Pipe Dreams: Exporting Canadian Natural Gas

In a world of rising fuel costs and environmental concerns, natural gas seems like a natural fit. It is cleaner than most alternatives, cheap, and abundant, positioning it as a promising part of the Canadian economy. Historically, producers such as EnCana (who extract the commodity) and distributors such as TransCanada Pipelines (who link supply to demand) have relied on infrastructure designed to connect supply in Western Canada with demand in Eastern Canada and the United States.

Starting in 2009, however, the natural gas market began a fundamental shift. Technological advancements unlocked previously unrecoverable reserves across North America that permanently increased supply. As a result, TransCanada finds its existing pipelines poorly positioned for this new environment, creating significant headwinds for their business. This is a structural market shift and if TransCanada is to remain North America’s leading pipeline company, it must connect its current supply with the region where Canadian gas is most competitive: Asia.

Asian Opportunities

TransCanada’s business model requires large investments in energy assets (pipelines and power plants) that generate stable cash flow over long payback periods. Traditionally, the gas in TransCanada’s pipelines has almost exclusively come from the Western Canadian Sedimentary Basin (WCSB). In 2009, an unprecedented glut of supply in the Eastern United States drove natural gas prices downwards, and consequently decreased gas drilling rates in the WCSB. Lower drilling activity means less gas travels through TransCanada’s pipelines. Of greatest concern, in the past five years, volumes have dropped over 70% in the “Mainline,” an asset representing 13% of TransCanada’s $8B 2010 earnings. Due to low volumes, TransCanada had to increase its prices to recover operating costs. This made shipping gas even less attractive.

There is no true global market for natural gas because the commodity is so difficult to transport, resulting in disparate regional prices. To transport natural gas across the ocean, it must be liquefied and shipped by specialized tankers. As a result of limited domestic supply, Japan, Korea, and Taiwan (JKT) have relied on liquefied natural gas (LNG) to meet their energy needs. This gap between domestic supply and demand results in natural gas prices as high as $16.25/mcf ($/thousand cubic feet), a stark contrast to North America’s price of roughly $3.25/mcf. Currently, there are no pipelines or liquefaction plants to connect Canadian supply with Asian demand, forcing producers to forego Asia’s more lucrative prices. Recently, producers have taken notice; there are several proposals to ship liquefied natural gas out of Kitimat, British Columbia and the Gulf of Mexico.

Canadian LNG Exports

In Canada, natural gas producers are feeling the pain of depressed prices. If these persist, producers will have no choice but to stop production. Large players with strong balance sheets have recognized this risk and have plans to access higher prices using LNG. Apache, EOG, and EnCana currently represent Canada’s first step into global LNG markets. Their project “KM LNG” includes a 1.4 Bcf/d (billion cubic feet per day) export terminal in Kitimat and the 1 Bcf/d Pacific Trails Pipeline connecting the terminal with supply. This terminal could provide an additional $1.3 billion in revenue annually on gas they are already producing.

Shell, Progress Energy, and Nexen, amongst others, have also recognized the value in exporting Canadian gas. Three further export terminals are slated to be online by 2020, which, if constructed, will raise Kitimat’s export capacity to 5 Bcf/d: approximately one third of total current Canadian natural gas production.

Global Market for LNG

JKT currently meets energy needs by purchasing LNG under longterm contracts from Indonesia, Brunei, and other Asian natural gas exporters. However, many of these suppliers face a combination of shrinking supply and rising domestic demand, raising the possibility that these contracts will not be renewed. It is therefore forecasted that JKT will face a shortage of gas mid-decade that Canadian LNG is primed to fill.

Canadian companies may face competition, as other countries prepare for the anticipated Asian shortage as well. Qatar is expanding its LNG export capacity to become the largest gas exporter in the world. Not to be outdone, Australia has 13 proposed LNG export terminals in addition to four already operating or under construction. In Canada’s favour, many of these proposed terminals are facing political and economic pressures. Presumably, JKT will prefer to contract with politically secure states with stable regulatory environments that can meet their demand mid-decade and beyond. Shell and Progress Energy have also managed to secure Asian energy firms as partners in their upcoming Canadian projects, perhaps providing Canada with an edge.

In the global LNG market, the wild card is demand from developing Asian economies such as China, India, and Thailand. Since gas can be piped from reserves on the Asian continent, these economies do not face the same supply constraints that confront JKT. LNG in these markets will serve to fill the gap between continental supply and demand. With global economic uncertainty clouding growth prospects for these nations, the rate at which these markets develop an appetite for natural gas and the need for LNG imports is uncertain.

