Keystone Folly

Excerpted from Issue 39 of the Powers Energy Investor

While members of America’s glitterazzi such as Darryl Hannah and the usual environmental suspects continue to protest the building of the Keystone XL pipeline expansion project to carry heavy crude from Canada’s oil sands region to America’s Gulf Coast, the importance of this project seems to have been completely lost by the mainstream press. According to a recent Bloomberg News report, eight Nobel Peace Prize winners wrote a letter to President Obama, a fellow Nobel Laureate, encouraging him to reject final approval of the expansion to the Gulf Coast since its rejection would be “a tremendous opportunity to begin a transition away from our dependence on oil, coal and gas and instead increase investments in renewable energies and energy efficiency.” The letter comes in response to the State Department issuance last month of its opinion that the expansion of the pipeline holds little environmental risk. Secretary of State Hillary Clinton is expected to give the final approval for the pipeline expansion later this year. Canada’s National Energy Board has already given approval for the Canadian portion of the expanded Keystone XL. Currently, the Keystone pipeline transports approximately 500,000 barrels per day (bop/d) of synthetic crude oil (heavy oil) from the Athabasca region of Canada to refineries in Illinois and Cushing, Oklahoma.

Though America’s oil production has risen over the past five years due to increases in production in North Dakota, Texas and the Gulf of Mexico, after three and a half decades of decline, increased imports from the oil sands is the least bad of America’s few unpalatable options to continue meeting its oil import needs. Currently, Canada is the largest oil exporter to the U.S. with approximately 2 million bop/d sent south, half of which comes from oil sands projects. (Source: Down Stream Today) In this issue, I will examine the history of the Keystone pipeline and the importance of its expansion to the refineries on the Gulf Coast as it relates to the both the oil consumer and Canada’s oil sands industry.

The Keystone Pipeline System is a $13US billion pipeline system that is owned an operated by TransCanada Corporation. Keystone was implemented in two phases. Phase I began construction in March 2008 and connected Hardisty, Alberta to refineries in Wood River and Patoka, Illinois. The Canadian portion of Phase I involved the conversion of the existing 30-inch, 537-mile Canadian Mainline pipeline from a natural gas export pipeline to an oil pipeline, the construction of 232 miles of new pipeline and 16 pumping stations. The U.S. portion of Phase I involved construction of 1,084 miles of 30-inch pipeline and 23 pumping stations. Nearly all portions of the Keystone system are buried below 4 feet of ground cover. (Source: Hydrocarbons Technology) Below is a graphic displaying the pipeline and the proposed extension:

Source: TransCanada Corporation

Construction of phase II began in 2010 and extends the pipeline by 480km (298 mile) from Steele City, Nebraska, to Cushing, Oklahoma. Phase II opened in February 2011 and boosted pipeline capacity to 591,000 bop/d.

The proposed Keystone Gulf Coast Expansion Project is an approximate 2,673-kilometre (1,661-mile), 36-inch crude oil pipeline that would begin at Hardisty, Alberta and extend southeast through Saskatchewan, Montana, South Dakota and Nebraska. It would incorporate a portion of the Keystone Pipeline (Phase II) through Nebraska and Kansas to serve markets at Cushing, Oklahoma before continuing through Oklahoma to a delivery point near existing terminals in Nederland, Texas to serve the Port Arthur, Texas marketplace. (Source: TransCanada)

Two important facts seem to have been lost in the current debate over whether Secretary of State Clinton will approve the U.S. portion of the Keystone XL pipeline expansion. First, while the U.S. is currently experiencing plentiful supplies of oil at Cushing, failure to approve the XL will almost certainly result in significant oil sands exports to Asia. In fact, during a June 2010 conference call, Robert Jones, the TransCanada executive in charge of the Keystone project stated that failure by the U.S. to approve the Keystone expansion will have “no impact on oil sands production” due to two projects under consideration to transport oil sands to a proposed terminal in Kitimat, B.C. The two proposed pipelines would serve markets in China and other Asian markets. (Source:ibid)

