By Philippe Casey of OilPrice.com:
Little over a century after the world-famous Spindletop gusher blackened the skies over Beaumont, Texas and ushered in an era of United States oil dominance, the country’s energy profile has drastically shifted once again due to the shale revolution. In 2009, the United States surpassed Russia as the world’s largest producer of natural gas. According to International Energy Agency projections, America will overtake Saudi Arabia in 2020 to become the top oil-producing nation. Additionally, late May saw domestic production exceed imports for the first time in 16 years, further fueling speculation that the US could be energy independent by 2030.
It must be emphasized that the magnitude of the shale finds and consequent United States production boom was almost completely unanticipated, even by industry experts. This can be seen in the clear inability of aging US infrastructure to keep up with the resulting supply glut. The American Society of Civil Engineers (ASCE) recently gave domestic infrastructure a “D+” rating – a poignant condemnation of the status quo and a reminder of the important task that lies ahead.
Among other effects, these infrastructural constraints have initiated a fundamental shift in the global oil market. Historically, US-based West Texas Intermediate (WTI) crude has traded at premium to the North Sea’s Brent crude and served as the global benchmark for reference pricing purposes. This is no longer the case. The large bottleneck at the landlocked storage facility in Cushing, Oklahoma has placed strong deflationary pressure on WTI. A detailed analysis of the subject can be found in a recent article of mine: The Shifting Dynamics of the Brent-WTI spread.
If North American infrastructural constraints have yielded one clear winner, it is the railroads. With much of the production increases coming from remote locations in North Dakota and Alberta, there has been a major shortage of pipeline outlets for the glut of crude. Railroads have eagerly rushed to fill the gap in a phenomenon that is rapidly becoming known as “shale by rail.” Crude oil shipments on US Class I railroads have correspondingly increased over 3200% in the past five years. A Class I railroad is defined as a carrier with an operating revenue of more than $433.2 million. Presently, there are seven such railroads operating in the United States. The American Society of Civil Engineers estimates that freight tonnage will increase 22% by 2035, rising from 12.5 billion tons to 15.3 billion tons.
Railroads hold several advantages over pipelines. Firstly, pipelines only move crude at an average rate of 3 to 8 miles per hour, much slower than freight trains. When crude markets are in a state of backwardation – a scenario in which spot prices are higher than front-month futures prices due to a temporary supply squeeze – the speed of transportation is important. The crude that arrives first is the crude that captures the premium.
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Pipeline construction is also slower and more costly than railroad construction. Given the incredible rate of production increases during the shale boom, the ability to rapidly expand outtake capacity from these fields is critically important. Most producing fields have limited on-site storage capacity and a buildup can negatively impact crude prices.
Additionally, railroads offer delivery a degree of flexibility that cannot be matched by pipelines. The United States has some 160,000 miles of railroad track and 565 freight railroads. Though total petroleum pipeline mileage is slightly larger at 180,000, it is overwhelmingly concentrated along the Gulf Coast. The majority of states do not even have a crude pipeline running through them. It is also significant that no major pipeline network crosses the Rocky Mountains – this is one of the reasons why California’s energy prices are consistently elevated. With trains, crude can be moved from production point to any major demand hub in the lower-48 with relative ease. The increased favorability of rail over pipelines is especially evident at the Bakken. Rail takeaway capacity from the field is projected to have risen from 115,000 b/d at year-end 2010 to 1,120,000 b/d by year-end 2013, an increase of 9.7 times.
The shale boom’s impact on railroads has not been exclusively positive. As the percentage of oil and natural gas in the energy mix continues to rise, the coal industry has suffered collateral damage. In 2011, domestic coal consumption was lower than in 1996. The share of coal-fired power in the US energy mix has also fallen from 48.5% in 2007 to 37.4% in 2012. In response, industry players have looked to China, Brazil, and Europe (particularly the Netherlands and UK) as sources of demand replacement, seemingly with success – June 2013 saw US coal exports reach an all-time high of 13.6 million short tons. The shifting demand dynamics for coal, however, have caused a drop in its transportation by rail. Carloads of coal fell 11% between 2011 and 2012. This decline can be partially attributed to the fact that Baltimore, Maryland and Norfolk, Virginia – two of the largest coal exporting ports in the United States – are located in relatively close proximity to the Appalachian Coal Belt.
Skeptics say the July 6, 2013 derailment of a petroleum-carrying train in Quebec may signal the beginning of the end for “shale by rail.” The incident claimed 47 lives and destroyed much of a small town. Thankfully, a radical knee-jerk reaction has been rejected in favor of pragmatic reforms which will increase safety without unjustly crippling the railroad industry. The changes proposed by Canadian transport authorities are twofold: 1) trains carrying dangerous materials will require at least a two-man crew 2) trains carrying dangerous materials will not be allowed to be left unattended on a main track. The implementation of these common sense measures is the right and reasonable response to a one-off occurrence. While tragic, the derailment is about as likely to end rail transport of crude oil as the Macondo Blowout was to ending offshore drilling in the Gulf of Mexico.
Despite the tragedy in Quebec and the decline of coal, the prognosis for the US railroad industry remains very favorable. Accompanying the increase in petroleum carloads has been an increase in industrial sand shipments, which have risen 160.77% between 2009 and 2012. The majority of this increase can be attributed to the movement of “frac sand” by rail. Frac sand is used in the hydraulic fracturing process to prevent the newly-formed fissures in the shale formation from closing up. A single horizontal well is thought to require between 3000 – 10,000 tons of sand. Consequently, production of frac sand has tripled over the last three years and railroads have been a primary beneficiary – unlike liquid petroleum products, sand cannot be moved through a pipeline.
North America’s largest railroad in terms of revenue – Union Pacific – recently released earnings figures that reaffirm the positive impact of shale on the industry. Earnings per share (EPS) reached an all-time high of $2.37, up 13% from one year before and 49% from 2011. Operating revenue and operating income also recorded best-ever performances. This is a remarkable achievement for a company which dates back to 1862 – only one year after the outbreak of the American Civil War. Not surprisingly, the destination of most crude carried by Union Pacific is the Gulf Coast, as indicated by the red triangles on the route map found at the bottom of this article. Union Pacific’s success is no outlier, however, and serves as a microcosm for the entire railroad industry. As seen below, the Dow Jones US Railroad Index (DJUSRR) has climbed nearly 220% in the past 4.5 years, more than doubling the performance of the S&P 500 over the same period.
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Over the next decade, increased pipeline infrastructure and a potential repeal of the Jones Act will gradually reduce the current dependence on railroads for the transport of crude. This is partly because pipeline transportation costs are, on average, lower than the cost of crude-by-rail. Indeed, this can be seen in the fact that rail transportation of Bakken crude from the Williston Basin to Albany, New York is estimated to cost $12 per barrel.
Ramped-up shale oil production from Eagle Ford, the Bakken, and the Permian Basin – coupled with large-scale increases in bitumen production from Alberta – will ensure ample demand for railroad services over the coming years. Unconventional oil continues to outpace both infrastructure and expectations, and the flexibility afforded by rail will cement the industry’s critical role for the duration of the shale revolution.
This piece will be the first in a multiple-part series examining the diverse effects of the US shale revolution. The next two pieces will be: 1) The Far East: The New Demand Hub for Crude Imports and 2) Shale Goes International – But Challenges Await. By Phil Casey of OilPrice.com.