Keystone XL and the Future of the North American Energy Market

c. 2011, Sean Daly


When the Canadian dollar is trading at $1.20 U.S. and they’ve just announced Exxon has taken out Imperial Oil and plans to double their investment in the Canadian tar sands, this will get on the radar screen.


--Jeff Rubin, former chief economist at CIBC World Markets [1]


I believe the U.S. is going to continue to import oil for decades to come. They consume 10 million barrels per day. . . . I do believe that the Canadian oil sands are going to continue to develop, that growth is going to accelerate, and that there's going to be a need for new pipeline out of there.  The key trend will ride on the oil side, and that's going to lead to all kinds of laterals and tankage and all kinds of things in that business for us.

-- Russ Girling, CEO, TransCanada [2]


I have seen the future.

It skulks nervously and just tracked tar across your carpet.

It’s been touched by a bitumen that snakes down from northern Alberta, a gummy substance that presents the American polity with a stark near-term dilemma. Yes, Green may be the angel of our better nature, but the “golden arm” still screams out for another hit of ol’ petrol.

Canada’s oil sands will be a big topic of discussion in early 2011. The Athabasca oil sands hold almost 1.7 trillion barrels of oil. It’s been called a “new Saudi Arabia.” TransCanada’s (TRP) proposed Keystone XL pipeline will profoundly re-direct this oil southward. This $7-billion expansion would lay another 1,800 miles of new 36” diameter pipe across the continental US and double TRP’s heavy crude deliveries into the U.S. to 1.1 million barrels per day. Since it transgresses a national border, the contentious project presently awaits U.S. State Department approval.

Keystone XL is a project reminiscent of the Alaskan pipeline in scale and circumstance. Both are reactions to higher oil prices, local depletion and geo-political instability. Both are mega-level infrastructural projects, spanning a good portion of the continent. Both will be sired by meta-level Washington operative Bechtel Corp.

As this new pipeline and its oil soon take center stage, its opponents and allies are already prepping for total war in the court of public opinion. Expect Newsweek covers and annoying TV ads.

Imagine Keystone XL as a bulging new artery set to expand and re-orient US energy security. Tapping this oil will have consequences. There are plans to route cheap Asian steel to Alberta down from the MacKenzie River’s icy mouth; there are miles of pipe over major aquifers; there are refineries being revamped in Houston’s Ship Channel area; there are vast lakes of toxic waste water that kill birds on contact.

The transport, refinement, and remediation issues of this oil will be the basis for a new economic model that stretches north-south across the continent, literally from the Arctic Sea to the Gulf of Mexico. A few companies will do very well.

Approval for XL was delayed in 2010 and is now expected to occur by early 2011. Why am I confident of approval? Is it the $20 billion that refineries in the U.S. Midwest and along the Gulf Coast have already invested in heavy crude refining assets? Is it that Paul Elliot, a close Clinton confidante and her former campaign director, heads the TransCanada lobby effort in Washington? Was it in the quiver of Hillary Clinton’s voice in response to an XL question at a conference last month, or that she said she was “inclined” to approve it back in October? Yes, all of the above. But there is something a bit bigger going on.

Environmental fears of water and air pollution will be vetted, but the issue of Keystone XL has already entered the crush zone of geopolitics.

According to the US Energy Information Administration, the top five oil suppliers to the United States in May 2010 were --in descending order--Canada, Mexico, Venezuela, Saudi Arabia and Nigeria. They represented 59% of imports collectively.

Fortunately, our two top suppliers of crude oil are Canada and Mexico. According to the latest statistics, Canada contributed 21%, while Mexico supplied 11.7%.

Unfortunately, Mexico’s oil depletion continues. Like the following chart suggests, it will see serious declines next year as will the UK, Norway, and the US.  The country has seen steady oil depletion over the past seven years. Cantrell, its mega-field, has become the textbook example of Peak Oil.

According to Mexican Energy Minister Georgina Kessel, output will likely average 2.55 million barrels a day in 2011, down from 2.58 million in 2010. In her December 6th address she went on to assure the audience that, “From there on, we’ll continue to increase, very gradually, our production.”