A second and more important reason the U.S. should approve the Keystone XL pipeline, which would bring an additional 500,000 bop/d of Canadian crude to U.S. markets, is declining imports from both Mexico and Venezuela--the third and fourth largest exporters of crude to the U.S. respectively. In the four weeks ending 9/2/11, Mexico exported an average of 1.060 bop/d to the US while Venezuela exported an average of 874,000 bop/d (Source: EIA). Further production declines from Mexico’s massive Cantarell field—which has dropped from 2.1 million bop/d in 2004 to 464,000 bop/d by the end of 2010—are unlikely to be made up from the offshore KMZ field or by troubled onshore projects. Given the maturity of Mexico’s producing fields and its lack of exploration success, there is almost no foreseeable scenario under which the country will be exporting oil to the U.S. in five years time.

Venezuela’s mismanagement of its national oil company, PDVSA, its unstable economy along with the nationalization of all foreign assets in the country, have guaranteed the country oil production and its exports to the U.S. will continue to decline. Though Venezuela has one of the world’s largest heavy oil deposits, the country is unlikely to exploit it without significant foreign investment, which will never happen under President Hugo Chavez. I expect Venezuela’s exports to the U.S. to drop by 300,000 to 500,000 bop/d within the next five years. It should be noted that both Mexico and Venezuela have seen material drops in exports in the past five years and therefore my prediction of further declines is merely an acceleration of an existing trend.

So where is the U.S. going to make up for the decline in imports of 1.3 to 1.5 million bop/d in the next five years? It could certainly reduce demand through higher mileage vehicles and fewer miles driven. However, Americans have already reduced their consumption of gasoline from a peak of 9.6 million bpd during August 2007 to 9.1 million bpd in August 2011 and further declines are likely to require materially higher prices. (Source: EIA)

Additionally, opposition to the Keystone XL expansion project dismisses the idea that U.S. oil production may fall materially from current levels. While the U.S. has enjoyed higher production in recent years through the development of several offshore fields and the unconventional oil plays such as the Bakken, the recent upturn is unlikely to last long. For example, consider the recent fluctuations in crude production in the past decade from the State of Montana.

The Elm Coulee field of eastern Montana was the first Bakken field to be commercially developed in the entire Williston Basin. Between the discovery of the field and its subsequent commercial development in 2000 and 2006, production in the field grew to 55,000 bop/d. (Source: Search and Discovery) Below is a graphic displaying the field and it proximity to drilling activity in North Dakota:

Source: Wikipedia

Remarkably, the Elm Coulee field singlehandedly turned around oil production in the State of Montana. Production additions from the field grew the State’s daily oil production from 41,000 bop/d in 1999, the year before the first Elm Coulee well went online, to 99,000 bop/d in 1999, a whopping 141 percent increase. As you can see from the below table, the peak production rate of Elm Coulee of approximately 55,000 bop/d was more than the entire State of Montana was producing in 1999:

Average Daily Oil Production in Montana

Source: EIA

As you can see in the above table, since peaking in 2006, Montana’s oil production has dropped by nearly a third due to declining production in the Elm Coulee and lack of new discoveries. The State’s lack of new prospects is reflected in the huge drop-off in drilling activity. After peaking at 28 rigs active in the State in December 2005, the Baker Hughes rig count dropped to 5 for the week ending 9/9/11. Barring a significant new discovery in the near future, Montana’s oil production will continue to fall at a near double-digit rate for the next several years.

The experience of Montana provides insight into future production trends in North Dakota where the majority of the prospective Bakken acreage lies. (It should be noted that Bakken production peaked in Saskatchewan at approximately 70,000 bop/d in 2008.) While production continues to grow in North Dakota (currently at approximately 350,000 bop/d), the outer limits of the field are now being identified and the era of rapid oil production growth in the State is likely coming to an end. I do not expect North Dakota production to experience a reversal as sharp as Montana’s; however, I believe the State will see a production plateau modestly above current rates for several years before a gradual decline sets in.

Conclusion: Without the option of importing an additional 500,000 bop/d from the Canadian oil sands via an expanded Keystone Pipeline system, the U.S. will see significantly higher oil prices in both the medium and long-term—despite weak or negative GDP growth—due to declining domestic production and reduced imports from Mexico and Venezuela.