Under Pressure – Narrowing Crude Differentials Squeeze Bakken Rail Economics

If 2012 was “the year of the tank car” in North Dakota then 2014 could turn out to be the year when crude by rail economics turned sour for producers. New pipelines are coming online to deliver increased volumes of crude to the Gulf Coast with more projects on the drawing board. Safety issues and traffic congestion are raising the cost of rail freight. But the biggest challenge to rail is the pressure from narrowing crude price differentials between North Dakota and coastal markets. Producers can now get better returns shipping barrels by pipeline and in a falling price market they are more incented to make the switch. Today we explain why rail may be losing its edge.

RBN cut its blogging teeth during the growth of crude-by-rail in North Dakota in 2012. Bakken producers couldn’t get their oil to market because existing pipelines were full and new pipelines had yet to be built, so they turned to the railroads to bypass Midwest congestion. We followed changing transport options for Bakken producers ”From a Famine of Pipeline to a Feast of Rail” and the subsequent impact the stampede of crude barrels to rail had on the pipelines (see Railing Against the Pipelines). By February of 2013 we were looking back on “The Year of The Tank Car”. Ever since then we have pondered how long the crude-by-rail phenomena can last – asking in June of 2013 if we had seen the “Last Train to Bakkenville” as the crude price differentials between domestic benchmark West Texas Intermediate (WTI) and international Brent collapsed briefly before widening out again in the fall of that year. Then rail came under fire from a different direction by the end of 2013 – safety issues associated with transporting crude oil (see Could New Tank Car Rules Derail The Bakken Boom). All the while midstream companies continue to invest in crude rail terminals (see Are Crude–By-Rail Terminals Here to Stay?) and we have followed significant growth in crude-by-rail deliveries from Western Canada to the US as that region’s pipeline takeaway capacity fell short of booming output (see the Go Your Own Way series). But narrowing crude differentials this year are placing particular pressure on rail economics versus pipelines.

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Don’t get us wrong - we are not writing off crude-by-rail as a transport option for Bakken producers. It’s just that all the advantages rail had in North Dakota in 2012 have gradually disappeared and this year they have become even less obvious. Back in 2012 rail had four main advantages over pipelines. The first was the speed with which a rail terminal could be constructed to load crude oil - initially into small groups of tank cars known as “manifest” trains and then into the more efficient 100 car plus “unit” trains dedicated to conveyor like movements of crude from source to destination. In the right circumstances, a rail terminal can be up and running in less than six months – a lot faster than planning, permitting and building a pipeline that takes at least three years if everything goes smoothly and usually longer. The second advantage of rail over pipelines is that the cost of building a rail terminal is a fraction of the cost of a pipeline. A unit train rail terminal can be constructed for as little as $50 MM whereas most long distance pipelines run into the hundreds of millions or billions of dollars. The lower start up cost and speed to market of rail terminals translates to their third advantage over pipelines which is that shippers do not need to commit as much time and capital in order to reserve capacity at a rail terminal as they do for a pipeline. Rail terminal operators can offer capacity to shippers based on volume commitments for two years or less with no up-front investment. Pipelines typically look for 10 year volume commitments and an up front investment in line-fill (the cost of crude to fill the pipeline before it operates). The fourth advantage of rail over pipelines is that because the network is already mostly in place, rail can deliver to multiple destinations and offer flexibility to reach different markets. Pipelines run from A to B and don’t offer such flexibility of destination.

Of course these advantages for railroads over pipelines still exist but over time they tend to be reduced as crude infrastructure matures. For example, it will always be quicker and cheaper to build rail terminals than pipelines. That is why we see rail terminal development continuing in the “hot” shale plays like the Niobrara where pipeline capacity is not yet adequate (see Hey Mr. D.J.). But as pipelines are built to get crude from new production plays to market, the rail advantage starts to fade. That is because once pipelines are built their tariffs are usually much lower per barrel than the equivalent cost of rail freight, so given the choice producers will choose the cheaper option. Second – because of the low time commitments required to secure capacity on trains, the railroads don’t have much hold over their customers once pipeline options are available and the latter can switch their barrels easily. And as the pipeline network is built out, the flexibility advantage of rail over pipelines is reduced. As we see happening in the Bakken (and elsewhere like the Niobrara), pipeline developers start to offer shippers different routes to market and better connections to pipeline hubs such as Cushing or Patoka in the Midwest that can send oil to different destinations. In addition, real and perceived issues with tank car safety have not helped the railroad case as producers weigh whether to switch to pipelines. Neither have considerable Midwest rail congestion issues that have slowed down trains and increased freight costs. 

