Houston Lateral Thinking Lacks Canadian Barrels New TransCanada pipeline from Cushing to Houston faces uphill challenge.

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1 ? Houston Lateral Thinking Lacks Canadian Barrels New TransCanada pipeline from Cushing to Houston faces uphill challenge. Morningstar Commodities Research Aug. 1, 2016 Sandy Fielden Director, Oil and Products Research New Pipeline Lacks Canadian Supplies TransCanada's new Houston Lateral pipeline comes on line this month to deliver crude from Cushing, Oklahoma, to Houston. The pipeline is an extension of the Cushing Marketlink that represents the southern leg of the proposed Keystone XL pipeline that was expected to deliver heavy crude from western Canada to the Gulf Coast. Since the U.S. denied the Keystone XL pipeline a presidential permit in November 2015, shippers on the southern leg are hard-pressed to source Canadian heavy crude. That constraint undermines the purpose of the Houston Lateral leaving committed shippers likely delivering light sweet barrels into a Houston market already saturated with light shale crude. Market Impact We expect the new pipeline to be bearish for Houston crude prices in an already saturated market where light sweet crude has averaged just $1.44 per barrel over Cushing this year despite the $4/barrel Seaway tariff. The process of filling the new lateral with crude will be bullish for Cushing inventory draws in the next month. Demand for crude to ship on the new lateral will also be bullish for prices although with inventory in Cushing still close to record levels there is no danger of any shortage of supplies. Houston Lateral The Houston Lateral pipeline runs 46 miles from Liberty, Texas, to the Moore Road terminal in Houston and provides shippers on the existing 700 thousand barrels/day, or mb/d TransCanada Cushing Marketlink pipeline between Cushing and Nederland, Texas, with the option of a delivery point connected to 2.7 million barrels/day of refining capacity in the Houston area. The Cushing Marketlink (completed in 2014) and the Houston Lateral together form the southern leg of the ill-fated 830 mb/d TransCanada Keystone XL pipeline. That pipeline was supposed to run all the way from Hardisty, Alberta, to the Gulf Coast. The northern part of the system, from Hardisty to Cushing, has not been completed because it was denied a presidential permit to cross the U.S. border in November The original 590 mb/d Keystone Pipeline, on line since 2010, runs from Hardisty to Steele City, Nebraska, and then branches to Patoka, Illinois, and Cushing. The Houston Lateral will carry both light and heavy crude and has the same 700 mb/d capacity as the Cushing-Nederland line. A TransCanada storage terminal at the Houston end of the new lateral has 700,000 barrels of storage capacity and is already linked to Enterprise Product Partners' Houston Ship Channel pipeline network. TransCanada and Magellan Midstream Partners are currently constructing a 9-mile pipeline linking the TransCanada Houston terminal to Magellan s East Houston terminal and crude distribution network that

2 Page 2 of 6 is expected on line in the first quarter of The initial tariff for uncommitted shippers on the TransCanada system delivering light crude from Hardisty to Houston will be $7.113/barrel and for heavy crude $7.730/barrel, the same price as deliveries to Nederland. The initial tariff between Cushing and Houston is a special discount rate of $2.50/barrel for light crude and $3/barrel for heavy crude. Current Crude Flows Into Houston The Houston Lateral comes on line just as the infrastructure building frenzy resulting from the oil shale production boom between 2011 and 2015 is winding down in the face of lower prices and production. During the boom, 2.2 mmb/d of new pipeline capacity came online into Houston from the South Texas Eagle Ford Basin, the West Texas Permian Basin, and from Cushing. Another 900 mb/d of pipeline capacity already delivered offshore Gulf of Mexico and legacy South Texas crude production to the Houston area. In addition to all that domestic crude, Energy Information Administration data indicates that Houston imported just over 1 mmb/d of crude on average this year much of it delivered from the water. All these numbers add up to about 4 mmb/d of existing crude delivery infrastructure into the Houston region. As detailed in Exhibit 1, the area s 11 refineries and processing plants can only process a nameplate 2.7 mmb/d, meaning that the Houston market is already saturated with crude. That reality sets the bar pretty high for TransCanada s committed shippers to find a home for up to 700 mb/d of new barrels in the short term. Exhibit 1 Houston Refining Capacity Source: Morningstar Scarce Canadian Barrels TransCanada s original intent was to provide Keystone XL shippers with ready access to Houston-area refineries configured to process heavy crude from western Canada. As we detailed in May (see Western Canadian Wildfires), the heavy bitumen crude produced in Alberta has to be diluted with lighter hydrocarbon diluents to flow in pipelines. Although crude prices have fallen by more than 50% in the past two years, Canadian crude production from the oil sands region continues to grow as a result of

