Never Say Goodbye, Part 4 - A Rebound In Canadian Crude-By-Rail May Not Come Until 2021

Western Canada’s relentless, decade-long increase in crude oil production began maxing out its export pipeline capacity in the past few years. With more supply than could be carried by pipelines, exporting crude by rail tank car became the next best alternative, leading to record amounts of rail-based exports earlier this year. However, this year’s wild swings in oil prices and COVID-led demand destruction resulted in drastic production cutbacks that freed up space on pipelines and put the kibosh on more expensive crude-by-rail, at least temporarily. Things are shifting again, though. With oil production recovering somewhat in the past couple of months and excess pipeline capacity dwindling, are we headed for a resurgence in the use of rail to export Canadian crude? Today, we conclude a series on Western Canada crude production and takeaway options with an analysis of what’s ahead for crude-by-rail.

Crude oil has been transported to market by rail tank car since the late 19^th century, but pipelines overtook rail as a more reliable and cost-effective alternative early in the 20^th. While pipelines remain the safest and cheapest means of delivering large quantities of barrels to refiners, moving crude by rail never really disappeared and has played a vital role in terms of destination flexibility and as an option when pipeline capacity is in short supply. That’s certainly been the case in Western Canada in recent years, as production growth outpaced the addition of new pipeline takeaway capacity and forced shippers to turn to rail with increasing frequency as a supplement to pipelines. That trend was interrupted this spring, however, when a combination of demand destruction and sharply lower crude oil prices spurred a sharp decline in production.

We initially explored the supply pullback in Part 1 of this series, where we computed a total output reduction of 940 Mb/d from just before the market’s downturn in February 2020 to the peak of the cutbacks in May. Most of that reduction was focused in Alberta’s oil sands and tied to a sharp decline in the price of the heavy oil benchmark, Western Canada Select (WCS). After hitting record low single digit prices for much of April, WCS prices began recovering in May, spurring a gradual rebound in supplies. We concluded that ~470 Mb/d of oil supply had restarted or was on the verge of restarting by July.

In Part 2, we dealt with how the enormous supply swings have impacted the utilization of Western Canada’s takeaway-pipeline capacity. The region’s three major export pipelines, Enbridge’s Canadian Mainline System, TC Energy’s Keystone Pipeline, and the Government of Canada’s Trans Mountain Pipeline, had all been experiencing very high rates of utilization and near-zero spare capacity since 2018. When the supply downturn came, combined oil throughput on these three pipelines fell by ~520 Mb/d between February and May, with the Mainline seeing the largest drop of the three pipes: an estimated 465 Mb/d. All signs indicated that oil throughput/utilization was beginning to recover into July.

We looked at those signs of throughput recovery more closely in Part 3 by considering apportionment, the process by which a shipper’s monthly nominated supplies are reduced by the pipeline operator so that it can accommodate all shippers’ requests. When apportionment is running high it is usually a good indicator that there is more supply than can be transported by available pipeline capacity. The downturn in pipeline volumes in May resulted in zero apportionment for all three of the major pipelines, an almost unheard occurrence in the past five years. However, more recent data into August and September showed apportionment increasing on the Mainline. We concluded that last blog with the view that the supply increases taking place since June appeared to be more fully utilizing available pipeline capacity, but that there was still some space currently available, depending on the type of crude being shipped and on the pipeline being used for those barrels.

Today, in this final blog of the series, we examine the potential for a complete refilling of the pipelines and what that might mean for crude-by-rail volumes going forward. To get some perspective, we turn to data on crude oil exports by rail published by the Canada Energy Regulator (CER) covering 2012 up to June of this year, the latest available (Figure 1). The rise — and especially the fall — of these rail exports have seen three distinct phases.

With pipeline constraints starting to build from 2012 through 2014, rail exports of crude began their first serious increase, topping 150 Mb/d for much of 2014. Crude-by-rail volumes saw their first decline with the crude oil price crash that started in late 2014; the decline in volumes was due to a combination of slowing supply growth and a handful of incremental pipeline expansions. Railed volumes eventually hit bottom in June 2016 at just 43 Mb/d (dashed red oval). A second phase of rail export growth got underway in 2017 as mounting pipeline constraints (and more apportionment) re-emerged on the back of renewed oil sands supply growth. This second expansionary phase eventually led to record-wide price differentials between WCS and West Texas Intermediate (WTI). This led Alberta’s provincial government to curtail oil production there starting in January 2019, which quickly (and temporarily) reduced supply and slashed crude-by-rail exports to only 130 Mb/d that same month (dashed black oval).

Figure 1. Canadian Crude Oil Exports by Rail. Source: CER

However, as price differentials quickly improved (meaning higher absolute prices for WCS), the curtailments began to ease through the remainder of 2019 and into 2020. When combined with more production gains in the oil sands over this time — Canada’s total oil supplies hit a record high late in 2019 — and pipeline constraints that again became severe, rail exports eventually reached a record high of 412 Mb/d in February of this year. Most inconveniently, this was just in time for the previously mentioned oil price crash and COVID-led demand destruction, forcing the 940 Mb/d in production cuts by producers that we discussed in Part 1. This sent rail exports of crude plummeting to just 43 Mb/d by June (dashed green oval), their lowest level in exactly four years and a stunning 369-Mb/d drop in just four months. We suspect that the only reason the rail exports did not completely collapse to zero was due to some long-term, fixed contractual railing obligations between a few refiners and producers. Using more frequent, but less accurate, weekly rail shipments in Canada, we estimate July and August crude-by-rail exports to be holding in the range of 50 Mb/d (orange bars to far right in Figure 1).