The most significant blow to the Bakken railroad advantage this year however, has come from the erosion of the market price differentials that helped justify the higher cost of rail freight in the first place. Consider the chart in Figure #1 below showing data for the premiums of three different crude prices over the WTI benchmark at Cushing (purple zero line on the charts) during 2012. The red line is Brent – the international benchmark that sets the market price for crude imports of light sweet crude to the U.S.. The green line is Alaska North Slope (ANS) crude – the benchmark price for West Coast refiners and the blue line is light Louisiana sweet crude (LLS) the benchmark at the Gulf Coast. These crude premiums over WTI effectively determine the prices that Bakken producers can realize by delivering their crude to coastal destinations instead of selling it at the wellhead (typically at a discount to WTI) or sending it to Cushing to realize the WTI price. We have discussed this “netback” analysis previously in detail (see for example Netback, Netback, Netback to Where You Started From) but it all boils down to the extent to which transport cost to a specific destination is offset by realizing a higher price for crude when you deliver at that location.

Figure #1

Source: CME NYMEX and Alaska Dept of Revenue data from Morningstar (Click to Enlarge)

So, bearing in mind, as we said earlier, that railroads offer flexible destinations but charge higher freight rates than pipelines, the advantage of rail is greater when the price differentials between locations are wider because rail can get to any destination. That was the case in 2012 where you can see that premiums to WTI were above $10/Bbl for most of the year. ANS prices averaged a $16.50/Bbl premium over WTI, Brent averaged about $18/Bbl premium over WTI and LLS about the same premium as Brent. Given that during 2012 Bakken producers were receiving wellhead prices that were at times $20/Bbl below WTI, the reward for paying rail freight to ship crude to the East, West or Gulf Coasts easily justified the extra cost. 

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The situation in 2014 is considerably less “rail friendly’ as shown in Figure #2. This year the premiums of Brent, ANS and LLS over WTI have been far weaker than they were in 2012. The average ANS premium over WTI (through October 22, 2014) is $5.50/Bbl, the average Brent premium is $7.00/Bbl and the average LLS premium is $3.70/BBl. And those premiums have shrunk as absolute crude prices have fallen by 25 percent since June. These shrinking premiums no longer justify the extra cost of sending crude to coastal destinations by rail and that means Bakken producers today typically get better netbacks sending their crude to Cushing or to the Gulf Coast by pipeline rather than to the East and West Coast by rail. 

Figure #2

Source: CME NYMEX and Alaska Dept of Revenue data from Morningstar (Click to Enlarge)

All of which has transpired primarily because of two changes in market fundamentals that look set to stay in place for a while. First is the opening up of new pipeline capacity between North Dakota and Cushing and between Cushing and the Gulf Coast that has reduced congestion and price differentials between these market locations. In other words the price differential between WTI in Cushing and LLS at the Gulf Coast has narrowed to $3/Bbl - a number that barely covers the pipeline cost of shipping between the two markets – let alone rail. That discourages rail movements from the Bakken to the Gulf Coast because the rail journey can cost as much as $10/Bbl more than the pipeline. The second and potentially more significant fundamental market change is in the international crude market. There as we discussed recently (see Crude Falls To Pieces) an over supply of light sweet crude has put downward pressure on the price of Brent – bringing the whole crude complex down by 25 percent since June. That pressure has narrowed the premium of Brent to WTI – reducing the advantage of shipping crude by rail to the East Coast (where refiners pay Brent based prices for imports from overseas). And the falling Brent price has started to take a toll on the West Coast – where the price of ANS has recently been at less than $1/Bbl premium over WTI. Part of the reason for the ANS slide is that Middle East producers have dropped their prices in Asia to retain market share – putting downward pressure on the crudes that compete with ANS on the West Coast. The result is that the economics of rail to the West Coast at freight rates of $15-$18/Bbl are underwater as well. So international crude price pressure is adding to the narrowing of domestic spreads between WTI and LLS to squeeze out the advantage of shipping Bakken crude by rail to coastal destinations.

What does this mean for the future of Bakken crude-by-rail? As we have seen before, it takes time for producers to react to market price changes and so we don’t see an overnight exodus away from the railroads in North Dakota. But the longer that rail economics remain underwater the more barrels will move to pipelines. The recent spate of new pipeline project announcements out of the Bakken reflects shipper interest in moving away from rail when they can. Trouble is that there are no pipelines yet from North Dakota (or anywhere else) to the East or West Coasts, so incremental pipeline barrels out of the Bakken are going to end up at Cushing or the Gulf Coast – where they will compete with a flood of light crude from the Texas Permian and Eagle Ford basins – putting further downward pressure on the LLS premium over WTI – reducing the pipeline netbacks. But in a downward pricing market, the lower cost of pipelines trumps pricier railroads. That means those Bakken producers that continue to supply the East and West Coasts will have to eat higher transport costs to compete with Brent and ANS. And as crude prices fall, you can be sure that producers are paying close attention to getting the best netbacks available to sustain their new drilling investment.

“Under Pressure” was recorded by Queen and David Bowie in 1981