Our Suggestion To Premier Notley: Act Now, Don’t Let The Liberals Accelerate The Phase Out Of Jacketed CPC-1232 Tank Cars

We aren’t on Premier Notley’s special envoy consultation list to come up with solutions to narrow the heavy oil differentials, but, if we were, we would tell them that the first priority should be to not make the situation worse.   And we would be strongly pushing that they act now to make sure the Liberals do not move on their announced desire to accelerate the phase out of the jacketed CPC-1232 tank cars. The jacketed CPC-1232 tank car is likely the majority of crude by rail tank cars in Canada and any elimination or earlier phase out of the existing CPC-1232 tank cars would directly reduce Cdn crude by rail capacity and volumes.  This would lead to an increasing in heavy oil differentials.  We don’t think it is an easy task, but it will be a lot easier for her to stop the Liberals from moving on this issue as opposed to trying to get it overturned after it has been implemented.  Our concern is that if Alberta does not act now, they run the risk of a similar situation as Bill C69, where something gets passed that is a big negative to the oil sector.  No one should forget that its not just Alberta that has elections in 2019, the next we shouldn’t forget that the Canada federal election has to be held by Oct 21, 2019.

Yesterday, Premier Notley announced her urgency to try to come up with short term solutions to narrow the wide heavy oil differentials.   We listened to Notley’s press conference (including the Q&A) yesterday on how she will be “Fighting to get full value for Alberta oil”.  Notwithstanding there is a provincial election within 6 months and the NDP trails the UCP in the early polls, Notley is rightly focusing on this issue as it is having a massive impact on the oil patch, Alberta and as the Premier says, Canada.   She estimates the impact is $80 million impact per day.   Yesterday, she announced her key initiative for Alberta to work with the oil patch leaders to come up in the next 2 to 4 weeks with short and mid term solutions to narrow the differential.   She was clear – no options are off the table.

Any refinery solutions are likely several years away and not big enough to make a difference.  One of the specific actions announced yesterday was Notley establishing an energy upgrading unit reporting to her, which will work with Albertans to “think big and supercharge” move to build more upgrading/refining in Alberta.  Notley said Alberta needs to upgrade and refine more at home.  We don’t disagree that this would help increase demand for Cdn heavy oil, but the reality is that any expanded Sturgeon Lake refinery or new refinery would likely take at least several years.  Plus, a Phase 2 at Sturgeon Lake or new similar refinery would not provide any significant heavy oil demand relief.  The recent Sturgeon Lake refinery startup was years delayed and ended up well over budget at ~$9.8 billion.  And Sturgeon Lake Phase 1 is designed to process ~50,000 b/d of heavy oil and 29,000 b/d of diluent ie. its incremental heavy oil demand is only ~50,000 b/d on a project costing ~$9.8 billion.   One point to note is that Notley teased that there should be announcements within a month on accelerating our “upgrading efforts”.   If Notley is talking about oil upgrading/refining projects, the only significant project that comes to mind as perhaps being that decision ready would be a Phase 2 at the Sturgeon Lake refinery.

Three special envoys are working with industry to develop short term solutions, no options are off the table.  Notley’s key action was to appoint a team of three “special envoys” to “work with key energy leaders on bold solutions for closing the historically high oil price gap that is robbing the Canadian economy of more than $80 million a day”.   She stressed that this to develop short and mid term solutions and report back as soon as possible.  Notley say this was a process that should be done within 2 to 4 weeks.  The Premier was also clear that no options were off the table.  When asked, she said she didn’t want to get into too many specific potential solutions. However, she was asked about “air barrels” or the issue of apportionment on Enbridge’s mainline and gave some views.  Notley replied that the efficient use of pipelines has been one topic of discussion, but there is disagreement among the various players as to the role that this plays in the problem.  Air barrels has and will continue to get a lot of discussion and be high profile.  We should note that our view is likely different than most and we don’t believe air barrels are likely a problem today ie. they aren’t really a solution to narrow the differentials today.  Air barrels may have been an issue in the spring, but we aren’t convinced that air barrels are a problem today given Cdn heavy oil production has increased and, with Alberta oil storage at high levels, all barrels are likely being pushed or find their way into Enbridge.  It is important to remember that increasing heavy oil production over the past six months has been the driving factor for widening differentials.