Analysts are not so sanguine. Alejandra Leon, an analyst with Cambridge Energy Research Associates, based in Mexico City, responded to the report saying that Pemex “was betting in the implementation of new contracts to revert the falling production.” She estimates that Pemex won’t be able to stop output declines until 2018. New innovative techniques will be needed but investment has been slow to move.

Not only will Mexico’s imports to the US be drying up, but this may have consequences for the country’s GDP and tax base. Pemex is the government’s greatest source of income, responsible for financing 40% of the federal budget.[3] The government celebrates its ownership of the industry. It has long subsidized gasoline prices, a venerable plank of its state populism that has existed for decades. Depletion will hurt the tax base and a repeal of the subsidy would likely cause unrest.

Iran just recently repealed its Khomeini-era gasoline subsidies and prices quadrupled. (It’s still unclear whether this effort at furthering oil sales abroad will create social instability as protests have been curtailed with truly iron-fist police action). Imagine what might happen if Mexico, already a “failed state” candidate according to CIA white papers, saw its gasoline price quadruple. Its law enforcement agencies have enough problems coping with the cartels. The Keystone XL termini at Houston and Port Arthur will allow for a profitable export of diesel to Europe in the near future. It may also offer Washington the more distant hedge of using Canadian oil to prop up Mexican prosperity after 2020.

When we look to our third provider, Venezuela, we also see production problems in 2011. Back in heady days of “21st century socialism,” Chavez took over PDVSA and declared it a revolutionary instrument.

Though a recession and 30% inflation blighted the country undeniably in 2010, the government still insists that PDVSA is thriving. But according to a leaked Oct. 2009 U.S. Embassy report, "equipment conditions have deteriorated drastically" since the government expropriated some 80 oil service companies earlier that year. It said safety and maintenance at the now state-owned oil facilities were in a "terrible state."

According to another source (also exposed via Wikileaks):

Chevron (CVX) was funneling profits to the U.S. and no longer investing in Venezuela, the manager said. An executive at oil exploration company Baker Hughes Inc (BHI) said the firm had a similar strategy and “received a congratulatory message from BHI corporate headquarters for not growing the business (and increasing its risk exposure).[4]

A senior manager from Chevron estimated the state oil company’s output at 2.1m to 2.3m barrels per day, well below official declarations of 3.3m.

Declines in production will further US need to tap more Canadian sources, though Venezuela’s eventual pumping of more heavy oil will synch well with our refinery investments in Houston and Port Arthur. According to a December 2 report, China is moving on Venezuela’s heavy fields. Beijing is investing more than $40 billion in the oil- and gas-rich eastern Orinoco belt by 2016. The new found economic viability of this heavy oil is complicated by China’s own voracious needs.

With declines expected in the US, Mexico, and Venezuela, where can we expect a pickup in production? OPEC production capacity will be tight, though Iraq is a wildcard. I see only Canada, Iraq and maybe Columbia in a position to alter the near-term supply.

Let’s not underestimate the impact of the Gulf spill for putting the limelight on Alberta. As Jeff Rubin, former chef economist at CIBC, colorfully suggested last month: If you’re the board of Exxon or Chevron, you’re saying look, 'Those guys at BP just messed up, they were the No. 1 at deep water drilling, and they lost $40 billion—is this really worth it to us? Let’s go to Edmonton. Let’s go to Fort McMurray'.

Exxon (XOM) is making massive investment in the oil sands, moving so many mega-loads of equipment from Idaho to Canada that last month it became an issue of the governor’s office. So many slow-moving wide-load trucks were likely to cripple traffic lanes and crimp commercial activity in the state.

At present, 16% of US oil imports comes from Alberta, but that number should expand drastically in the near future. Collectively, the oil majors BP, Royal Dutch Shell (RDS.A) and Exxon have already committed $125 billion to Alberta production over the next 20 years. And that number will rise.

Of the 1.25 million barrels extracted daily from the oil sands, 1 million of it goes directly to the United States. According to the National Resource Defense Council, by 2020, the total US imports from Alberta could be as high as 5 million.[5]

How does one play this historic re-orientation towards heavy and unconventional Canadian crude? One under-the-radar choice is Graham Corporation (GHM), a designer and manufacturer of critical equipment for the oil refining, petrochemical, and power industries. As I discussed in my December report, 2011 is likely to be a banner year for the company as the “$100 oil” mantra becomes an inevitability and more robust investments in heavy crude refining pile on.

