PBO report on Trans Mountain purchase is sombre reading

The sticker price Kinder Morgan put on the Trans Mountain pipeline when it entered negotiations with the federal government last year was $6.5 billion. Hence, finance minister Bill Morneau and his team thought they’d scored a bargain when they sealed the deal at $4.4 billion.

But it looks increasingly like he may bought a cat in a sack.

The Parliamentary Budget Officer released a detailed valuation of the pipeline on Thursday and it makes grim reading for the government.

The finance minister leapt on the headline finding that the purchase price was within the PBO’s $3.6 billion-to-$4.6 billion valuation.

But the PBO added the weighty caveat that the valuation range assumes the pipeline will be built on time and on budget.

If anyone really believed that, there would be a line of potential buyers forming outside Morneau’s door, keen to take it off his hands. Suffice it to say, there is not.

The purchase price included around $2 billion for the existing 1,147-km pipeline that runs between Alberta and British Columbia, and a further $2.4 billion for the right to nearly double the pipeline’s capacity to 890,000 barrels a day.

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But after the Federal Court of Appeal quashed cabinet approval for the project last August over inadequate consultations with First Nations and environmental concerns, that became a right the government could not exercise.

Recouping the investment now looks to be a very long shot, as the PBO report makes clear.

The pipeline expansion was initially forecast to be in service by the end of this year. The latest estimate from the project’s management is some time in 2022. The PBO was extremely conservative in its base case assumptions, valuing the expansion at $1.5 billion if construction is completed by the end of December 2021. The value falls by $700 million if it is delayed by a year, as seems entirely possible.

The PBO also used the proponents’ construction cost estimate of $9.3 billion and allocated it a discount rate of 10 per cent. (This essentially reflects the perceived risk of money going forward. The existing pipeline has a discount rate of 6 per cent and the PBO added a premium for the expansion, given it has not yet been built.)

These are generous assumptions and Morneau was clutching at straws when he said the price paid was “appropriate.”

In all probability, the pipeline will take longer to build than anticipated; the construction costs will be greater; and the risks associated with the project mean the discount rate will be higher.

Now we’re on the hook for it

If any of those variables moves in the wrong direction, the value of the pipeline falls off a cliff. For example, PBO estimates that it is not worth the government proceeding with construction if the project is delayed a further two years and construction costs rise just 10 per cent.

What are the chances of that? As one veteran of the government infrastructure projects commented: “I’ve never seen one come in ahead of schedule or below budget.”

As for the risks, they have increased exponentially since the deal was struck with Kinder Morgan in May.

Aside from the Federal Court’s intervention, recent protests over the pipeline to a liquified natural gas plant in northern British Columbia show how difficult building energy infrastructure has become in Canada. In that case, Coastal GasLink had the support of both provincial and federal governments, and agreements with First Nations along the route. That did not prevent the establishment of camps blocking construction, nor the outbreak of protests across the country when the camps were raided by the RCMP.

There are additional threats to the business case for Trans Mountain.
While 80 per cent of the capacity of the expanded pipeline is pre-sold, those contracts may not be as firm as the government might wish. If construction costs go up, so will tolls and the shippers may decide to use other routes. Last November saw 330,402 barrels of crude a day transported by rail — double the volume from the previous year. Analysts suggest shippers no longer view oil-by-rail as a Band-Aid solution.

In question period, NDP MP Nathan Cullen said the government had panicked and overpaid by $1 billion for an aging pipeline — a problem compounded to the tune of $700 million a year, thanks to the delays caused by the Federal Court of Appeal’s decision.

“They were fleeced by a Texas oil company and now we’re on the hook for it,” he said.

That is a judgment made with the benefit of hindsight. If the project does proceed, there will be economic benefits for Canada, not least from the increased capacity of producers to sell oil to export markets, which could reduce the differential between oil sands crude and West Texas Intermediate. The PBO suggested a reduction of US $5 per barrel in this gap would translate into a $6-billion annual impact on GDP.

Morneau and his team may not have been fleeced, but they certainly paid at the high end of the valuation scale, apparently assuming that everything would proceed smoothly.

It is apparent now the plan had holes and they were guilty of sloppiness bordering on negligence by not including a clause making the purchase conditional on a positive court decision.

The PBO report ultimately concluded that if costs rise by 10 per cent or more and construction is delayed further, it makes no financial sense to build this pipeline expansion.

Inevitably, with an election pending, sense — financial or otherwise — will have little to do with it.