The Impact Of The Trans Mountain Pipeline Decision

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Includes: AAV-OLD, AETUF, CVE, GENGF, MEGEF, PEYUF, TRMLF
by: Hervé Blandin
Summary

The nullified approval of the Trans Mountain pipeline expansion project has an impact on Canadian oil and gas producers.

The extra export capacity by rail does not solve all the issues.

When investing in oil and gas Canadian producers, choose the ones that can sustain low prices during many years.

The uncertainties around the Trans Mountain pipeline expansion hurt the Canadian oil and gas producers. The railway exports provide some help, but not enough to handle the growing oil production over the next years.

And the Trans Mountain pipeline expansion is the only project to get Candian oil outside of North America.

If you want to invest in the Canadian oil and gas producers, choose those that can sustain a depressed price environment during the next few years.

Pipeline in Canada

Image source: robzor via Pixabay

The WTI/WCS differential issue

The oil infrastructure issue in Canada is well known. Oil producers in Western Canada struggle to reach different markets due to the lack of export capacity. Three pipeline expansions are planned. But last Thursday, the Canadian Federal Court of Appeal nullified the approval of the Trans Mountain pipeline expansion.

It comes as a big disappointment for Canadian oil producers. For instance, in the Q2 2018 earnings press release, a few days before the nullified approval, Gear Energy (OTCPK:GENGF) stated:

The Gear team remains cautiously optimistic regarding future commodity prices with recent positive news on two major oil pipeline developments and the continued crude-by-rail expansion.

Cenovus Energy (CVE) mentioned the importance of the pipeline projects in the Q2 2018 press release:

The company remains supportive of new pipelines and pipeline expansions and has committed capacity on the Keystone XL project and Trans Mountain Expansion project.

From the refiners' perspective, the situation looked less optimistic. During the Q2 2018 conference call, the CEO of Phillips 66 (NYSE:PSX) said:

We had the Syncrude outage this summer, which supported WCS temporarily. But it – now that project is starting to come back on. We expect additional volumes in August and September. Fort Hills is continuing with its impressive Brent towards 200,000 barrels a day potentially higher.

As we look at maintenance activity, pad two has well above average refinery maintenance planned for the fall, and some of that is going to reduce the demand for WCS as well. So we see a seasonal opening of WCS discounts this fall. We expect the discount to be set by rail, assuming there is sufficient rail capacity, which would be the equivalent of kind of a WTI minus 20. If rail is not sufficient, it could be wider.

In any case, the consequence is the WTI/WCS differential increases again. As a result, the share prices of Canadian oil producers dropped by a few percents over the last few days. For instance, the chart below shows the drop in the share prices for Cenovus Energy and MEG Energy (OTCPK:MEGEF) after the court decision.

Chart CVE Price data by YCharts

How important is the Trans Mountain pipeline?

As shown on the picture below, the Trans Mountain pipeline is the only pipeline that brings Canadian oil out of North America. Without this pipeline, the unique client for Canadian oil exports is the US. And the US is becoming a net oil exporter.

Map of pipelines in North America

Source: capp.ca 2018 crude oil forecast

Having the possibility to export oil to Asia is important in the scope of the development of the dynamics of the oil markets. On the chart below, we can see the growing net oil imports in China and India. As a contrast, the graph shows the US is becoming a net exporter of oil.

Global net oil imports

Source: capp.ca 2018 crude oil forecast

Also, the Canadian Association of Petroleum Producers forecasts growth for Canadian oil production.

Canadian oil production forecast

Source: capp.ca 2018 crude oil forecast

By 2021, Canada should produce about 5 MMboe/d, with most of it coming from Western Canada. The table below shows the current 3.3 MMboe/d pipeline capacity to export oil out of Western Canada.

Major export capacity by pipeline from Western Canada

Source: capp.ca 2018 crude oil forecast

As Canada imports about 0.8MMboe/d, the 1.8 MMboe/d local oil consumption will not be enough to absorb the production. Thus, the pipeline expansion projects were planned as shown below.

