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