Analysis: A Modest Proposal To End Western Canada’s Railway Pinch

A new Western Canadian oil pipeline pinch had been widely predicted for the fourth quarter of last year. The corresponding increase in regional oil price differentials was expected to be gradual and moderate, with Canadian National Railway (CN) and Canadian Pacific Railway (CP) coming to the rescue of oil shippers, just as they did earlier this decade. Instead, the railways are playing hardball with the shippers, and regional crude price differentials have blown sky high — accentuated by a mid-November accident on the South Dakota leg of TransCanada’s Keystone pipeline.

Some regional oil shippers may be optimistic about negotiations with the two railways, but the Canadian Association of Petroleum Producers (CAPP) would be prudent to request early involvement of the Canadian Transportation Agency (CTA) given the scale of potential losses to Western Canadian oil producers and governments and the federal government if negotiations drag on. If need be, the CTA has the power to impose a compromise solution on the two sides.

Presently, the two Canadian railway companies are unwilling to assign substantially more locomotives and crews to move Western Canadian crude oil to the U.S. unless producers put significant “skin in the game.” The mid-decade collapse in crude-by-rail volumes, due to new pipeline capacity and the oil price collapse, hit CN and CP share prices hard. “We are looking for strategic partners with long-term objectives that allows us to have a more stable book of business,” said CP CEO Keith Creel while reporting his company’s fourth-quarter results on January 18.

CP is seeking multi-year, take-or-pay contracts that guarantee minimum volumes from Western Canadian oil shippers. CN, on the other hand, is reconsidering its policy of demanding long-term contracts to move crude-by-rail, which has been in place since 2015, according to Jean-Jacques Ruest, the company’s chief marketing officer. But CN is likely to charge higher tariffs under take-or-pay contracts when it offers additional capacity to Western Canadian oil shippers in the second half of this year. The company cut its shipments of crude oil by 30 per cent in the final quarter of 2017, as it scrambled to meet commitments to grain producers following three train derailments in the autumn.

As of now, a negotiating standoff between the two Canadian railways and oil shippers is keeping Western Canadian crude differentials extra wide. In mid-December, with regional storage tanks full, the spread between North American benchmark West Texas Intermediate (WTI) and regional heavy crude benchmark Western Canadian Select (WCS) spiked to almost US$35 per barrel, and it has since tended to hover around US$25 — compared to a normal differential, based on quality differences and differing costs of piping each crude to WTI’s traditional pricing point of Cushing, Oklahoma, of US$13-14 per barrel.

In contrast, if the two railways were providing sufficient service to Western Canadian oil shippers, the WTI-WCS differential would be roughly US$20 per barrel, representing the extra cost of transporting WCS to more distant markets such as the US East Coast and U.S. Gulf Coast by rail rather than pipeline. Hence, Western Canadian oil producers are currently losing around US$5 per barrel, which translates to forgone revenue of roughly US$20 million a day, US$600 million a month and US$7.3 billion a year ($9.1 billion Canadian) — on top of the US$9.5 billion annual loss due to the pipeline pinch. In turn, this means significantly lower royalty and tax revenue for the oil producing provinces, and tax revenue for the federal government.

The CEO of Cenovus Energy, Alex Pourbaix, recently expressed optimism about ongoing negotiations between the railways and oil shippers, believing they will bear fruit in the next few months. “We are negotiating with both of the rail companies,” he said during a session of a CIBC World Markets conference in Whistler, BC on January 25. “At the end of the day, I think there is ample margin for both parties to come together and for rail to get an enhanced return and for the producers to get a much-enhanced netback.”

But what if Pourbaix’s optimism is misplaced? The rail companies have Western Canadian oil producers over a barrel. Oil shippers are going to have to increasingly rely on rail transport for at least the next few years, as legacy investment from the last oil price boom pushes oilsands production substantially higher again this year, while substantial additional pipeline capacity will not come online until the beginning of next decade at the earliest.

The three major oil pipeline projects still on the books — Enbridge’s Line 3 Replacement, Kinder Morgan Canada’s Trans Mountain Expansion and TransCanada’s Keystone XL — may have the potential of adding 1.79 million barrels per day of pipeline capacity, and hence the legitimate concern of the two railway companies of again being backed out of crude transport by lower cost pipe. But despite all three pipeline projects having most if not all the necessary federal, state and provincial government approvals to proceed, none of them are a slam dunk.

At the same time, Western Canadian grain producers have long complained about rail service from CN and CP — this past crop year being a notable exception —suggesting the two railways are an oligopoly that misuse their market power to secure greater profits. In turn, the two railways have as much as said, “You get what you pay for,” as the revenue they can make moving Western Canadian grain is capped by the Maximum Revenue Entitlement (MRE), a remnant of the 1897 Crowsnest Freight Rate.

The federal government has passed a long line of legislation in an attempt to improve rail service for Western Canadian grain producers — with new legislation currently in the Senate—while the CTA has been involved in numerous disputes between the grain growers and two railway companies. The CTA is an independent, quasi-judicial tribunal and regulator, with the powers of a superior court. One of its three core mandates is to help the national transportation system run efficiently and smoothly. To do so, the CTA makes and enforces ground rules that establish the rights and responsibilities of transportation service providers and users, levels the playing field among competitors, and resolves disputes using a range of tools from facilitation and mediation to arbitration and adjudication.

To conclude, there is plenty of rail-related capacity to move Western Canadian crude to U.S. markets and bring regional oil differentials back down to more reasonable levels. For example, the National Energy Board estimates there to be 1 million barrels per day of crude-by-rail uploading capacity in the region, with only 139,754 barrels per day of it being used to export oil to the U.S. in November — the latest month in which statistics are available. The sooner CAPP involves the CTA in negotiations with the railways, the more likely CN and CP will bargain in good faith, and the sooner the CTA can impose a fair deal if they don’t — saving Western Canadian oil producers and governments, and the Feds barrels of cash in the process.