Notley says she expects to hear soon on her proposal for the Liberals to add capacity to move more crude by rail ie. add locomotives,  In the Q&A, Notley said she has had conversations with the Liberals on her proposal to increase crude by rail capacity, does not have a “final answer”, but expects to get something from them “pretty darn soon”.   Its hard to tell if there is any hint one way or another, but the decision is coming quickly.  As first reported in late Oct, her proposal was that the Liberals should invest in locomotives sufficient to haul an extra 1 or 2 unit trains per day.  We typically use 700 bbls of light oil per tank car vs 575 barrels of heavy oil per tank car.  So just using 600 barrels per car, each unit train (100 cars) would be 60,000 barrels.  Ie. 2 unit trains would be 120,000 barrels.  Based on comments from recent Q3 earnings calls on lead time for locomotives and tank cars, we would expect it would likely take at least a year to implement her plan to get delivery of the additional new locomotives and acceptable tank cars.  Then the next issue will be getting time on the railway lines ie. getting CN and CP to prioritize crude by rail. It was also interesting to hear Notley say that a “reasonable expectation” is her hope to shovels in the ground a year from now on Trans Mountain expansion.   We aren’t as optimistic on Trans Mountain expansion.  Perhaps, we gave her too much credit, but when her proposal was first reported, we thought her proposing of adding new rail capacity was more of a backup plan in the likely event that a Trans Mountain expansion potential diminished ahead of the May 2019 provincial election.  But we also see the value in the proposal as there is the likelihood that there will be the need for some semi permanent additional crude by rail capacity ie. another 200,000 b/d.

Our suggestion is that Notley should also have a priority to make sure she doesn’t make the problem worse.  In the Q&A, Notley raised the issue of Bill C69 and how that is likely to lead to a crisis of not getting a significant project approved for decades and that she needs to see the Liberals have heard her team on Bill C69.  We don’t know the real story on how or what her team did as soon as they first saw the proposed Bill C69.  But our fear is that we heard nothing in her press conference and haven’t seen her or her ministers in the news that shows her team is working to avoid another potential Bill C69 – the Liberals stated desire to accelerate the phase out of the jacketed CPC-1232 tank cars.  It is why we are suggesting to Notley and her team – put a priority today to avoid another Bill C69 problem because this issue is on the horizon in 2019 and will widen the differentials.

If we were advising the Notley special envoys, we would be strongly recommending don’t wait, act now to focus on stopping the Liberals from accelerating the phase out of jacketed CPC-1232 tank cars . We continue to be surprised that this issue isn’t at the forefront for Notley and for investors. Its why we are writing this blog – there is a lack of focus on this issue that could make differentials worse and worse quickly.  We have to believe that Notley would have taken advantage of the broad investor, sell side and media audience to specifically highlight this issue if it was front and center for Alberta.  Our Oct 28, 2018 Energy Tidbits memo [LINK] stressed that this is not a potential issue, rather the Liberals have clearly warned that they plan to accelerate the phase out of jacketed CPC-1232 tank cars.   Our fear is that this could emerge as a decision in the run up to the Oct 2019 national election.  This will widen differentials and reduce crude by rail volumes.  The Liberal government’s recent Sept 19, 2018 “Transport Canada speeds up removal of least crash-resistant rail tank cars from service” press release [LINK]  also included a key warning sentence “The Minister today also announced his support for an industry-led crude oil and condensate tank car working group that will make recommendations to Transport Canada on advancing the timelines for the phase out of jacketed—with a layer of thermal protection—CPC 1232 tank cars.”  The Liberals clearly said the Transport minister was supporting this acceleration.  One other factor that makes us worry about this acceleration is that the Liberals will have the cover of following the relatively under the radar similar changes that started to happen on certain railway lines in the US this summer.  We say act now before its too late so the Liberals don’t act on this earlier phases out, which leave the oil sector is faced with another Bill C69 type situation.

The problem is that the jacketed CPC-1232 are likely the majority of tank cars on Cdn railway lines. The jacketed CPC-1232 tank cars are the work horse of crude by rail in US and in Canada and, if the Liberals accelerate the phase out of the jacketed CPC-1232 cars, it will directly impact crude by rail capacity and volumes.   The top of line tank cars are the DOT-117J, which are the new builds and are allowed everywhere.  Whereas this summer started to see some restrictions on the jacketed CPC-1232 cars on certain railway lines in the US.  Our Nov 11, 2018 Energy Tidbits memo [LINK] noted comments from our attending a small group meeting arranged by BMO with CN rail management that week. At that meeting, we asked mgmt. if they had a sense of the percentage of DOT-117J tank cars that run on their system.   We discussed, they didn’t have a specific precise number but said that the split is likely similar to the US at roughly 40% DOT-117J vs 60% others that would include jacketed CPC-1232 tank cars.  But that over time the percentage of new build DOT-117J will continue to increase.

Good timing, Notley’s push to reduce heavy oil diffs should have the benefit of the normal spring narrowing in heavy oil differentials.   The next Alberta election has to be held before May 31, 2019, which means this is good timing for Notley to come out hard with her determination to reduce heavy oil differentials and to do so soon. If there is a typical seasonal narrowing, it will be a good story line for her going into the election.   The below graph shows WTI less WCS differential and normally there is a seasonal narrowing of heavy oil differentials every spring as we move into peak refinery demand for heavy oil

WTI Less WCS Differential (US$)

 wcs

Source: Bloomberg, SAF