Outlook Clouded for U S - Canada Cross-Border Trade

Michael R. Waller

ince the mid-l980s, cross-border natu- S ral gas trade between Canada and the United States, consisting almost entirely of the export of Canadian gas to U.S. markets, has grown significantly. The Department of Energy (DOE) reported that in the first quarter of 1993, long-term imports from Canada were 26 per- cent higher than in the same quarter last year. Overall imports (both long-term and short- term) were up about 12 percent. For 1992, imports from Canada were 21 percent higher than for 1991, according to the DOE. Over the last ten years, both the annual quantity of Canadian gas entering U.S. markets and the share of the U.S. gas markets held by Canadian suppliers has increased si@icantly. It is esti- mated that 2.3 trillion cubic feet of Canadian gas was exported to the United States in the contract year that ended October 31, 1993.

Growth from a Number of Factors

factors: This growth is attributable to a number of

The elimination by the Canadian gov- ernment in the mid-1980s of a single, regulated border price for gas exported to the United States that was set well above marketclearing levels The resultant attractive unregulated prices for Canadian gas (due largely to the relatively low finding and operating costs that characterize Canada's west- em sedimentary basin) The willingness of Canadian sellers to enter into long-term contracts (includ- ing contracts for terms long enough to satisfy the financing requirements

of indepen- dent power Michael R. Waller Is a p a m r In the

law firm of LeBoed Lamb, Leiby & project de- MacRae, in Washington, UC. velopers)

The substantial amount of new Canadian and U.S. pipeline put into service to move Canadian gas to U.S. markets over the last five years (TransCanada Pipelines Limited alone has doubled its capacity in the last four years) The decision of the National Energy Board of Canada (NEB) to no longer apply a restrictive "social cost-benefit test" it had previously employed in determining whether to approve applications for ex- port licenses

Warning Signals One might, therefore, conclude that the out-

look for U.S.-Canada cross border trade in natu- ral gas is quite rosy. In my view, although sales of Canadian natural gas into U.S. markets will remain strong, there are warning signs that the level of growth in such sales in recent years, particularly in long-term sales, may not be sus- tainable. Once again regulatory obstacles could possibly interfere with what has recently been a very smooth transactional flow.

. - . warning signs that the level of growth in such sales I - . There are three interrelated reasons for con-

cern: the looming end of the Canadian gas deliverability bubble; the effect of higher gas prices, caused in part by prices for exported gas, on the eastern Canadian provinces, whose indus- tries and economies are in the grip of a continu- ing recession; and the election of a majority Liberal government in the Canadian federal par- liament, placing Liberals in control of energy policy for the first time in a decade.

End of the Canadian Bubble As in the United States, the addition of gas

reserves in Canada through investment in gas

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drilling and development operations has not kept pace with production over the last several years, due principally to low prices caused by the substantial surplus of deliverability over demand. Canadian gas reserves declined about 7 percent in 1991 and 1992, while demand for gas has increased, driven by low prices, a booming export market (particularly for long- term contracts), and environmental concerns over the use of other fuels. Inevitably this has finally resulted in a closer balance between supply and demand.

. . . more adverse to Canadian gas consumers than to US.

consumers.. . This relative balance between supply and

demand in both the United States and Canada is now beginning to have the result of raising wellhead prices for gas in both countries. This result is not necessarily unhappy, because rising prices will induce increased supply (Canadian gas well completions reached a ten-year high in the first ten months of 1993). In turn, the new supplies will tend to damp down the upward price trajectory.

Canadian Government in the Act However, in the near term, tightening of the

supply/demand equation does not bode well for cross-border natural gas trade. Both the NEB, with respect to applications for export licenses, and the Alberta Energy Resources Conservation Board (AERCB), with respect to permits to remove gas from the province, re- quire that the seller demonstrate that it has uncommitted reserves sufficient to meet the seller’s obligations over the term of its export contract. There is anecdotal evidence that U.S. buyers seeking long-term firm supplies from Canada are finding fewer sellers with uncom- mitted reserves sufficient to enter into such contracts, particularly contracts with terms of fifteen years or more, which are necessary to support the frnancing of adependent power projects. In late August, reflecting the growing concern about sufficiency of supply to meet Canada’s domestic requirements, the NEB an- nounced that it intended to conduct an assess- ment of the current status of Canadian gas reserves and deliverability, the results of which will be: used in determining the appropriateness of licensing additional exports.

