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US concerned about anti-competition issues from proposed Canadian National-Kansas City Southern acquisition

Highlights

Canadian National ups offer to include $700 mil breakup fee

Canadian Pacific has five business days to make counteroffer

Either deal makes prime Canada-to-US crude route

Houston — The US Department of Justice on May 14 sought to derail the proposed $30.5 billion acquisition of Kansas City Southern by Canadian National Railroad, arguing it presents serious anti-competition concerns within the US railroad network.

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The DOJ is asking the railroad regulatory body, the US Surface Transportation Board, to reject Canadian National's request for a voting trust after the STB already approved similar terms for a competing deal by CN's smaller rival, Canadian Pacific, to acquire Kansas City Southern for $25 billion.

Kansas City Southern said May 13 it planned to terminate its deal with Canadian Pacific and instead accept Canadian National's sweetened offer in an escalation of the Canadian railroad war. Canadian Pacific has until May 20 to make a counteroffer. CP said it would not get into a "bidding war," but promised to respond within the allotted five business days.

Either deal would create a prime crude-by-rail network to move Canadian crude to the US, as well as the first rail company to stretch from the Canadian oil sands deep into Mexican fuel markets. That combination is expected to prove more beneficial thanks to the revised United States-Mexico-Canada Agreement trade deal. Right now, only Canadian National even has rail routes stretching from Alberta to the US Gulf Coast.

But the DOJ believes CN and KCS have more intertwined rail networks than CP does and, thus, more anti-competition concerns in an industry that has not seen a major railroad merger in about 20 years.

Both CN and CP are counting on voting trusts to close their competing deals. Part of CN's argument is KCS shareholders have nothing to lose because they would be paid from the trust even if the deal fails to pass regulatory muster.

"The board should not permit the proposed CN voting trust because CN's proposed acquisition of KCS appears to pose greater risks to competition than the risks posed by a CP-KCS merger," the DOJ said in comments to the STB. "Thus, even though the terms of CN's proposed voting trust are similar to the terms of CP's proposed voting trust, the board has good reason to hold CN's proposed voting trust to a higher bar."

After KCS agreed to be acquired by CP in March for $25 billion, CN in April jumped in with an unsolicited, nearly $30 billion offer for the Missouri-based railroad. Now that CN has upped the offer to pay the $700 million termination fee for the prior agreement, KCS said it has deemed the larger offer the "superior proposal."

However, CN and KCS have more parallel rail routes and would eliminate customer options, CP CEO Keith Creel contends, arguing that a CN-KCS combination cannot pass the regulatory test. CP and KCS, on the other hand, have no overlap, and their rail networks meet neatly in Kansas City, Missouri.

CN has argued that it is the larger, stronger company and has the better offer and long-term value. CN CEO JJ Ruest claimed that less than 1% of the company's rail networks overlap, primarily in Louisiana. CN's rail network moves crude to the refining hub of St. James, Louisiana, but KCS additionally offers more direct access to hubs along the Texas Gulf Coast and into Mexico.

REGULATORY QUESTIONS

In question are the STB's updated merger regulations from 2001 that require major deals to show they are in the public interest. Since then, no major rail mergers have come to fruition, not counting Berkshire Hathaway's 2010 acquisition of US leader BNSF, including failed flirtations from CP to merge with CSX in 2014 and with Norfolk Southern in 2016.

The STB already has said a waiver to the 2001 regulations would apply to the CP deal with KCS because KCS is the smallest major US railroad and is more regionally focused with less overlap with competitors. CP's argument is that its proposal would combine North America's sixth- and seventh-largest railroads, leaving the combined company as still just the sixth-biggest.

The DOJ was not keen to approve the voting trust for Canadian Pacific either, arguing that the STB has allowed railroad deals to rely too heavily on such trusts. But the STB granted the trust for CP earlier in May anyway.

CN is asking the STB to decide on its voting and regulatory processes by the end of May. Neither potential merger would be expected to close until mid-2022 at the earliest.

CN argued the same rules should apply to its potential deal. However, Ruest said CN can get the deal approved with or without the waiver. But CN is still counting heavily on the voting trust.

CN noted it would only have the fifth-largest rail network in the US if it acquires KCS. However, within all of North America, CN would grow large enough to rival the two biggest railroads, BNSF and Union Pacific.

CRUDE-BY-RAIL IMPACTS

While either of the competing deals might offer cheaper shipping rates for Canadian heavy oil sands, analysts said notably greater crude-by-rail volumes would only come if major oil pipelines are shuttered, such as the in-progress Line 3 replacement project, the four-year-old Dakota Access Pipeline and the pending Trans Mountain Pipeline expansion.

Canadian oil production has recovered to its pre-pandemic volumes of about 5 million b/d of crude oil, condensate and diluent, while US production is still down by about 2 million b/d from its pre-pandemic volumes.

However, crude-by-rail volumes have not yet recovered and may not rebound for quite some time.

A decade ago, Canada's crude-by-rail exports were borderline insignificant, but that changed when production started outpacing pipeline capacity. Rail volumes surged from 2018 until the pandemic took hold in March of last year. Canadian crude-by-rail exports plunged from an all-time high of 411,991 b/d in February 2020 to an eight-year low of 38,867 b/d in July.

Exports have since rebounded to 195,531 b/d in January, according to the Canada Energy Regulator, but fell back to 111,871 b/d in February.

Since early this year, the price spread between Western Canadian Select at Hardisty, Alberta, and the USGC has narrowed to levels that make most spot rail shipments uneconomical. Shipping crude by rail from Hardisty to the USGC can cost anywhere between $12/b and $18/b, traders say.