Full Price for Kinder Morgan’s Sale of Platte/Express to Spectra

Though there can be no doubt that the Platte/Express crude oil pipeline system which brings crude from Western Canada and the Bakken to markets in the Rockies and eventually the Mid-West is a very valuable asset, it would seem that Kinder Morgan (“KMP”) was able to extract a full price for the system from Spectra Energy (“SE”). As a result, its strange that KMP

KMP was able to sell its interest in the pipeline system for $380 million, or at a distribution yield of 3.9%. This is well below the partnerships distribution yield of 6.3%. Like with bonds, yield and price are inversely correlated, with a lower yield indicating a higher relative valuation.

SE has indicated they are paying a total of ~$1.5 billion for an asset which it expects to generate ~$130 million of EBITDA, or an 11.5x multiple. Growing crude production in Western Canada and the Bakken have caused the Platte portion of the system to be over subscribed as of late, indicating there is minimal room for upside either through additional volumes or through higher tariffs. It is likely SE will try to expand the system to take advantage of this abundance of demand for its services. Looping entire 1,717-mile pipeline system, which begins in Hardisty, Alberta, and terminates in Wood River, IL is not likely to be inexpensive; and given the regulatory difficulties Keystone XL has experienced, the regulatory approval of such an expansion is not likely to be easy. We estimate that an expansion of the full system could cost $2.5-3.5 billion and take two to four years to complete. During this approval/construction period, SE would likely see some dilution to its earnings and DCF as it has to raise capital well in advance of project completion.

However, because Express portion of the system is currently operating at 70% of its 280,000 Bpd of capacity, it may be possible to initially only expand the over subscribed 900 mile 145,000 Bpd Platte section of the system. Expanding the Platte pipeline would allow SE to take advantage of Express’s ability to bring an additional 84,000 Bpd of Canadian crude to the Mid-West. – We estimate the utilization of the Express pipeline’s 84,000 Bpd of excess capacity could generate $15-25 million of annual EBITDA. Depending on capacity of the expansion, we estimate a looping of the 900 mile Plate system could cost as much as $1-1.5 billion. Though this would likely be accretive once completed, SE is still likely to experience some dilution to DCF as it still has to raise capital well in advance of project completion.

Getting Oil Out of the Bakken…

As the Bakken’s oil production growth continues to exceed expectations, oil production is now expected to eventually double or even triple to 1.2 – 2.0 million Bpd. The Bakken’s rapid growth is, however, being constrained by an inability to cheaply and efficiently move the oil out of the region. To this end, we thought we’d take a look at some of the infrastructure alternatives, and see if there might be an intriguing opportunities. Generally, lighter crude oils such as those produced by the Bakken have the greatest demand in the east in  PADDs I and II. This is because many of the PADD I and Ohio refineries have less ability to process heavier oils, as measured by their lower Nelson Complexity Ratings. Generally, heavier oils will go south to the PADD III refineries on the USGC which have been upgraded to process heavier oils.

There are two main ways to transport oil out of the Bakken: (1) by train, and (2) by pipeline.

Currently, because the Dakotas were never a historically prolific oil producing region, oil pipeline capacity out of the Bakken is limited to Enbridge’s (“ENB”) 200,000 Bpd pipeline, and many shippers have had to resort to shipping their oil to the USGC, or even the USEC, by rail. However, there are at least three pipeline systems under construction, and by 2015, pipeline capacity is expected to carry nearly all of the oil production from the Bakken.

Rail vs Pipeline Costs

One might ask why rail, as the incumbent carrier, wouldn’t be able to keep its current share of oil transportation customers. The answer is cost. Transporting oil by rail is dramatically more expensive than transporting oil by pipeline. Though much more expensive than a pipeline on a per barrel basis, rail has one big advantage. Many rail systems are already in place and need a minimal amount of capital upgrades to begin transporting oil. That said, as the $10 differential between the rail cost to St. James and the pipeline cost to the USGC shows, once up and running, pipelines are a much cheaper, more efficient, and more reliable way of transporting oil. However, pipelines are expensive to build, and take a fair amount of time to get permitted and into service.

The $14/Barrel differential in rail pricing to USEC vs to pipeline pricing to Petoka, IL creates opportunity to bring oil into Ohio and to the USEC. Petoka is about the farthest east that one can transport Bakken oil by pipeline. As was mentioned above, the the lack of heavy oil processing capability makes the Ohio and the PADD I/east coast refinery markets an appealing 1.5 million Bpd opportunity for Bakken oil. This said, once up and producing in the next three to seven years, the oil production from the Utica could satisfy 300k of this demand. Nevertheless, a 1.2 million Bpd market should be more than sufficient to support the construction of a pipeline to the east coast from the Midwest.