3 Page 3 of 6 investments made before the crash. A June 2016 Canadian Association of Petroleum Producers report 1 forecasts Canadian crude production growing by 540 mb/d, or 14%, from 2015 to 2020, with the majority of that growth being heavy crude. The principal target market for this new crude is the U.S. Gulf Coast, home to the world s largest concentration of complex refineries that have coking units to break down heavy crude into lighter refined products. As indicated in Exhibit 1, the six largest Houston-area refineries boast coking capacity. Therefore, in spite of the flood of light shale crude from Texas and Cushing that has descended on Houston via new pipelines since 2013, a large part of local demand uses heavy crude, and these plants have difficulty processing lighter, more volatile, shale crude (see our July note Gulf Coast Refiners Penalized). Most of Houston refiners' heavy crude is currently supplied by imports from Latin America. Exhibit 2 shows the makeup of crude imports supplied to Houston refineries since January 2009 according to the EIA. Over this period, light crude imports declined from an average 327 mb/d in 2009 to just 5 mb/d in 2016 through May pushed out by surging domestic supplies from shale. Medium crude supplies declined 35% from an average 444 mb/d in 2009 to 287 mb/d so far in Heavy crude imports have been more resilient, falling only about 14% from 868 mb/d in 2009 to 748 mb/d in 2016 through May. Some of these heavy crude imports (an average of about 154 mb/d in 2016) came from Canada (black line on the chart) delivered via the Enbridge/Enterprise joint venture Seaway pipeline and by rail. The rest are mostly from Mexico, Venezuela, and Colombia as well as the Middle East. These heavy crude imports are the incumbent supplies that Canadian producers are looking to displace. If the Keystone XL pipeline had been built, then the Houston Lateral would have been a go-to route to Houston for western Canadian barrels. However, in the absence of the Keystone XL conduit from Canada, the utility of the TransCanada Houston Lateral is questionable in the short term. 1 Crude Oil Forecast, Markets and Transportation, June 2016 CAPP

4 1/1/2009 4/1/2009 7/1/2009 1/1/2010 4/1/2010 7/1/2010 1/1/2011 4/1/2011 7/1/2011 1/1/2012 4/1/2012 7/1/2012 1/1/2013 4/1/2013 7/1/2013 1/1/2014 4/1/2014 7/1/2014 1/1/2015 4/1/2015 7/1/2015 1/1/2016 4/1/2016 thousand b/d Page 4 of 6 Exhibit 2 Crude Imports to Houston Refineries 2500 Light Medium Heavy Canadian Source: EIA The principal challenge for TransCanada shippers hoping to deliver growing heavy Canadian crude to Houston is a shortage of supplies coming across the U.S. Canada border due to a lack of pipeline capacity. The denial of the Keystone XL permit clearly stymies TransCanada from delivering incremental Canadian barrels to Cushing for onward delivery to Nederland or Houston via the Cushing Marketlink. Although the original Keystone pipeline can deliver up to 590 mb/d to Cushing from Hardisty, most of these barrels have been absorbed by Midwestern refineries since that pipeline came on line in The larger, rival Enbridge mainline and Lakehead pipeline system out of western Canada can deliver nearly 800 mb/d of Canadian crude to Cushing via the Flanagan South and Spearhead South pipelines, but these volumes are encouraged to move to Houston on the Enbridge/Enterprise Seaway system rather than to change horses in Cushing onto TransCanada s pipeline. In any case, continued pipeline congestion across the U.S. border restricts either Enbridge or TransCanada delivering more barrels to the Gulf Coast, causing continued price discounting for Canadian crude versus equivalent grades in the U.S. Evidence of this constraint can also be found in the EIA import data. As we said earlier, an average of only about 154 mb/d of Canadian crude is reaching Houston refineries in 2016, even though the Seaway pipeline capacity from Cushing to Houston is 850 mb/d with at least 450 mb/d dedicated to heavy crude. Likewise, the 700 mb/d TransCanada pipeline from Cushing to Nederland has facilitated little penetration of the Nederland-area refining market by Canadian barrels since coming on line at the end of The four Nederland-area refineries (Valero, ExxonMobil, Total, and Motiva) have over 1.4 mmb/d of capacity and imported an average 359 mb/d of heavy crude between January and May Canadian barrels represented just 16 mb/d of those imports on average in 2014 before the TransCanada pipeline came on line but that number only increased to 35 mb/d in 2016 through May.

5 Page 5 of 6 The dearth of new heavy crude supplies from Canada coming into Cushing is expected to continue through at least 2019 when Enbridge brings its Line 1 replacement on line to add 300 mb/d of capacity across the border. The best hope for TransCanada is a new presidential permit for the Keystone XL after the 2016 election. Until new heavy crude supplies from Canada materialize, committed TransCanada Cushing Marketlink shippers have had little choice but to move light sweet domestic crude to Nederland. Shipping light crude to Nederland from Cushing has made sense and contributed to the Cushing Marketlink pipeline s success. There is no other direct pipeline link between Cushing and Nederland and the latter has been the load point for a number of export cargoes of U.S. light crude since the export ban was lifted in December The attractiveness of the Houston Lateral for light crude shippers is another matter however. As we have detailed, Houston is already saturated with light sweet crude from the Permian and the Eagle Ford. In addition, the Seaway pipeline already has more than adequate capacity between Cushing and Houston. In the circumstances, we expect some heated competition between TransCanada and Seaway s owners on this route, as indicated by TransCanada s special discount tariff rate of $2.50/barrel for uncommitted light crude shippers. That compares favorably with the current Seaway walk-up tariff of $4/barrel for light crude. The lower rate should encourage some shippers to move crude onto TransCanada in Cushing. K

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