The U.S. Gulf Coast—with its 1.4 million barrels per day of coker[*] refining capacity geared to maximize output of high-value lighter products from lower-cost, heavy, high-sulfur crude oil feedstocks—is an ideal market for Canadian tar sands oil.[1] Two core factors have opened the door to Canadian supplies—which hit 377 thousand barrels per day (“kbd”) in January 2015 (Exhibit 1). First, Gulf Coast refiners need new heavy, sour crude supplies to compensate for declining Mexican and Venezuelan imports. Second, Canadian oilsands producers, who need cash flow to service debt and have multidecade operating time horizons, continue boosting output despite low oil prices.

Canadian oil is now a long-term proposition on the Gulf Coast. Exhibit 1 shows that in 2012 and 2013, Canadian exports to the U.S. Gulf Coast were opportunistic: refiners sought Canadian barrels during that time because they were cheap relative to other supplies. However, in 2014 and early 2015, import levels increased sharply despite Western Canadian Select (“WCS”) crude being less steeply discounted relative to Maya crude from Mexico. This suggests that Canadian crudes are becoming a baseline-heavy, sour supply stream for Gulf Coast refineries.

Complex politics impede pipeline projects, but the market is squeezing crude south via the expanded Seaway pipeline and by rail. The first unit train of Canadian tar sands crude reached the Gulf Coast (Natchez, Mississippi) in March 2014 and crude-by-rail volumes from Canada to the Gulf Coast hit 50 kbd in January 2015, according to the EIA.[2] Rail deliveries will likely reach 200 kbd by the end of 2015 if the differential between WCS and Maya widens to around $15 per barrel—a plausible scenario. The rail utilization impacts of this new trade flow will be significant. The author’s calculations suggests that rail routes between Alberta and the U.S. Gulf Coast could require 30 percent more tanker cars than Bakken-to-East Coast routes in order to maintain an equivalent daily level of crude oil deliveries.

Exhibit 1: Canadian Pipeline and Rail Oil Exports to the U.S. Gulf Coast Have Substantial Room for Growth

Click here to view the image.

Source: EIA, OSI Alberta, Author’s Analysis

Keeping Rail’s Role in Perspective

Pipelines will be the baseload channel for delivering Canadian crude supplies to the Gulf Coast. There are few available substitute crude oil grades for deep conversion refineries needing heavy, sour supplies. This dearth of alternative supplies makes higher-volume, longer-term pipeline agreements attractive from the refiners’ perspective. But rail will play an increasingly important role for producers and suppliers small and large.

For the large producers and shippers, increasing rail access will help them hedge against political problems and rapidly expand their Gulf Coast market share. Indeed, TransCanada’s president of Liquids Pipelines remarked in February 2015 that “rail will be a permanent part of the producers’ transportation solution, in part to access niche markets and in part to manage around … the lumpiness … of pipeline implementation.”[3] For the smaller producers—whose aggregate oil supply potential is significant—rail offers an option to secure reasonable netbacks for the oil without having to expose themselves to the risks of long-term pipeline transportation contracts. In addition, rail can bring what complex, deep conversion refiners on the Gulf Coast desire most: the pure or lightly diluted forms of bitumen that are physically impossible/uneconomical to pump through a pipeline.

Pure or Lightly Diluted Bitumen Makes Rail Economics More Competitive With Pipelines

The current system of shipping tar sands oil primarily involves so-called “diluted bitumen” or “dilbit.” In essence, every seven barrels of bitumen are blended with three barrels of condensate to thin it out and enable it to flow through a pipeline at normal temperatures. Three problems arise from this practice.

First, condensate is a premium-priced commodity in Alberta, costing 25 percent more on average than Cold Lake Blend heavy crude oil between 2012 and mid-2014, according to IHS.[4] If the U.S. further relaxes restrictions on the export of condensate and light crude oils, this would immediately tighten North American diluent supplies and further increase their price relative to the bitumen. Second, Gulf Coast refiners are already saturated with light, sweet crude oil supplies and have no use for the condensate that comprises 30 percent of the incoming dilbit volume. Third, for oilsands producers signing long-term pipeline shipping contracts, the need to secure condensate supplies to dilute their bitumen exposes them to an additional commodity price risk that is difficult to hedge.[5]

Less diluted bitumen (known in the industry as “railbit”) can be brought into the Gulf Coast at 15 percent lower cost than dilbit. Depending on how pipeline and rail costs move relative to one another, undiluted bitumen or “neatbit” can likely be shipped from Western Canada at nearly the same cost per barrel as diluted bitumen moved via pipeline (Exhibit 2). As part of our research, we located four terminals with 230 kbd of steam unloading capacity capable of handling raw bitumen on or near the Gulf Coast and believe the actual total is likely higher.[6]

Exhibit 2: Railborne Bitumen Can Compete on Cost With Dilbit Shipped by Pipeline

Cost from Western Canada to the USGC, USD/bbl

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Source: IHS

Refiners and producers are investing for a railbit/neatbit future. For instance, of the 5,320 tank cars Valero has ordered in recent years (more than 4,000 of which have already been delivered), approximately 45 percent have heating coils to enable them to handle viscous heavy crude oils.[7] Similarly, Cenovus, a large Canadian oilsands operator, is taking delivery of 825 coiled and insulated rail cars for shipping raw or slightly diluted bitumen.[8] For reference, a unit train consists of 100 to 120 cars and the cycle time between Alberta’s Hardisty oil hub and Houston is approximately one week each way.

Despite Regulatory Uncertainty, Canadian Crude-by-Rail Deliveries to the Gulf Coast Likely to Rise Significantly

The crude-by-rail market is currently in a state of tactical limbo driven by uncertainty surrounding new safety regulations that the Department of Transportation is scheduled to release on 2 May 2015.[9] The bigger strategic factor revolves around Canadian shippers’ ability to send unit trains of railbit and neatbit south, as rail shipments of dilbit face unfavorable economics relative to pipelines unless the WCS/Maya spread exceeds $15 per barrel. An industry source with a large Gulf Coast terminal operator tells us that refiners are ready to take more railbit and that the primary constraint is the lack of diluent recovery units in Canada that would allow rail shippers to economically remove diluent from tar sand extracts and create heavier forms of bitumen.[10]

The bottom line is that the longer Keystone XL and other pipeline projects are stalled by politics, the more crude oil cars will occupy the tracks between Alberta and the Gulf Coast refineries. Stay tuned as this rolling pipeline grows rapidly in 2015 and 2016.