Should Kenney Reconsider Trashing Notley’s Rail Plan?

To cancel the recently signed contracts with Canadian National Railway (CN) and Canadian Pacific Railway (CP) or not, that’s the question newly-installed Premier Jason Kenney must now answer.

Kenney criticized the $3.7 billion deal to lease up to 4,400 tanker cars to move 120,000 bbls/d of crude by rail for roughly a three-year period when the Notley government announced it in February, saying it made “little sense.”

The United Conservative Party’s (UCP) election platform read: “Since the private sector was already expanding oil by rail significantly, it is irresponsible to borrow such an enormous amount of money to lease these cars.”

Major oil companies with crude loading terminals, such as Cenovus Energy, appear to agree with this free market view, but the Kenney government should consider two additional factors before pulling the trigger — the cost of trashing the contracts with CN and CP, and the impact on small crude producers given the disproportionate market power of the two railways.

Industry reaction

During their first quarter earnings call on April 24, Cenovus executives explicitly said the oil industry would increase crude-by-rail volumes on its own if the new UCP government cancel Notley’s rail agreements. “With pipeline timing potentially pushing out, additional rail capacity is essential in order to clear the basin, and if it’s not the government taking that rail capacity I think it’s going to be industry stepping up to take that rail capacity,” said executive vice-president Keith Chiasson.

Cenovus president and CEO Alex Pourbaix appeared even more supportive of Kenney cancelling the Alberta government’s contracts with the railways. “This incoming government has really shown that they listen to our industry and they are thoughtful about the strategic and policy decisions that they make, and I think there are lots of opportunities to do something with that rail that could potentially get it out of government hands and get it where it needs to go,” he said.

On that front, Cenovus is currently spending “a little bit of capital” to expand loading capacity at its Bruderheim rail terminal from 100,000 bbls/d to potentially above 120,000 bbls/d to accommodate two unit trains-plus, according to Chiasson.

Financial loss?

The Notley government, through the Alberta Petroleum Marketing Commission (APMC), has signed binding contracts with CN and CP to lease the tanker cars and move the crude. The simple question, with a not so simple answer: how much will it cost the APMC and the province to break these contracts?

When asked this question directly, the two railways have been less than forthright. During its quarterly earnings call on April 23, executives from CP indicated it’s business-as-usual as it prepares for upcoming crude-by-rail contracts, including the one it has with the APMC.

 “We spent a fair amount of time working with the government in putting this contract together,” said Keith Creel, CP president and CEO. “I didn’t do it to have it ripped up … We’re planning for it and we have reserved the capacity to handle that business.”

Ominously, John Brooks, CP executive vice-president and chief marketing officer, said the APMC contract was negotiated in good faith. The company did not disclose the size of the penalty for breaking the contract, but as a rule their contracts are structured to backstop the cost of capital to meet their contractual commitments.

CN has declined to comment on whether its contract with the APMC has a negotiated cancellation penalty, and if so, the amount of that penalty.

At the same time, the Kenney government may wish to consider the opportunity cost of breaking the rail contracts. Notley claimed her crude-by-rail rail plan would make a “profit” of $2.2 billion over the life of the contracts primarily through increased royalties and tax revenue, a figure I mocked at the time (see Don’t Bet Farm On Alberta Rail Plan Making Money).

Since then, completion of Enbridge’s Line 3 Replacement project has been delayed by a good chunk of a year to the second half of 2020 and TransCanada’s Keystone XL by yet another year to early 2022, making Notley’s profit projection for the rail plan that runs to late 2022 look much more plausible.

Small producers

More importantly, the Alberta rail deal provides an indirect means of countering the market power of the two railways, allowing small crude producers to move their crude to market for better price and terms than they could negotiate individually. Small producers have been reticent to sign on the dotted line, as many feel they can’t risk three-year rail contracts and/or don’t meet minimum volume requirements as demanded by the CN-CP railway duopoly.

Alternatively, if the Kenney government decides to cancel the rail contracts, it should involve the Canadian Transportation Agency (CTA) in negotiations at the earliest possible date to encourage CN and CP to bargain in good faith, and if not, for the CTA to impose fair deals between the railways and small crude producers, something I suggested way back in February 2018 (see A Modest Proposal To End Western Canada’s Railway Pinch).

Over the decades, the federal government has passed round after round of legislation in an attempt to counter the market power of CN and CP and improve rail service for western Canadian grain growers — the most recent the Transportation Modernization Act, passed in May 2018 — while the CTA has been involved in numerous disputes between grain growers and the two railways.

From my perspective, the jury is out on whether Premier Kenney should have the APMC break its crude-by-rail contracts with CN and CP. It depends on the amount the province would be penalized for doing so, and if the Kenney government is willing to involve the CTA to protect small crude producers from the market power of the two railways.