Bakken to the Midwest

To get oil to the USEC and to Ohio, transiting through Cushing, OK seems unnecessary, adding additional distance and cost to the trip. That said, skipping Cushing will eliminate OneOK (“OKE”) and TransCanada’s (“TRP”) Keystone XL pipelines as potential carriers out of the Bakken. Skipping OKE and Keystone XL will leave ENB as the main pipeline alternative out of the Bakken.

If one takes either OKE’s or Keystone XL’s pipeline from the Bakken to Cushing, to get east, one will need to use ENB’s Ozark Pipeline to Wood River, IL or BP’s pipeline to get to Whiting, IL. Using either of these two alternatives does not seem like a cost effective alternative to using one of ENB’s pipelines the whole way from the Bakken. ENB’s mainline can get crude from the Bakken to Toledo, OH, or to either Chicago or Patoka, IL.

The High Prairie Pipeline, a yet to be built pipeline out of the Bakken is currently fighting with ENB to interconnect with ENB’s mainline at Clearbrook, MN. Another option for High Praire to move its crude south and/or east might be to interconnect with the Koch (Minnesota/Koch) pipeline system. Koch’s Minnesota Pipeline begins at Clearbrook, MN, and then interconnects with the Koch Pipeline in St. Paul, MN. The Koch Pipeline terminates at Wood River, IL. Because there are a lot of historical relationships between High Prairie’s management team and Koch, many members of High Prairie’s management team used to work at Koch, we feel like this could be a easier and better alternative than interconnecting with ENB.

Possible East Coast Pipeline Partners:

As oil production in the Utica ramps up, it is likely that local refiners in Ohio (Marathon, Husky, BP/Husky, and PBF) will absorb most of the 300k Bpd of light oil produced by this formation.This however, does not mean that there isn’t a need for pipeline infrastructure to get oil from Ohio to the PADD I refineries, most of which seem to be clustered in and around the  Philadelphia area. This pipeline need will play to companies who already service some or all of these refineries for either crude delivery or refined product take away capacity and to those companies who can aggregate disparate pipeline networks and rights of way. We see some possible players as being the following:

• Marathon Petroleum (“MPC”)
  • Has rights of way, and crude and refined products pipeline connections to terminals and refineries in Ohio.
  • Marathon Pipeline connects Petoka, IL to Marathon’s refineries in Ohio.
  • Does not have pipeline connectivity east of Ohio.
• Sunoco (“SUN/SXL”)
  • Has rights of way and pipeline connections from many of the Philadelphia area refineries to markets in Pennsylvania, Ohio, and Michigan.
  • Also controls the Inland Pipeline, a refined products pipeline which connects three refineries to eastern Ohio and western Pennsylvania markets.
  • Could be possible to use rights of way and underutilized/unused pipe to get crude from either Toledo or one of Inland’s Ohio refineries to Philadelphia.
• Buckeye (“BPL”)
  • Has rights of way and refined products connections to terminals and refineries in Pennsylvania, Ohio, New York, and New Jersey.
• Enterprise Products (“EPD”)
  

• EPD owns the interstate ATEX pipeline.
• Though it crosses Indiana, Ohio, and Pennsylvania, ATEX is primarily a NGL pipeline and does appear to connect to refineries.

Conclusion

ENB seems poised to be the dominant transporter of crude, not only from Canada, but also out of the Bakken. However, a good counter balance would seem to be a combination of the MPC pipeline network and either the SUN/SXL or BPL pipeline network. This combination would create a pipeline network which serves a thirsty but under-served region with 1.5+ million Bpd of light oil demand.

Getting North American Crude Production to Market

With 3.8 million Bpd of refining capacity and more than 3.5 million Bpd of oil supply either from within PADD II, or from near by Canada, PADD II refiners (ex Marathon (“MPC”), Phillips 66 (“PSX”), and BP (“BP”) are geographically well positioned to absorb much of the increasing oil production from the oil sands in Western Canada, and the Bakken and Utica formations.