The NEB’S “Reasons for Decision” released in November in TransCanada’s application for a 71.8-million-cubic-feet-a-day expansion of its facilities (almost all of which will carry gas for export) reflects the agency’s growing concern over the ability of Canada’s gas resource base to support continued rapid growth in exports. Although the NEB approved TransCanada’s expansion, it questioned TransCanada’s show- ing of future gas supply capability, fmding the estimate to be ”at the upper end of a plausible range of estimates of future gas supply,” and pointed out that its own estimate is signifi- cantly lower.

Price Spike Hurts Eastern Canada The price impact of the shrinking supply

surplus on Canadian gas consumers has been fairly dramatic. Eastern Canadian LDCs have seen the price of their western Canadian system gas supplies increase from a level of Can$l. 57- Can$l.70 a Gigajoule (a Gigajoule is roughly equivalent to a million BTUs) last year to Can$2.32-Can$2.38 a Gigajoule for 1994. Addi- tionally, the new price terms for sales to eastern Canadian LDCs are indexed to prices on the NYMEX, which links their gas costs not only to developments in the U.S. gas markets but also to changes in the currency exchange rate.

. . . long-running recession

.has resulted in increasing complaints I . .

The effect of higher gas prices in the North American gas market is relatively more adverse to Canadian gas Consumers than to U.S. con- sumers because of the substantial loss of value of the Canadian dollar against the U.S. dollar over the last two years. Eastern Canadian gas consumers must now compete with U.S. buyers for western Canadian gas supplies, but the eastern Canadian buyer pays a nominal price (in Canadian dollars) that is almost 40 percent higher than the price paid by the U.S. buyer in U.S. dollars.

In eastern Canada, a long-running recession has resulted in increasing complaints that the prices being paid for gas exported to the United States are raising energy costs in Canada and harming the competitiveness of Canadian in- dustry. Under current NEB regulations, a com- plaint procedure is the only means by which a Canadian gas consumer can attack a proposed

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export sale. The complaining party must show that it cannot obtain gas supplies on equal terms in order to prevail. Although at least one such complaint has been filed, to date there has not been a successful complaint case in the sense of preventing approval of an application for export license. Both the NEB'S complaint procedure and its attitude toward such com- plaints could change.

Liberals Take Control The recent Canadian federal election, in

which the Liberal party gained a majority of the seats in Parliament, calls into question Cana- dian natural gas regulatory and export policy in the coming years. It should be remembered that in 1980'the last Liberal majority govem- ment propounded a National Energy Program (NEP), which involved a set of draconian measures. These were aimed at limiting both the sales of gas from Canada to the United States and investment by U.S. companies in Canadian industries (including the oil and gas exploration and producing industry).

Cause for Concern Although newly elected Prime Minister

Jean Chretien, a former Energy Minister in the last Liberal government, has disavowed any intent to resurrect the NEP, which was effec- tively dismantled by the Conservatives under Brian Mulroney, there is still cause for concern. The Liberal platform took substantial issue with both the proportionality aspect of the energy trade provisions of the Canada-U.S. Free Trade Agreement (FIX), discussed be- low, and the failure of Canada in the North American Free Trade Agreement (NAFT'M ne- gotiations to obtain for Canada the right to abrogate contracts for expoxt sales of oil and gas in periods of shortage or emergency, similar to the right obtained by Mexico, as contrary to Canadian national interests.

. . . less Comforting when viewed in the light of a

disappearing gas surplus.. I

Late in the campaign Chretien sought to ease the fears of western Canadians that his government might pursue an energy policy adverse to gas exports, saying that the current problem is not to limit sales of gas to the United States but to find new gas markets. Chretien

cited the existence of a surplus of gas in Canada as the principal reason why there would be no return to the export-restrictive NEP. These re- marks are somewhat less comforting when viewed in the light of a disappearing gas surplus and a current concern that Canada could experience a peak-day deliverability shortfall during the 1993/ 94 winter season.

. . . policy adverse to natural gas exports is Impossible to

predict.. . In November, former Alberta Premier Peter

Lougheed pointed out that eastern Canadian gas consumers are becoming concerned about the security of their gas supplies, at a time of growing gas demand in Canada. Lougheed called atten- tion to the fact that NOVA Corporation of Alberta, the operator of the province's gathering and transmission system, has been working to in- crease its capacity to avoid last winter's bottle- neck problems for gas moving east. However, he went on to say that a disruption in supply to Ontario this winter at the same time that substan- tial quantities of Alberta gas are flowing into the western United States could cause an outcry for a federal government policy restricting new, and possibly diverting existing, exports.

