Last week new details emerged about ongoing cost increases on the Trans Mountain Pipeline Expansion (TMX) Project. If news media is to be believed, the price of the pipeline will likely exceed $17 billion. A far cry from the initial $7.4 billion price tag when the federal government bought the project. Opponents of the project will claim that at this price the TMX is a financial loser that should be abandoned. As I will demonstrate in this post, that claim is demonstrably false.
To summarize my argument, the opponents of the project will argue that the pipeline will possibly have a negative net present value (NPV) at its current $17 billion price tag. But as I will show, when it comes to government projects NPV is only part of the picture, and in this case, it is only a tiny piece of the much bigger economic picture. Except in the case of massive losses, the TMX makes absolute financial sense from a government perspective because the government has more than one way to generate revenue from this project.
I went into detail about the Parliamentary Budget Officer’s (PBO’s) report on the valuation of the TMX in a previous post (Understanding what the PBO report says about the Trans Mountain Pipeline Expansion Project). The PBO report presents numerous scenarios and depending on the cost of the project, the financing costs and other factors, the project may or may not have a positive NPV.
What does a negative NPV mean? Well, let’s think about why a company builds a pipeline. When Kinder Morgan proposed the pipeline, it had a simple plan. Build a pipeline for $4 – $7 billion and then sell space (tolls) on that pipeline at a price that allowed it to recoup its costs plus generating a profit for its shareholders. The challenge Kinder Morgan faced was that its only source of revenue on the project would be the tolls on the material transported by the pipeline. For Kinder Morgan, the NPV of the pipeline would really matter. If they were unable to recoup the costs of construction, over the lifetime of the project, then the project would be a money-loser and a financial drain. Companies don’t last a long time if they regularly build projects that generate a negative NPV.
In my earlier post I also went into detail into the concepts of “optionality” and the “WTI-WCS price differential”. To save you time I will copy some text from that post here:
Optionality refers to the availability of more pipeline export capacity to more downstream markets for Western Canadian oil producers. Optionality allows shippers more opportunities to maximize returns and reduce the netback disadvantage, reflected in the price differential between West Texas Intermediate (WTI) and Western Canadian Select (WCS)
The PBO also notes:
That analysis determined that a reduction in the WTI-WCS price differential of US$5 per barrel would, on average, increase nominal GDP by $6.0 billion annually over 2019 to 2023.
When considering optionality and the WTI-WCS price differential we are reminded that the federal and provincial governments are not private corporation with limited sources of incomes. Governments generate revenues from a variety of direct and indirect sources.
Consider the building of the Trans Mountain. When the government spends $17 billion building a pipeline, they generate tax revenues on that spend and the money invested has a multiplier effect throughout the community which generates more revenue. When a crown corporation pays GST that is direct revenue to the very government paying that crown corporation’s budget. Similarly, when a crown corporation pays staff to build a pipeline, that staff remits income taxes on all their income. Thus, a $17 billion project doesn’t actually cost the federal government $17 billion but rather $17 billion minus the taxes etc. that the government generated from that construction. Moreover, this type of economic activity generates spin-off economic activity from that construction activity.
If taxes and direct economic spinoffs were the only benefits from the project, then even the government could only afford a small loss in NPV over the long term since they can only make up so much value in taxes. But thankfully, those are really only secondary benefits. The primary benefit of the project is in optionality and its larger effect on national GDP.
When TMX is complete, it will increase optionality and will increase the value of the oil moved down the pipeline (as described by the PBO). Line 2 is projected to move 540,000 barrels/day. If optionality increases the value of that oil by a single dollar per barrel that means the pipeline would generate $540,000/day of added value to the economy at no additional cost. That multiplies to about $200 million/year per dollar of increased value. Remember this is simply an increase in the value of the existing production that would otherwise still be moving by rail to Asia or California Texas. It is pure cream which requires no further effort once the pipeline is built. If we use the PBO estimate of a $5 increase in value that comes out as $1 billion a year in added direct revenue from the TMX. That $1 billion in revenue means substantially higher royalties and higher tax revenues. That is more money for the government.
Thus, even if the pipeline ends up with a NPV of minus $1.2 billion, the government, through their other revenue sources, would make up that “loss” in very short order. Moreover, if increased demand raised the price of additional production (remember Alberta produces about 3 million barrels a day of heavy oil) that increase in value might spread to the remaining oil resulting in higher revenues off that oil as well. This is how the PBO comes up with their $6 billion/year in added revenue.
See how a negative NPV can still end up with a positive cash flow? Can you imagine any investment where $1.2 billion in one-time costs resulted in $1 billion to $6 billion a year in extra revenue? No business on the planet would say no to that proposition. And remember, this is not due to increased production this is simply increasing the value generated by producing the same product. It is simply getting paid more for the same product because you can now get it to a market that values it more.
Ultimately, we know the opponents of the TMX are going to make wild and unsupported claims about the project being a money loser, a financial drain, etc.. But the simple truth (as displayed above) is that their argument about NPV simply does not hold water. The federal government is not a private corporation with a single revenue stream. The federal government builds all sorts of projects that have negative NPV because they generate value through other means. From schools, to roads, to ports, to pipelines, these projects can generate either economic or social benefits. In the case of TMX both the direct and indirect revenue streams will result in the project being a big economic winner for the federal government even if it costs a bit more to build.