So far, we know where rail exports of crude oil have been, but where might they be going for the remainder of this year and 2021? The answer to that question will depend to a large degree on how much more production increases and, more importantly, how much this boost in supplies might increase the incremental cost of moving additional barrels to market.

In our RBN Studio Session Alberta Bound, we mentioned that the notional costs of moving Canadian crude by rail to the U.S. varies between $12/bbl and $18/bbl, depending on the distance involved and whether the crude is shipped by unit train (all rail cars carry crude oil to one destination) or manifest train (rail cars carry different goods, including crude oil, to various destinations). The cost of moving barrels by pipeline is lower than railing costs: typically under $12/bbl, again, depending on distance. But when the pipelines are completely full, as they have been much of the past few years, the price of Canadian crudes such as WCS have to be more heavily discounted to WTI to cover the cost of transporting the additional barrels by rail.

After allowing for a one- or two-month lag to allow for the adjustment of shipping schedules, there is a clear relationship between the monthly average price discount of WCS to WTI (shown as a negative value in the black line and right axis in Figure 2) and the amount of crude oil being exported by rail (blue and orange bars and left axis). When the discount becomes more negative (i.e. when the price of WCS is further below WTI), the cost of rail transportation is more easily covered and the incentive to transport additional barrels by rail increases (dashed red ovals). What is more striking of late is that when supplies were severely cut back, as they were between February and May, spare pipeline capacity became available, quickly eliminating the incentive to ship barrels by rail as the price discount rapidly narrowed (dashed pink oval).

Figure 2. Crude by Rail Exports vs. WCS-WTI Price Discount. Sources: CER, Bloomberg, CME Group

This considerably smaller discount for WCS relative to WTI has persisted in recent months and the low levels of rail shipments that we are estimating for July and August are consistent with this smaller discount to date. It is also consistent with the views we put forward in Part 3 that (1) the major export pipelines have not yet reached the point where all of their available capacity has been exhausted and (2) the availability of at least some pipeline space has kept the price discounts small enough to discourage increased use of alternative means (i.e. rail) to move crude to market.

To get some sense for how the price discount may or may not incentivize future rail exports of crude, there is a readily available forward curve for the price discount of WCS to WTI (green line in Figure 2). This forward curve does not dip much below $12/bbl until November 2020, and then the discount deepens toward $16/bbl later in 2021. Based on the $12/bbl-plus cost of transporting crude to the U.S. by rail that we mentioned earlier, the forward curve is suggesting that we may not see a notable increase in crude-by-rail volumes until later this year (November), when the price discount might be sufficient to warrant the potential for more rail shipments of crude. And, given the inherent lags in establishing shipping schedules, it could very well end up being early 2021 before we see any increase in Canada’s rail exports of crude to the U.S. There’s one caveat, though. With some major oil sands producers looking to bring long-planned expansions into service next year, as well as the restart of a good portion of remaining shut-in supplies, it is a good bet that Canada’s oil production will start to work its way back to the record highs (and beyond) that were seen in late 2019. As the timing of all the expansion work in the oil sands and the pipelines becomes clearer in the months ahead, and as Midwest refiners likely see additional demand recovery in 2021, more of Canada’s crude oil barrels may be riding the rails once again later in 2021.

"Never Say Goodbye" was written by Jon Bon Jovi and Richie Sambora and appears as the ninth song on Bon Jovi’s third studio album, Slippery When Wet. Released as a single outside the U.S. in June 1987, the song still went to #11 on the Billboard Rock Tracks chart and #28 on the Hot 100 Airplay Survey. Personnel on the record were: Jon Bon Jovi (lead vocals, rhythm guitar), Richie Sambora (lead guitar, backing vocals), Alec John Such (bass, backing vocals), Tico Torres (drums, percussion), and David Bryan (keyboards, backing vocals).

Slippery When Wet was recorded at Little Mountain Sound Studios in Vancouver, BC, with Bruce Fairbairn producing. The album was released in August 1986 and went to #1 on the Billboard Top 200 Albums chart. It has been certified 12x Platinum by the Recording Industry Association of America. Four singles were released from the album.

Bon Jovi is an American rock band formed in Sayreville, NJ, in 1983 by Jon Bon Jovi, Richie Sambora, David Bryan, Tico Torres, and Alec John Such. Such was replaced by Hugh McDonald in 1994 and Sambora by Phil X in 2013. Bon Jovi has released 15 studio albums, three live albums, five compilation albums, five EPs, and 66 singles. The band has sold over 130 million records worldwide, and has won two American Music Awards, one Billboard Music Award, one Brit Award, one Grammy Award, two MTV Video Music Awards, and two World Music Awards. Bon Jovi was inducted into the Rock and Roll Hall of Fame in 2018. The band has completed a new album, but the release date and touring plans are on hold due to COVID.