OIL SANDS:

Pitting rail against Keystone XL overlooks messy economic reality

The spring's hottest Keystone XL debate sounds both arcane and elegantly simple: Can the sort of crude-by-rail surge now taking place in the Bakken Shale move north to Canada's oil sands if the White House rejects the most famous pipeline in America?

But such a cut-and-dried question obscures the complex reality of oil pricing markets whipsawed in recent years by peripatetic pricing for North American crudes. Whether trains prove a strong long-term choice to send heavy Canadian crude south ultimately may depend on the very thing that rail's viability is now linked to -- new pipeline capacity to the Gulf Coast, symbolized by Keystone XL.

"Federal approval is not the end of the story on whether Keystone XL is built," Katherine Spector, head of commodities strategy at CIBC World Markets, said this week at an Bipartisan Policy Center forum on oil. "To me, it's a matter of the timeline. Does it take so long that other options become more economical?"

The State Department's March Keystone XL review cast rail in the leading role among those other options, citing its boom in the Bakken Shale and projections of increased western Canadian crude-by-train traffic for 2013 as evidence that oil sands development would suffer little if the iconic pipeline were not built. Yet environmentalists and Wall Street analysts have undercut that Obama administration assessment repeatedly, making any new admission from the oil patch about XL's importance to future growth into a new liability for the industry.

Forecasts of 200,000 barrels per day (bpd) riding the rails out of western Canada this year provided the foundation for the State Department's judgment about the trains' ability to carry enough oil sands crude to "prevent shut-in of" new oil sands production without Keystone XL. However, those rail traffic numbers include types of Canadian oil beyond Keystone XL's diluted bitumen, from upgraded oil sands crude to light and heavy conventional fuel.

Unconventional heavy oil such as diluted bitumen accounts for 34 percent of Alberta's crude production, with light and heavy conventional breeds contributing 22 percent and lighter upgraded oil sands crude making up 39 percent, TD Economics reported in March.

"Where that 200,000 bpd is likely to go and whether it's light or heavy is very important," Natural Resources Defense Council International Program attorney Anthony Swift, a leading Keystone XL critic, told House members last month. "The key question is whether it's economically feasible to move heavy tar sands crude to the Gulf Coast refineries by rail. The answer appears to be no."

But oil sands producers are not limited to a pure choice between rail and pipeline to reach their destination. The two modes "are also tying in with barge movements, notably from the Midwest to the Gulf Coast, using rail or pipeline for part of the way and then barges down the Mississippi River for the last leg," the industry-backed Canadian Energy Research Institute (CERI) wrote in its oil sands progress report last month.

One example of that new-school commute is a Canadian National Railway Co. (CN) terminal expected to open this month in Mobile, Ala. After disembarking from a CN train, oil sands can take a short pipeline or vessel ride to Gulf Coast refineries.

Even so, the 75,000-bpd CN terminal illustrates the challenge of predicting the oil sands' future without Keystone XL. Oil sands and light crude are both poised to travel there, making its fuel mix dependent on the biggest profit that producers can reap by buying in.

The industry calls the benefit for a real-world barrel, after production, transportation and every other cost is incurred, the "netback."

'An almost ever-changing array'

Higher oil prices and lower production costs generally increase netbacks. Given how depressed oil sands crude prices are in the absence of a White House green light for Keystone XL, using costlier rail to get Canadian fuel to the Gulf also can increase netbacks by letting producers charge higher prices.

The oil industry wants Keystone XL to help diluted bitumen fetch those higher, world-market prices for the long haul. But in the short run, as CN spokesman Mark Hallman explained in an interview, "rail helps producers access markets that are not pipeline-connected."

Regardless of whether construction ever starts on XL or its similarly stalled western-running competitor, Northern Gateway, other new oil sands crude pipeline connections are proceeding. Gateway sponsor Enbridge Inc. is in the midst of a U.S. network expansion likely to rival the entire capacity of Keystone XL, a massive project that does not require a presidential permit to cross the northern border.

If more pipeline connections decrease the netback potential for rail, then, oil sands shipped by train could sputter. But if Brent, West Texas Intermediate and Western Canadian Select prices continue to fluctuate as much as they have, the nimbler qualities of rail could prevail.

"It's not just a matter of adding up barrels" that determines how producers free up their crude for sale, Spector of CIBC observed. "How much value do companies devise from the optionality they might get from rail versus pipeline?"

CERI summed up the state of play in its May report, observing that the political problems plaguing XL and Gateway have sparked "an almost ever-changing array of new developments and proposals."

"[W]e are witnessing a race between production growth and infrastructure restructuring," the industry group wrote.

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