Whether a combination of pressure from eastern Canadian consumers and industrial inter- ests and the Liberal party's opposition to the energy provisions of the FTA and NAFTA will coalesce into a Canadian energy policy adverse to natural gas exports is impossible to predict at this time. After the election, Chretien approached President Clinton about both renegotiating the energy provisions of NAFTA and rescinding the proportionality provision of the FTA's energy chapter. Both Clinton and Mexican President Salinas strongly resisted any reopening of NAFIA. Moreover, the Clinton administration declined to change the FTAs energy provisions. Thereupon Canada unilaterally declared that, in times of shortage, it will interpret and apply NAFIA in a way that maximizes energy security for Canadi- ans and take any measures it deems necessary to assure Canada's energy security.

FTA an Obstacle to Cutting Off Supply If the Liberal government were to attempt to

restrict gas exports to the United States, such measures could well run afoul of the energy chapter ofthe FTA, Chapter 9. That portion of the

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FTA obligates the two countries to avoid dis- criminatory prohibitions and taxes that would inhibit trade in energy goods (i.e., gas, oil, and electric power). Under Article 904, the two governments agreed that they will not impose any restriction on the export of an energy good to the other country that reduces the proportion of the export shipments of that energy good relative to the country’s total supply of the good, as compared to the proportion prevailing in the most recent prior thirty-six-month period for which data are available. This basically means that Canada cannot interfere with sales of natu- ral gas to, or divert natural gas from, the United States because of shortfalls in supply in Canada, except on a basis proportionate to any reduc- tion in the total available supply of Canadian natural gas.

Other Obstacles There are rwo other substantial obstacles to

a change in Canadian gas export policy by the Liberals. First, Alberta relies on natural gas royalties for a substantial share of provincial government revenues, which are enhanced by a thriving export market. The current light- handed approach by the NEB to its regulation of gas exports rests in substantial part on the so- called Western Accord between the federal government and the gas-producing provinces, Alberta, British Columbia, and Saskatchewan. Therefore, if export policy is to change, this intergovemment agreement must be amended or abrogated by Ottawa. Any attempt at the federal government level to sigdicantly restrict exports would likely be vigorously opposed by some or all of these western provinces. As an example, Alberta Premier Ralph Klein publicly has urged Chretien to drop his demand to rewrite the energy chapter of the ETA.

. . . cannot interfere with sales of natural gas to, or divert

natural gas - . - The dispute between Alberta and California

over the enforceability of the long-term con- tracts between Pacific Gas & Electric Company’s Canadian purchasing operation and the A&S Producers Group has been settled. Consequently, Canadian federal and Alberta provincial ob- stacles raised to natural gas exports because of that controversy have been dismantled. In addi- tion, Alberta has recently rescinded its prohibi-

tion against eastern Canadian core markets purchasing gas directly from producers, as a means to increase domestic sales of Alberta gas to those markets. Now the Alberta government is considering the elimination of a standard clause in AERCB removal permits that requires the diversion of permitted gas to any Alberta utility in the event of supply shortfall. Although the existence of this provision has not yet had a serious impact on export sales, that could be the result if there are supply shortfalls this winter. Therefore its elimination could serve to limit attempts to interrupt existing export sales.

Second, over the longer term, one has to believe that simple economics will dictate that the Liberals support a high volume of gas exports to the United States. Realistically, it is not likely that regulatory obstacles in Canada will deny U.S. buyers relatively free access to Canadian gas supplies in the near term, largely because of the benefits of gas exports to Canada and because the Liberal party’s energy policy will take some time to develop, and additional time to implement.

Mixed Bag Therefore, the outlook for cross-border gas

trade between Canada and the United States is a decidedly mixed bag. Canada has a vast natural gas resource base that over time will provide more supply than Canadian markets require. The United States is the only practical market into which this gas can go.

Canadian sellers have more pipeline access to more U.S. markets than ever before. These sellers are increasingly active in U.S. markets. However, these sellers’ reserves and deliverability are de- dining, at least for the present, and we appear to be approaching the limit of the level of exports that Canada can sustain.

The Canadian federal government under Liberal party control has a history of regulatory interventionism with respect to the export of Canadian gas. Canadian gas consumers are facing substantial increases in the prices they pay and potential peak-day shortages this win- ter, which could invite government action to impose export restrictions consistent with the government’s position on NAFTA. Therefore, we may well see more careful NEB scrutiny of proposals for long-term export sales and slower growth in approved, new long-term transitions with U.S. markets beginning in 1994. H

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