Three recent orders suggest the firm’s new found connection to the oil sands market. The first order was for a custom-engineered surface condenser and liquid ring pump package at an oil sands processing facility in Alberta, serving as a “vapor recovery unit” for bitumen storage tanks. A second order is for a similar package destined for a U.S. refinery and designed to reduce the sulfur content in transportation fuel. And just days ago, on January 7, the company reported an ejector system that will be bound for yet another refinery being revamped for Alberta’s oil.

According to Graham CEO James R. Lines:

We were encouraged to see several large orders break loose during the quarter, particularly our win for the oil sands project. I believe that the oil sands order is important because it is Graham’s first in the extraction/production process. Investment in new oil sands production is expected to ultimately lead to increases in capacity for the upgrade process where Graham has historically had a strong presence. . . .Graham continues to benefit from sulfur reduction initiatives in North America.[6]

Graham’s business is very cyclical and highly dependent on the energy markets. By the firm’s own admission, Graham’s markets tend to bottom 18 months after the bottom of a recession. Back in early 2010, Graham forecasted that the next two quarters would mark the bottom in their market. The post-drop upswing is now occurring.

This cyclicality –with its lumpy excesses at a certain span of each recovery—is what will put the stock in the “sweet spot” within the next two quarters. More heavy oil usage, more LNG facilities, more diesel sent to Europe –these issues will drive the sector’s growth. Like Chart Industries (GTLS), another of my December report picks, it is positioned for these exact developments.

While Graham is currently is very wedded to oil refineries and other petrochemical powered projects, they are technically “energy agnostic” --their products work for geothermal, natural gas, and bio-fuel power. They also do fertilizer-related facilities and their new acquisition (see below) adds nuclear installations to the mix.

A lot of the company’s new growth in revenue should fall to the bottom line. Normalized cap-ex for GHM runs between $1 and $2 million per year. As small 204 M cap company, Graham can generate lots of excess capital and cash when it is at this point in the cycle. It’s a financially strong company with a cash balance of over $70 million, no bank debt, impressive inventory turnover, and gross margins standing at near 30%.

GHM Industry Quick Ratio 2.76 0.27 Current Ratio 2.89 0.39 LT Debt to Equity 0.17 6.09 Total Debt/Equity 0.25 8.19 Inventory turnover TTM) 9.88 1.13

Last quarter (2Q11), GHM reported earnings of $0.16, beating the consensus estimate of $.07 set by analysts a full 128.57%. Revenue increased 18% from the 1Q11.

For the coming quarter –the third quarter 2011-- analysts estimate GHM will earn $0.13 per share, an increase of 67.01% over the prior year third quarter results. Revenue is expected to be $18.4 million, an increase of 50.90% over the prior year third quarter results. Fourth quarter revenue should really pop, with analysts expecting between 20.2 and $25.5 million.

Fears that the GHM might make a poor acquisition with its growing war chest ended December 15 when they purchased Energy Steel and Supply. It was -- I believe-- an excellent choice. The firm brings in expertise and demand from the “nuclear build-out” space, an area that is seeing real growth in Asia, and one that –like GHM’s refinery business—privileges exacting, “systems critical” quality over price. It will also smooth out earnings.

Graham gets less Street scrutiny due to its niche size and intense cyclicality. That is why you are prone to see wild upside surprises at certain time periods.

Remember: from April 2008 to July 2008, a similar moment of expensive oil and intense energy capacity build-out, Graham blasted from 18 to 53 in four months.

As we saw last month with GE’s purchase of Wellstream, companies offering specialty products for the energy market may be acquisition targets this season. Though there was a Brazilian angle to that purchase, GE (GE) will continue to expand its oil services business into areas where it can deploy its “technological edge.”

Graham’s clean balance sheet, its focus on Tier 1 products of exacting quality and a demand that now spans a wide spectrum of the energy market might make it similarly attractive.



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