COLUMN-Rail M&A suggests U.S. crude glut won't ease soon: Campbell

Thu Dec 6, 2012 11:31am EST

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By Robert Campbell
    NEW YORK, Dec 6 (Reuters) - The value of terminals for
loading crude oil onto trains is rising in the United States, a
sign that big players are betting inland oil prices will remain
lower than previously thought.
    Closely-held U.S. Development Group announced on Wednesday
it would sell five of its terminals to pipeline giant Plains All
American Pipeline LP for $500 million. 
    The five terminals have a combined capacity to handle
approximately 225,000 barrels per day of crude, putting the
purchase cost at over $2,200 per bpd of capacity.
    This is significant as the cost of building new rail
terminals has generally run between $1000 and $1500 per bpd of
capacity, based on publicly disclosed costs at other projects.
    The transaction doubtless represents a nice profit for U.S.
Development, which only got into the crude by rail business in
2010.
    Perhaps this foray into rail is an uncharacteristic
multi-million dollar blunder by Plains All American, regarded as
a savvy operator with a long track record of well-executed
acquisitions.
    A more likely explanation is that Plains has made a
strategic move to capitalize on long-term weak North American
inland oil pricing.
    But why pay so much more than it might cost to build new
terminals? It may be that Plains saw more value in buying the
assets now rather than building new sites, despite the fact that
new terminals can be built very quickly.
    It could also be that U.S. Development had locked up the
best real estate for building these terminals, making it more
worthwhile to pay up rather than construct a new facility at a
lower capital cost.
    But those two points don't cover the critical ground here.
    
    GLUT GOES ON 
    Rail infrastructure, which is very cheap and quick to build
but very expensive to use, was always seen by oil industry
insiders as a stop-gap measure.
    The idea was use trains until new pipelines were built,
making as much profit as possible in a short period of time
because producers would quickly abandon costly trains in favor
of cheaper pipelines as soon as pipeline capacity was
sufficient.
    Since the modest capital investment required to build the
terminals would have already been recovered, rail project
developers would still be happy.
    But look what is happening. This story is not playing out as
it was supposed to. 
    The North American oil market is a few years into the
crude-by-rail phenomenon and therefore ought closer to getting
to the time new pipelines will wipe out the rail business.
    But if that was the case the value of crude-by-rail assets
ought to be declining, not rising, because any acquirer would,
by definition, have less time to recover its investment,
particularly in any facilities in more mature markets like
several of those being sold by U.S. Development.
    Instead Plains is paying a premium price for these
terminals, indicating it sees a much longer time frame for oil
to be moving on trains than once thought.
    Lets look at the cash flows that Plains might achieve with
these terminals that are costing it half a billion dollars.
Assuming these facilities are able to operate at 80 percent
capacity year-round the most oil they could handle would be
around 66 million barrels a year.
    If so, recovering the initial investment of $500 million and
earning a modest annualized return of 10 percent on this
investment over five years implies that the terminals will
capture at least $2.50 per barrel.
    But that $2.50 has to come after Plains pays all of its own
operating expenses and covers the very high cost of getting a
rail company to actually move the crude.
    For instance, BNSF railway quotes a price of approximately
$13 a barrel to move crude from the Bakken field in North Dakota
to St James, Louisiana, according to pricing on its website.
    Plains would likely get a somewhat better tariff but clearly
there needs to be a wide spread between inland North American
oil prices and world prices if train movements are to remain
economical.
    And that means Plains is viewing this investment as a
longer-term play. Indeed, it does not make sense except as a
play on the spread remaining wide over the next few years.
    
    ANYWHERE BUT LOUISIANA
    But changes in the oil market are afoot. Indeed, Plains is
likely positioning itself for the next phase of the
crude-by-rail phenomenon.
    In many ways the least valuable of the assets acquired by
Plains may well be the St James, Louisiana terminal, hitherto
the jewel in U.S. Development's rail crown.
    Why? St James was a superb location for a number of years as
it is the trading point for Light Louisiana Sweet crude, a grade
that traditionally traded higher than Brent due to the United
States' need to attract foreign imports of light sweet crude.
    With the shale revolution driving crude towards the U.S.
Gulf Coast, LLS has started to suffer. And next year may well
bring another step lower in value as new pipeline connections
between oversupplied inland markets as well as Houston send
cheap domestic barrels flooding into Louisiana.
    But that only means that the inland glut of light sweet
crude is spreading south, not that the price of inland grades,
represented by West Texas Intermediate crude, are poised to
reconnect with global trends.
    Instead the real opportunity in crude-by-rail lies in
getting oil to other North American coastal markets that
currently rely on crude priced against global benchmarks.
    Notably, Plains is already active in this market, building a
rail facility at Yorktown, Virginia where oil will be able to
move on barges or larger vessels to refineries elsewhere on the
East Coast in the United States or even Canada.
    Indeed, if the spread between LLS and globally-priced grades
got wide enough, Plains could even conceivably start moving oil
out of St James, Louisiana to more profitable markets.
    But the key point here is that for all of this to work
inland prices must remain significantly depressed for more than
a few more months. If inland prices rise enough to make moving
oil by train unprofitable train movements will cease. And with
the cost of rail movements running anywhere from $10 to $15 a
barrel, the gap required is anything but insignificant.
    That means anyone betting on a rapid narrowing of the
Brent-WTI futures spread next year thinks they know more about
the oil market than one of North America's top physical oil
marketers.
    Plains is clearly betting against a big narrowing of
Brent-WTI any time soon. It has just staked half a billion
dollars on a belief that inland and perhaps also Gulf Coast
crude prices, will remain sufficiently depressed to support very
high-cost movements to the East and West Coast for years to
come.
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