Proposed crude oil pipelines exiting Western Canada

Source: capp.ca 2018 crude oil forecast

The total extra capacity would have barely covered the additional needs to transport Canadian oil. The Trans Mountain issues postpone 590,000 boe/d of takeaway capacity to an unknown date. It is putting more pressure on the short and medium term for the Canadian oil producers.

Is oil export by rail a solution?

Several Canadian oil producers turn to rail transport as a solution to the pipeline limitations. There were recent reports of increased rail capacity. And the table below confirms the increase of crude oil export by rail.

Oil export by rail is increasing

Source: National Energy Board

According to this article, the transport by rail could reach 390,000 boe/d in 2019. But it is still not enough to absorb the increasing oil production.

The CEO of Philips 66 said during the Q2 2018 conference call:

When you look at the Canadian exports by rail, we did see a new high in April, 190,000 barrels a day, but that’s only about – only slightly higher than the average of 130,000 barrels a day last year. So we’re getting a little bit more rail, but not substantially more. So we expect WCS discounts to be attractive for at least the next 18 months and potentially longer.

The transport by rail helps, but it comes with extra costs and it still does not offer any possibility to export oil outside of North America. The companies don't communicate about the amount of these extra costs, though. But these higher transportation costs by rail explain a part of the increasing WTI/WCS differential.

Impact on Canadian gas producers

Since this court decision, share prices of Canadian gas producers also dropped. I see several reasons for the drop in Canadian gas producers' share prices.

With low gas prices and better NGL netbacks, Canadian gas producers like Peyto (OTCPK:PEYUF) and Advantage Oil (AAV-OLD) turn to NGL production. Canadian companies use NGL to dilute their oil sands bitumen for transport.

But with the oil infrastructure uncertainties, heavy oil production could increase less than the CAPP expects. Thus, the demand for NGL could decrease as well.

The court decision is also a bad signal for natural gas infrastructure projects. There is a big expectation for a positive decision about the Shell LNG project to proceed. The difficulties for oil pipelines could reduce the probability that Shell decides to go ahead with the LNG project.

The other reason for the drop of natural gas producers could be the AECO prices that are low these days.

AECO gas prices

Source: gasalberta.com

In any case, there is currently pessimism in the Canadian oil and gas environment, which also provides investment opportunities.

How to invest in Canadian oil and gas companies?

Considering this environment, the valuation for some Canadian oil and gas producers is low. But it is important to consider the companies that can survive a depressed environment.

The producers that can sustain this situation for many years can adapt their production. A few weeks ago, I had written an article about the flexibility of Gear Energy to adapt to the WTI/WCS differential volatility.

Some gas producers also start to adapt to the depressed AECO prices. For instance, Peyto has reduced its production during Q2 2018.

A low debt is also an important factor to survive in this environment. As an example, producers like Gear, Tourmaline (OTCPK:TRMLF), and Arc Resources (OTCPK:AETUF) have this advantage. These companies have a net debt around 1x annualized cash flow.

And being a low-cost producer is essential. Gear, Tourmaline, Peyto, and some other producers are amongst the lowest cost producers for their respective type of resources.

These are just examples and there are some other criteria to look at when considering Canadian oil and gas companies. But it is important to keep in mind the solidity of the producer in the context of low prices for many years.

Conclusion

The uncertainties around one of the three pipeline expansion projects are hurting Canadian oil and gas producers. Besides postponing extra export capacity, it also reduces confidence in the other expansion projects.

The extra rail export capacity is not enough to cover the increasing Canadian oil production. And it does not offer any possibility to export oil to Asia anyway.

This depressed environment offers investment opportunities. But it is important to consider oil and gas companies that can sustain low prices for many years.

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Disclosure: I am/we are long PEYUF, BTE, CPG.

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.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.