionally, by delaying construction of the proposed $7.5 billion, roughly 1,700-mile oil pipeline from Hardisty, Alberta to the U.S. Gulf Coast, U.S. railroads have benefitted as the primary source of transportation of crude oil from North Dakota to key demand markets in Oklahoma and Texas. Burlington Northern Santa Fe, owned by Warren Buffet’s Berkshire Hathaway, was among the big winners. None of the drama, bad press and “unintended” consequences of the Keystone XL delay were lost on our neighbors to the north.
Our job at PIMCO has been to recognize the importance of this delay and how, over a long time horizon, it has dramatically altered the flow of crude oil and capital within the midstream energy sector – i.e., companies that transport product from the source and before end use. In this outlook we discuss the shift in Canadian energy policy that has occurred since the delay of Keystone XL, the potential impact on the United States’ ability to achieve energy independence over the next decade, and investor opportunities surrounding the pipeline projects that are being contemplated in the wake of these developments.
Pipeline delay sparked dramatic shift in Canadian energy policy and capital budgets
The delay in Keystone XL and the barrage of protests and negative press served as a major wake-up call in Canada. It was viewed as a slap in the face to the Canadian government and TransCanada Corporation; Prime Minister Stephen Harper has since publicly commented that Canada should be looking to expand export capability to growing markets in Asia-Pacific, or Canada will run the risk of stunting the development of its oil industry in Western Canada. As a result, a number of proposals have been made to build or expand pipelines to ship oil to the British Columbia coast, including Enbridge’s Northern Gateway Pipeline and Kinder Morgan Energy Partners’ Trans Mountain Pipeline expansion. However, these projects are certain to face considerable political and environmental hurdles from Canada’s First Nation communities. Assuming both of these pipelines were built and in-service by 2018, Canada would be capable of exporting close to 30% of its crude oil to Asia-Pacific.
The North American energy boom: Do you believe in miracles?
We believe the recent explosion in North American (which we define as the U.S. and Canada – two major producers with closely aligned markets) crude oil production is a “game changing” event which will have long-term impacts on global supply and demand and over the next 12 years lead North America to the Promised Land: energy independence.
Based on current forecasts, North American crude oil production is expected to increase at an average rate of 6% per annum from 2012 to 2020. According to Bentek Energy, non-U.S., non-Canadian waterborne imports will decrease from approximately 50% of crude oil supply in 2010 to 14% in 2017 and to only 5% in 2022. Additionally, from 2012-2020 approximately half of all incremental global crude oil production – roughly 4.5 million barrels per day (bbl/day) – will emanate from North America.
This projected growth will be particularly meaningful for the U.S. A recent report published by the International Energy Agency stated that rising oil output by the U.S. is “nothing short of spectacular” and will exceed that of Saudi Arabia or Russia by 2017. Based on current production forecasts, we believe U.S. energy independence is achievable by 2025 – though the U.S. will likely continue to import from Canada. This is certain to have dramatic ripple effects on U.S. manufacturing, foreign policy, defense spending, the U.S. current account balance and the nation’s looming budget deficit. Even if these growth expectations prove to be overly optimistic, onshore production growth in North America will provide a meaningful opportunity for the U.S. to dramatically wean itself away from non-Canadian waterborne imports.
However, U.S. energy independence will be much more difficult to achieve without continued support from the Canadian energy sector. According to the U.S. Energy Information Administration, Canadian oil reserves are estimated to be the third-largest globally, behind Saudi Arabia and Venezuela. Approximately 95% of these reserves are in oil sands deposits in the province of Alberta. More importantly, about 98% of Canadian oil exports are sent to the U.S. each year, and Canada is the United States’ largest supplier of crude oil at 29% of total imports (representing about 2.4 million bbl/day in 2011).