TransCanada’s Position

With the potential for 5 Bcf/d of supply committed to Asia, the amount of gas left to be transported through TransCanada’s pipelines is limited. Assuming Shell, KM LNG, and BC LNG come online by 2020, the supply available to TransCanada for shipment drops over 20% from current levels. If all proposed export terminals come online, TransCanada’s position is even weaker. While some of this downside will be tempered through alterations of their pipeline toll structure, the position of their existing natural gas infrastructure remains weak. This, compounded with regulatory concerns faced by their Keystone XL pipeline, leaves the strength of TransCanada’s competitive position less clear.

Fortunately TransCanada can still become the primary shipper of Canadian gas to Kitimat. Current existing and proposed pipe capacity to Kitimat is only 1.2 Bcf/d. To preserve its status as Canada’s premier pipeline company, it is imperative that TransCanada own and develop infrastructure connecting the WCSB to export terminals in Kitimat.

TransCanada’s Strategy

TransCanada’s first step should be to acquire the Pacific Trails Pipeline from Apache, EnCana and EOG. Building the Pacific Trails Pipeline in BC is risky due to the mountainous, rocky terrain and unresolved First Nations land claims. TransCanada’s risk-averse business model does not fit with building this project; however, TransCanada would likely fare well as its operator. The core competencies of Pacific Trails’ current owners do not include operating large natural gas pipelines. These companies (especially EnCana who has been heavily divesting assets) would likely be willing to sell their de-risked project to a pipeline operator given adequate consideration, including first rights to space upon completion.

TransCanada’s competitor, Spectra Energy, is a motivated bidder as well; Spectra owns the major natural gas pipeline connected to Pacific Trails which makes this project a tempting target. The company that owns a controlling stake in Pacific Trails controls the export terminal’s gas supply, an enviable market position. Of note, however is the different geography of Spectra’s assets; the firm is currently making large capital investments developing its Eastern US assets, while its BC system is entirely isolated. Unlike Spectra, TransCanada is entirely dependent on the WCSB, and investments in this area represent an extension of its core business. Additionally, Pacific Trails would allow TransCanada to recapture lost volumes that LNG sales represent. TransCanada is well positioned for this acquisition and should be able to outbid Spectra for the rights to Pacific Trails.

The second step is to approach Shell or Progress to become the exclusive shipper of their gas to its proposed export terminals. TransCanada would connect existing pipe infrastructure in Alberta to Kitimat with a 2 Bcf/d pipeline. As a complement to Pacific Trails, it could share existing right of way and infrastructure which will dramatically reduce construction costs. Additionally, TransCanada would become the sole high-volume gas shipper to Kitimat, allowing them to capture more value from the Asian-Canadian price differential. Building the pipeline for Shell or Progress would allow TransCanada to almost fully recapture the gas flows lost to the rest of its system, and due to the toll structure, charge a higher rate per distance than its can charge on its older assets.

Finally, TransCanada should build a natural gas power plant at Kitimat to meet new industrial demand in the area which consumes enormous amounts of electricity. There is insufficient generation capacity in BC to meet growing demand without the government breaking its promise of electricity self-sufficiency by 2016. The power plant provides a synergistic low risk, long term capital project which diversifies revenues and lowers risk for TransCanada’s BC operations. The power plant represents an additional customer for its pipeline, provides electricity to local mines and industry, as well other provincial consumers. This additional gas buyer decreases risk for TransCanada and the sale of electricity would provide an additional 10% increase in revenues. Only TransCanada’s management has the experience to successfully develop and operate a power plant of this scale. This extra vehicle of return represents an additional competitive edge, especially when bidding for Pacific Trails, as TransCanada could accept lower returns on the pipeline.

Once built, these three projects will generate over $1 billion dollars in revenue annually. Although TransCanada is well positioned to gain from the North American LNG revolution, history has shown that natural gas markets are fickle. Prior to 2009, the North American gas story was also one of shrinking supply and future dependence on LNG imports to meet demand. Billions of dollars were invested to build import capacity to fill the gap in supply.

Unfortunately, that gap never materialized and billions of dollars of investments were wasted, including some of TransCanada’s. The energy industry is very volatile and presents sizeable risks for every investment. Despite the industry’s riskiness, LNG exports are likely to materialize, grow, and develop into a market of their own. TransCanada cannot afford to be left behind.