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Crude Loves Rock’n’Rail – Bright Future in Shales (Season Finale)

There is a bright future for crude by rail in the oil shale plays regardless of what happens to crude price differentials. That is because the flexibility of rail transport meshes well with the rhythm of shale oil development. Meantime Canadian heavy crude will be the focus for rail terminal development in the near term as continued pipeline delays force producers to look seriously at rail options. And the economics of raw bitumen by rail may end up undercutting pipelines. Today we look ahead to these trends.

This is episode 16 – the season finale of our Crude Loves Rock’n’Rail series. If you had told us a year ago that we could write 16 blog posts on crude by rail without beating the topic to death we would have been highly skeptical. Now we are sure that the network will retain the show for another season and longer term we’re looking at syndication….

Previously on Crude Loves Rock’n’Rail…

The first episode in this crude by rail series provides an introduction and overview of the “Year of the Tank Car” (see Crude Loves Rocking Rail). We describe the rapid growth in US crude oil production that put pressure on pipeline logistics and made rail a viable alternative for moving crude to market. The second installment (see Crude Loves Rocking Rail – The Bakken Terminals) began our survey of rail loading terminals with a map and a complete list of facilities in North Dakota.  The follow up episodes covered EOG, Hess and Inergy, Plains, Enbridge and Global, Bakken Oil Express, Dakota Plains, BakkenLink and Savage and Bakken terminals north of the Canadian border in A Plethora of Terminals in the Williston Basin. We discussed the development of rail terminals loading heavy oil sands bitumen crude in Western Canada in two episodes Heat It! (Bitumen Economics Part 1) and Part 2. The last episode on rail loading covered terminals built outside the Bakken and Canada in the Niobrara, Eagle Ford, Permian and Anadarko basins as well as Cushing, OK (see Load Terminal Craze). Next we surveyed rail destination terminals covering the East (see East Coast Delivery Terminals) West (see West Coast Destinations) Eastern (see The Bakken St James Shuttle) and Western Gulf Coasts (see Houston Ship Channel and Outside the Ship Channel respectively. Turning to the money side of things we devoted an episode to how producers can determine the best netback return from their transport options (see Brent WTI and the Impact on Bakken Netbacks). Last time we provided a handy summary of the 154 crude load and discharge terminals that have sprung up across North America in the past two years (see 154 Terminals Operating).

A Major Cog in the Oil Shale Wheel

In this episode we look at the future of crude by rail in North America. The business has grown from a minor sideline into a major cog in the oil shale wheel and is now poised for a more permanent future. Instead of being a temporary “fix” to get around pipeline constraints, rail now has an important part to play in the development of shale oil resources.

A crude by rail terminal infrastructure is now built out across the US and Canada. Today you can load crude at 88 terminals in every significant crude production play and deliver it to any one of 66 destination terminals. And the network continues to grow with almost daily announcements of new projects. The latest we heard about was the Black Thunder Terminal being built by Arch Coal and Meritage Midstream Services in the Powder River Basin close to Arch’s mining operations in Cambell County, WY.

Terminal Development

The existing rail terminal network can be rapidly expanded when required. Investment costs range from $5MM for a small manifest terminal at the side of the tracks loading 1 or 2 tank cars at a time (see picture below), to $70MM for a top of the line unit train loading or receiving terminal that can turn around 100 tank cars in 14 hours. Unless you want to build in California the project duration can be measured in months not years. [It takes longer in California because of the need to jump through tougher permitting hoops].

Manifest Crude Load Facility Hobbs, NM. Source: Permian Basin Railways (Click to Enlarge) 

Investment in a new terminal typically provides a high rate of return and a rapid payback for investors. For example a new terminal handling 100 car unit trains might cost $50 MM to build – including storage tanks. The terminal can handle 100 X 650 = 65 MBbl trains. At a conservative 2 trains a week, the terminal operator gets ~$1.50 per Bbl or $195 M in revenue. That works out at $10.1 MM per year or a 20 percent return on the $50 MM investment. The payback period is 5 years. If the terminal handles 4 trains a week the payout doubles and the payback period falls to 2.5 years. Compared to the billions of dollars spent on pipelines, the investment required is minor.

Once these terminals are built they are not going anywhere. They typically secure throughput barrels under two year contracts to justify their investment. After the first two years they will still prefer to have contracted barrels running through to guarantee revenue but will likely be happy to handle “walk-up” barrels if they have spare capacity. Because of the rail option, producers will need to make smaller commitment of time and money to secure transportation for their incremental crude output.

The Nature of Shale Production Provides an Ongoing Role for Rail

That suits the nature of shale oil production. Horizontal drilling and hydraulic fracturing technology (fracking – see Tales of the Tight Sand Laterals) typically result in high initial production (IP) rates and rapid declines after the first year. As a result producers are looking for flexible transport arrangements that can handle big swings in production and provide a baseline service for the smoother longer production life of older wells. This output volatility is increasing because of improved drilling and completion technology. Horizontal wells are now being drilled close together to accommodate pad drilling techniques (see Will the Crude Production Boom Keep Running?). Fracturing is completed on several wells in a cluster before production commences with each well producing at a high IP. That means several thousand barrels of oil per day of new production can come online all at once. Producers are looking for a way to get those barrels to market rapidly and rail terminals provide that flexibility without having to enter into a longer term commitment to a pipeline (assuming a pipeline is available in the first place).

As producers exploit the sweet spots in oil shale formations the production numbers increase rapidly. We saw a 40 percent year-on-year increase in Bakken crude production from 558 Mb/d in February 2012 to 779 Mb/d in February 2013. Permian production grew by 15 percent or 200 Mb/d during 2012. These dramatic increases inside a year are hard to plan for and hard to accommodate with pipelines. That is because pipelines take too long to build. Even pipeline reversal projects take more than a year to obtain adequate permitting and to engineer. And that is if the demand for the pipeline already exists. In reality, midstream companies build pipelines only once they can get shipper commitment. The open season commitment process takes months and the permit and FERC tariff requirements eat up another year or more. So the pipeline model and the shale crude model are not compatible unless you have a third transport option to take up the slack. That is where rail came into play. Originally as a band-aid to ship production until pipelines were built. Now that the rail network is set up however, the band-aid becomes part of the solution and no longer just a work around.

Initially the use of crude by rail was justified by the price differentials between inland “stranded” crude constrained by a lack of pipeline capacity and coastal crudes that sold at higher international prices. Rail provided Bakken producers a way around the pipeline constraints. The higher crude prices at rail destinations paid the increased cost of rail transportation. Now those price differentials are starting to erode and pipeline capacity continues to increase.  In the future, rail will carry incremental barrels whenever crude pipelines are full or have not yet been built. Or when rail can reach markets where crude prices are better than those offered by pipeline destinations. Either way, rail now offers long term optionality to shale producers.

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