This said, over the next 10-20 years, total oil production from these regions is expected to more than double, with the great majority of this increased production being heavy oil from the oil sands. To take advantage of this, many of the PADD II refiners who have low average Nelson Complexity ratings, are retooling some of their refineries to be able to handle some of the cheaper heavier grades of crude. The Nelson Complexity Index measures a refinery’s ability to process inferior quality crude or heavy sour crudes. It also measures a refinery’s ability to produce a high percentage of LPG, light distillates and middle distillates and low percentage of heavies and fuel oil.To date, three PADD II refiners have announced capital plans which will allow them to take advantage the price differential between the cheaper heavier crudes which come from Canada and the lighter crudes which these refineries had been importing from PADD III. Even if PADD II refiners displace all of the crude oil they currently import from PADD III, Western Canadian producers will still have to find buyers for this incremental production. With over 9 million Bpd of refining capacity and the ability to process heavier crude oils like the oil produced by the Canadian oil sands, the PADD III refineries on the USGC would seem to an optimal home for this incremental North American oil production.

In order for Canadian oil producers to be able to take advantage of the 9 million Bpd refining market in PADD III, there needs to be sufficient cross border pipeline to import the oil into the US. Additionally, there needs to be sufficient north to south pipeline connectivity to bring the crude from the upper Midwest to the USGC.
With just 2.5 million Bpd of current oil imports from Canada and 3.8 million Bpd of current Canada-US pipeline capacity in operation, over 1 million Bpd of excess cross boarder capacity would seem to be sufficient. However, with Canadian production expected to double, and with the long lead times which are often needed to build a pipeline, it’s important keep ahead of this production increase to keep as much of the oil in North America as possible. Regardless of this sentiment, three pipeline expansions totaling nearly 1.5 million Bpd of capacity are in development.The TransCanada’s Keystone XL pipeline is intended to service the USGC and upper Midwestern refinery markets. The Canadian oil producers are especially excited about the Enbridge (“ENB”) and Kinder Morgan (“KMI”) pipelines as they are largely intended to create a second market for Canadian crude by servicing Asia’s growing demand. Having a second buyer for its crude is likely to benefit Canadian oil producers by introducing some price competition for Canadian crude.

Southbound Crude Pipelines

In addition to needing cross border pipeline connectivity, selling crude to the USGC will require an enhancement of the North south capacity from Midwest/Cushing to USGC. Lack of north to south pipeline capacity south of Cushing has been causing oil inventories in Cushing to pile up.

• To date, the reversal of Enterprise Products (“EPD”)/Enbridge Seaway pipeline has increased the Cushing to USGC capacity by 150k Bpd. This is hardly sufficient to keep up with the increase production, but Seaway is due to increase its capacity to 400k Bpd by early 2013 and to 850k Bpd by 2014.
• While the cross boarder portion of Keystone XL is still waiting approval, Keystone’s Cushing MarketLink pipeline is due to be completed in 2013. This will bring an additional 500k Bpd of crude south from Cushing to the UGCC.
• Finally, according to a FERC regulatory filing, Energy Transfer (“ETP”) is in the process of getting FERC approval to reverse the flow and change the service of one of the three parallel pipelines of its Trunkline gas pipeline system. Once approved, using an existing and contiguous pipeline should allow ETP to begin shipping oil south from Tucola, Illinois to connect with Sunoco Logistics’ crude oil system in the Buna, Texas region by early 2014. Without entering into a partnership with a Bakken or Canadian crude gather, not having direct access to Canadian crude may hinder ETP vis-à-vis Enbridge and TransCanada as ETP’s two competitors will be able to offer a one stop shop to get crude from Canada to the USGC.

When all three of these southbound pipelines enter service, they should bring an additional 1.6 million Bpd of oil to the USGC. This should be sufficient to keep up with production increases for the next few years, but may be insufficient in the medium to longer term.

PADD I Market Potential

An additional but much smaller market, for some of the growing North American oil production could be PADD I refineries on the east coast. These refineries have never had very good terrestrial crude oil access to the rest of the country. As a result, they have imported a lot of oil from North and West Africa. Because these refiners have not spent capital to upgrade their ability to refine heavier and cheaper grades of crude, they would not be able to take advantage of much of the new heavy oil production from Canada. Rather, they will be forced to buy from the Bakken and once its up and running, from the Utica. They will also be able to take advantage of some of the lighter crudes which are being displaced for heavier crudes in PADD II. All this said, PADD I refiners will probably the most eager buyers of domestic crude as they currently have to pay for premium seaborne crudes which are priced at a premium to North American crudes.