Canada’s oil industry hit yet another setback with the recent announcement from Enbridge that it was delaying the in-service date for its Line 3 replacement project.

 

Canadian oil sands have been plagued by midstream bottlenecks for years, but the constraints have grown worse over the past year as production inched up at a time when the region has been unable to add any significant takeaway capacity. The Line 3 replacement was expected to come online later this year, but the delay has once again led to disappointment, and could stretch out the pain for upstream producers.

Enbridge’s Line 3 replacement is the only significant source of additional midstream capacity that is expected to come online in the near future.

Line 3 left standing 
Enbridge’s Line 3 replacement is the only significant source of additional midstream capacity that is expected to come online in the near future. Canada’s oil industry has been hit by repeated pipeline failures in recent years. TransCanada’s Keystone XL pipeline has been in legal limbo for over a decade. The same company also scrapped the Energy East pipeline in 2017, a project that would have traveled across much of the North American continent to carry oil from Alberta to refineries and ports in Canada’s eastern provinces.

In 2016, the Canadian federal government rejected Enbridge’s Northern Gateway pipeline, which would have carried oil from Alberta to the Pacific Coast for export. That rejection was made in conjunction with an approval for Kinder Morgan’s Trans Mountain expansion, a twin line that would run parallel to an existing pipeline from Alberta to British Columbia’s coast. The government of Prime Minister Justin Trudeau reasoned that a twin line would be less controversial than one charting across virgin terrain.

He was sorely mistaken. The Trans Mountain expansion was bogged down in both protests and legal morass. Kinder Morgan was on the verge of cancelling the project in the spring of 2018 until the Canadian government purchased it, effectively nationalizing the pipeline proposal in order to keep it alive. It still faces legal questions.

Against that messy backdrop, Enbridge’s Line 3 remained as one of the last projects expected to move forward in the near-term. The $9 billion project consisted of overhauling an aging pipeline, and the replacement would result in a near doubling of the system’s throughput to 760,000 barrels per day (b/d). Originally slated to come online in late 2019, Enbridge announced on March 1 that it would delay that timeline until the second half of 2020 due the lengthier-than-expected permitting time from the U.S. state of Minnesota.

The delay could have knock on effects for the whole of Canada’s oil industry. “Absent the expanded replacement pipeline, some combination of yet-more oil-by-rail capacity and continued production discipline—whether voluntary, due to low pricing, or by government mandate—will be required to balance the Western Canadian oil market through 2020 and prevent discounts from experiencing a replay of last year’s blowout sale on Canadian crude,” Scotiabank wrote in a note.

The lack of pipeline capacity has at times led to painful discounts for Western Canada Select (WCS), an oil marker that tracks heavy crude in Canada. In the fourth quarter of 2018, WCS fell sharply, trading at a discount as large as $40-$50 per barrel below WTI. In other words, while WTI was trading in a $50 to $60 per barrel range in November, WCS crashed below $15 per barrel for a period of time.

Oil trading in the teens presented a crisis for Canada’s oil industry, forcing the provincial government in Alberta to announce mandatory production curtailments for all operators. In December, Alberta Premier Rachel Notley ordered the industry to slash output by 325,000 b/d beginning in January. The cuts were a temporary measure, to be lifted gradually as storage levels fell back to normal levels. The cuts had the desired effect. WCS prices spiked on the news, erasing a good portion of the discount relative to WTI.

More delays
The production cuts helped balance the market, but the midstream conundrum was not resolved, and Enbridge’s 6-12 month delay of the Line 3 project once again puts the spotlight on the lack of takeaway capacity.

Meanwhile, the path forward for Enbridge in Minnesota is not entirely cleared away. The company put some positive spin on its announced delay of the project, stating that they received an updated and “firm” schedule from Minnesota regulators. Yet, the state’s Governor recently decided to allow a lawsuit against the project to go forward. At the same time, indigenous groups have vowed to protest the pipeline, threatening to turn it into another flashpoint similar to the Dakota Access and Keystone XL protests.

Ironically, the mandatory production cuts have arguably pushed up WCS prices too far.

In the meantime, there could be renewed pressure on WCS prices. Ironically, the mandatory production cuts have arguably pushed up WCS prices too far. Canadian oil companies have been shipping increasing volumes of oil by rail to the U.S., but such shipments require a hefty discount to justify higher transit costs. WCS prices have climbed to levels that no longer support crude-by-rail, which is a problem given that the industry will need more rail until the Line 3 replacement comes online in late 2020. “Current heavy oil strength relative to lighter grades in the Gulf of Mexico could mean that rail theoretically breaks even at slightly less than $15/bbl, but a discount level of $15–20/bbl is still likely required to provide sufficient incentive for the private sector to grow additional oil-by-rail capacity,” Scotiabank concluded.

The Alberta government has decided that it would intervene in the market to support crude-by-rail shipments. The province recently announced contracts with Canadian National and Canadian Pacific to lease 4,400 rail cars to support more exports. But the rail plan is only a partial solution. The first shipments won’t begin until July of this year, and initial shipments will only amount to about 20,000 b/d. By mid-2020, shipments will reach 120,000 b/d, still less than half of the additional takeaway capacity that the Line 3 replacement would add. But, given the bottlenecks and the endless delays facing the midstream sector, Alberta’s rail program and its mandatory production cuts are the only tools the oil industry has left, at least in the short run.

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