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How ‘Air Barrels’ Let Companies Game the Pipeline System and Cut Prices — and Royalties

While Alberta calls for more pipelines, industry manipulates the current system.

By Andrew Nikiforuk 28 Nov 2018 | TheTyee.ca

Andrew Nikiforuk is an award-winning journalist who has been writing about the energy industry for two decades and is a contributing editor to The Tyee. Find his previous stories here.

Oilsands producers are using “air barrels” to game the pipeline system, reducing capacity, lowering bitumen prices and costing the Alberta government royalty revenues.

While the Alberta government is pressing for more pipelines, the Enbridge Mainline to the U.S. is running almost five per cent below capacity due to chaos created by “air barrels” and a “lack of integrity” in the shipping process.

Moreover the problem has existed for years while provincial and federal governments have done little to end the gaming of the pipeline system.

“Air barrels” is the industry term for shipments that companies overbook on the pipeline system even though they can’t actually provide the oil.

The Enbridge Mainline system has the capacity to transport about 2.75 million barrels of heavy and light oil a day into the U.S.

But earlier this year Canadian Natural Resources Ltd., a major oilsands producer, calculated the pipeline is running up to 125,000 barrels a day below capacity — 4.5 per cent — because companies are booking shipments and not delivering.

And in correspondence with the National Energy Board, oilsands producers Devon and ConocoPhillips argued that “air barrels” or “over-nominations” are causing significant economic harm.

“Air barrels” not only keep pipelines from being full, but can result in lower heavy oil prices. That helps oilsands producers that own upgraders and refineries.

Lower prices for bitumen, a cheap refinery feedstock, also results in reduced royalties for Alberta.

“The oil sector, Alberta government and the NEB have known about the unused capacity for years,” says independent economist Robyn Allan.

“But instead of fixing the problem the regulators allow big players to continue to scam the system, standing idly by while royalty payments to Albertans are eroded” said Allan.

Here’s how the “air barrel” scam works.

Shippers put in orders for space on Enbridge’s Mainline each month. Unlike some other pipelines, Enbridge doesn’t sign long-term contracts. (The Trans Mountain system has also had a long history with air barrels as only 20 per cent of its capacity is covered by long-term contracts.)

When shippers want to transport more than the pipeline’s capacity, as has been the case for the last year, or when pipeline breaks reduce capacity, something that typically happens at least once a year, Enbridge cuts the allocation to shippers.

So shippers will routinely book more space than they need to ensure they are protected even if allocations are reduced. If a shipper wants to move 100,000 barrels, it will place an order for 110,000, anticipating across-the-board allocation cuts.

But the more the industry overbooks, the more Enbridge cuts allocations.

There are winners and losers when reductions are imposed. Limits tend to favour companies with refineries that can process the heavy oil and benefit from lower feedstock prices created as a result of reduced shipments to the U.S.

Steve Laut, vice-chairman of oilsands producer Canadian Natural Resources Ltd., recently told analysts and Bloomberg News that “a few players” often nominate “air barrels” they don’t intend to ship.

That results in space not being utilized on the pipeline, which leaves other producers with bitumen they can’t transport.

Producers with storage facilities or refineries can then scoop up that bitumen at bargain prices. And that increases the volatility of prices for bitumen, a cheap refinery feedstock, in an oversupplied market.

In a letter to the National Energy Board in June, Devon, a U.S.-owned oilsands producer, said the price impact is significant.

“Producers are required to market the post-apportionment barrels at a significant discount to the month index price,” the company wrote. “Over nominations inflate the demand for pipeline capacity and the pipeline apportionment on the Enbridge Mainline and negatively impact the ability of producers to access pipeline capacity to sell their monthly oil production.”

Alberta Premier Rachel Notley said last week that the government will look into the practice.

But a Tyee investigation found the problem has been worsening over a long period without any government response.

In June, lawyers for the Alberta government wrote to the National Energy Board to ask to be included in any review of the allocation system. “Alberta is the owner of significant Crown resources and as such Alberta is interested in matters relating to pipeline apportionment,” they wrote.

Enbridge, which tried to fix the problem earlier this year with disastrous results, now claims “air barrels” aren’t a problem.

“The Enbridge Mainline system is essentially full,” Jesse Semko, an Enbridge spokesman, told Bloomberg News last week. “There is no material capacity to be gained by changing the apportionment and supply verification procedures.”

Enbridge, which runs the world’s longest crude oil transportation system, did not reply to repeated queries from The Tyee.

But Semko’s claim contradicts what Enbridge told the National Energy Board, Canada’s pipeline regulator, earlier this year.

That’s when Enbridge tried to correct the gaming of its Mainline system by abruptly changing to a new system that caused an uproar among shippers, oil traders and refiners.

Enbridge told shippers that any orders above their average shipments for the last 12 months would have to be verified.

The abrupt rule change caused chaos at refineries and prices for Western Canadian Select, or diluted bitumen, dropped by nearly US$10 a barrel.

When Enbridge cancelled the proposed change 11 days later, prices rebounded.

Suncor, Canada’s largest bitumen producer with both upgrading and refining capacity, welcomed the reversal.

“It’s not that the current system didn’t have challenges with it, it’s just that the new system had more challenges with it and it was eroding the value of Canadian crude,” Mark Little, Suncor’s chief operating officer, told Bloomberg.

“We are very thankful that Enbridge backed off, because it’s great to see we’re getting a fair price for the product.”

In contrast BP, which owns a refinery in Indiana, filed a complaint with the National Energy Board about “the sudden and unexpected implementation of the supply verification procedure” and its equally sudden withdrawal.

That complaint generated correspondence from 10 shippers to the National Energy Board about Enbridge’s unsuccessful attempt to end “air barrels.”