We believe Canada’s changing trade policy and new focus on the Asia-Pacific market is a clear validation of the United States’ ability to increase oil production, as the health of the Canadian oil sector on a long-term basis will likely hinge on its ability to access new markets before U.S. crude oil supply from the Permian Basin, Bakken Shale and Eagle Ford Shale satiates U.S. demand and potentially pushes down prices for Canadian crude. However, the response from the Canadian government has been deliberate and potentially deleterious to U.S. ambitions of energy independence. Specifically, assuming all proposed pipelines to the West Coast and East Coast of Canada were completed and fully subscribed, the vast majority of Canada’s incremental oil production from 2012-2020 would be exported to Asia-Pacific markets and/or consumed by Canadian refiners in Quebec for domestic use
Pipeline capacity constraints: Conundrum or opportunity?
Our analysis of the events surrounding the Keystone XL pipeline delay and long-term energy production trends in North America points to investor opportunities in rail transportation and specific pipeline systems that possess excess capacity that can be converted to crude transportation, unlocking the hidden value of having “pipe in the ground.”
Technological innovation, combining horizontal drilling and hydraulic fracturing, has transformed the entire North American energy landscape, including the supply/demand balances of crude oil as well as the coal, natural gas, ethane and propane markets. However, crude oil pipeline takeaway capacity has not been able to keep pace with exploding production experienced since 2010, resulting in supply bottlenecks and massive swings in crude oil spreads across various receipt points (i.e., West Texas Intermediate vs. Brent Crude, Western Canadian Select vs. Brent Crude). Additionally, the construction of new pipelines in North America is a long and arduous process (not to mention extremely expensive).
In the case of Keystone XL, TransCanada filed its application in September 2008. Thus, if approval to proceed is received in 1Q13, Keystone XL will have taken over four years to gain the necessary permits and construction will take at least another 18 months. Given the barrage of economic uncertainties this country is dealing with – the fiscal cliff, the European sovereign debt crisis, China’s growth rate slowing, quantitative easing, and a slowdown in capex spending by U.S. corporates – U.S. midstream energy companies and producers have been hesitant to build new pipeline capacity.
As a result, we are seeing increasing value for existing pipelines which are already “in the ground” and carry the associated rights-of-way and permitting approvals. In the past few months, we have seen a steady stream of proposed/contemplated crude oil pipeline projects which either reverse flow on an existing pipeline or convert a natural gas pipeline to crude. As a result, larger master limited partnerships with ubiquitous footprints of pipeline assets and excess capacity on existing natural gas pipeline systems are favorably positioned to benefit from this emerging trend over the next several years. These conversion projects are typically cheaper to construct, take less time to complete and result in returns which are 50%-60% higher than new-build pipeline projects. Recently, during Plains All American’s 3Q12 earnings conference call, CEO Greg Armstrong stated:
“Converting existing pipe versus building new pipe is important because
if you’re building new pipe you’re talking about trying to make a
10-year commitment that may not start for two to three years from
now by the time it gets built. So you’re talking about a 13-year period,
whereas conversions can happen faster than that, and that’s what
producers want right now. They want near-term relief.”
We note that the energy industry and markets are cyclical and subject to unpredictable swings in both supply and demand. In a recession, global demand for energy can fall significantly, leading to lower prices and reduced transportation volumes. Additionally, conversions of existing natural gas pipelines require Federal Energy Regulatory Commission approval to proceed with the abandonment process of existing customers. This process can take over one year and is certain to attract opposition given concerns that a more balanced natural gas supply/demand market will lead to higher prices to consumers.
In our view, the midstream energy sector will grow more quickly than the overall economy over the next several years, which will continue to support current fundamentals. In North America, technological innovation in drilling is bolstering crude oil production and raised the prospect of potential energy independence by the middle of the next decade. Based on these tremendous growth prospects, and given that political and regulatory uncertainties highlighted by TransCanada’s Keystone XL pipeline are likely to continue (or potentially intensify) under President Obama’s second term, our approach has been to identify the companies, including pipeline operating companies, favorably positioned to benefit from the changing energy landscape in North America.
Investors may be able to capitalize on these trends by analyzing specific midstream energy companies with abundant assets in areas with strong production and new development. Additionally, specific pipeline systems in both Canada and the U.S., of which a portion of existing capacity can be converted to crude transportation, represent attractive opportunities to unlock the hidden value of having “pipe in the ground.”