The letters reveal a divided industry that can’t agree on how to address a problem that keeps the Mainline pipeline from running at full capacity.

Contrary to the recent denial of an “air barrel” problem, an Enbridge letter to the National Energy Board responding to the BP complaint acknowledged the pipeline operator had a tarry mess on its hands.

“Despite the high apportionment levels, there have been numerous months when many shippers have not filled the space they were allocated, which can result in Enbridge issuing calls for crude, missing opportunities to ship batches and ultimately reduced Mainline throughput,” Enbridge told the NEB.

“Such behaviour indicates that shippers are nominating more than they intend to bring into the Enbridge system; in other words, shippers are nominating what the industry refers to as ‘air barrels.’”

Enbridge said in months when orders exceed capacity shippers will submit as many 3,000 change requests “such as cancellations or changes to receipt and delivery points” after the company has posted its transportation schedule.

These changes, added the letter, result in “schedule inefficiencies and missed opportunities to ship batches, which is problematic when, as is currently the case, pipeline capacity out of Western Canada is in extremely high demand.”

In the same letter Enbridge noted that it has wrestled with “air barrels” for more than two years to no avail.

“Potential solutions have not garnered significant shipper support because, ultimately, apportionment is a zero sum game: every time a shipper gains a barrel through the process, another shipper loses a barrel. Accordingly, any proposed methodology to curb air barrels results in a lack of consensus from shippers.”

BP later replied to Enbridge that it welcomed the commitment to engage with stakeholders.

Other companies were not so kind.

Devon Energy, for example, stated that “air barrels” or “over-nominations” are costing the industry millions of dollars every month.

Devon also noted that gaming the system lowered bitumen prices and therefore royalties. “The lower the producer’s netback price, the lower the Government of Alberta’s royalties for oil.”

ConocoPhillips added that since late 2017 air barrels or “over-nominations” had caused it to “sell barrels at a distressed price in Alberta,” and that the matter couldn’t be fixed “without further direction form the board.”

Three months after the unsuccessful reform effort, Guy Jarvis, executive vice-president of Enbridge, confirmed the problem was getting worse during a second quarter earnings call with investment analysts in August.

“We continue to believe that the integrity of the nomination process is not what it needs to be,” Jarvis told them. “We’re concerned that we are seeing legitimate barrels backed out of the process by nomination barrels that are less than legitimate. And that’s causing pain to some of our customers, particularly in the producing community.”

Enbridge has been imposing cuts of up to 45 per cent on the orders submitted by producers.

“There are so many machinations going on in the market... that our schedule often times gets upset early in the month, and we miss windows and we just simply can't make up the barrels that we thought we would move,” Jarvis said.

“What we're seeing is that the throughput at the end of the month versus what we accepted for nominations is not matching up. And we have to work hard on that and our customers have to work hard on that, because we understand the importance of every barrel.”

Jarvis said Enbridge is working on a plan to eliminate air barrels and would submit it to the National Energy Board sometime this fall.

Canadian Natural Resources Ltd. president Tim McKay reported to financial analysts Nov. 1 that an industry group known as the Crude Oil Logistics Committee tried to fix the problem earlier this year, but failed.

The committee, composed largely of shippers, producers and government regulators, including the NEB as a non-voting member, voted on a proposed solution, but it fell just short of attracting the needed 75-per-cent support, said McKay.

“Right now it is kind of in no man’s land,” explained McKay. “Obviously what we would need is some enforcement that could come through the Alberta government or by industry players agreeing it needs to be fixed.”

Roger Read, the Wells Fargo analyst who asked MacKay about the problem, summed up the current situation: “So essentially, there are winners and losers and some aren’t as interested as others in changing the set up, I guess.”

"Yeah,” confirmed McKay. “And it’s unfortunate in my mind. Seventy per cent is a very strong majority. And that it shouldn’t be more consensus, we should do what’s right to optimize the system.”

The NEB, which sets the rules for pipelines and monitors capacity, decided that “no further board process” was required last spring “as long as Enbridge adheres to its commitments and consults with all interested stakeholders to develop a solution to the apportionment issue.”

Chantal Macleod, a communications officer with the board, wrote in an email to The Tyee that “Actual air barrels on the system has not been demonstrated to the NEB in a formal manner. If a party attempts to make this demonstration, the NEB will assess the information filed, and determine what action needs to be taken.”

The Enbridge Mainline system, she added, “is operating as close to capacity as possible.”

Yet in a recent earnings call, Enbridge said its throughput was 2.6 million barrels a day — 91.2 per cent of capacity, noted economist Robyn Allan.

The Tyee investigation found that the problem has a long history.

In 2010, a major bitumen pipeline spill on Enbrdige’s Line 3B in Marshall, Michigan, forced Enbridge to cut shipment orders.

Flint Hills, the owner of the Pine Bend refinery in Minnesota and a highly profitable Koch Industries subsidiary, lodged a complaint about “air barrels” on the U.S. portion of the Enbridge Mainline system.

Instead of allowing old customers such as Flint Hills to transport what they historically did, Enbridge awarded them a share of existing capacity based on all shippers’ orders.

Flint Hills argued bookings made by shippers rose from 1.35 million to 1.75 million barrels a day. Enbridge imposed a 43-per-cent across-the-board cut based on the orders.

“These nominations were inflated to such a degree that shippers commonly called them ‘air barrels,’” Flint Hills wrote in a complaint to the U.S. Federal Energy Regulatory Commission in 2013.

Enbridge should have based shipping quotas on historical volumes, the Flint Hills said.

Ten other shippers, including Suncor and Imperial Oil, supported the Flint Hills complaint.

In the end the U.S. federal regulator supported Enbridge’s decision to switch to a new system that attempted to verify orders based on the capacity of refineries to actually receive them.  [Tyee]

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