Kevin Smith, who runs Denver-based Crescat Capital, is a thematic value investor: He identifies big themes and then looks for stocks to execute his theses. Kevin made a case for Dallas, Texas–based Trinity Industries, a maker of railcars, barges and storage tanks. Kevin believes Trinity will benefit from the U.S. shale oil production boom, especially on the railroad side, as it is the largest maker of tanker oil cars. On the surface, Trinity is not expensive at 9 times forward earnings, and there is two-year visibility on the backlog of orders. During our Q&A (every presentation at the conference is followed by ten minutes of take-no-prisoners questions), it became apparent why the market is putting such a low earnings multiple on this stock. Pipelines are a real competitive threat and, because a tanker car has a 40-year life, with every sale of a tanker Trinity is creating competition for its future sales for the next 40 years.
Though Trinity is not my cup of tea, I’ve been fascinated by the dynamics of the U.S. oil market, which is going through one of its largest transformations in decades. In fact, watching this market is like watching the invisible hand of a maestro conduct a gigantic orchestra within the constraints imposed by various laws and regulations.
If transporting a barrel of oil from the oil fields of the Bakken formation to Los Angeles by rail costs $15, the price difference between those two points should not deviate much from $15. Let’s say the price of light crude is $75 in North Dakota and $100 in Los Angeles. You’d buy it in North Dakota for $75, pay $15 to Burlington Northern Santa Fe to transport it to LA, sell the barrel for $100 and book $10 of easy, riskless profits. However, if you did this enough, the price in North Dakota would rise, the price in Los Angeles would decline, and your risk-free profit would go away.
This is how economics should work, but it assumes that transportation for your barrel of oil is readily available, that there is enough refining capacity in Los Angeles and that there is sufficient demand there for the refined barrel (otherwise it has to be transported somewhere else, incurring additional transportation cost).
The U.S.’s present oil transportation and refining infrastructure has developed over a long time, based on production and consumption patterns.
Historically, about one third of imports arrived from Canada and Mexico and a further 40 percent came from OPEC countries, though most of them were outside the Arabian Gulf (Algeria, Angola, Nigeria, and Venezuela). Half of all U.S. imports came to the Gulf of Mexico region, which also accounted for half of total U.S. refining capacity.
Because higher-cost, unionized refineries have meant a lack of cheap refining capacity, the East Coast imported mainly refined petroleum from Canada, Russia and Europe. However, the discovery of new oil and enhanced production using horizontal drilling and fracking in the Bakken (where production has gone from practically nothing five years ago to 700,000 barrels a day today) and Texas (where oil production has tripled in three years, to 2.1 million barrels a day) has changed oil industry dynamics dramatically. Midcontinental North America has the least amount of refining infrastructure, but this is where a big volume of new oil is coming from.
There are some additional constraints on the oil industry. To start with, U.S. law prohibits exports of unrefined oil. Historically, this was not a problem, as our oil production stagnated for years as demand gradually declined. (U.S. consumption of oil is down 9 percent from 2005 to 2011.) Now we have oil coming from places that used be grazing ground for cows. Also, gasoline regulations in California are so strict that only refineries in California can meet them; this explains why gasoline prices in California are some of the highest in the U.S.
Because this new oil cannot be shipped to the coasts and put in tankers and sent overseas, its flow needs to fit into our existing transportation and refining infrastructure. It costs five times more to build a new refinery than to add capacity to an existing refinery — and refineries cannot move. We probably will not see a lot of new refineries built either, as nobody wants one in their backyard. (Until March 2013, when a new refinery opened in North Dakota, we had not seen a single new refinery built in the U.S. since 1976.) So the big question is, how will oil get from midcontinent to the refineries?
There are only two answers: rail or pipelines.
There are four interested parties in this debate: producers, railroads, pipelines and refiners. Producers favor pipelines because it costs 50 to 70 percent less to transport oil by pipeline than by rail. Lower transportation costs mean higher profits for them. However, railroads desperately need to transport this oil to offset declining demand for coal. It costs tens of millions of dollars to build new terminals or lay new track, a fraction of what it costs to build a pipeline.
Railroads are a more expensive transportation alternative than pipelines, but they are more flexible and they are already in place. Railroads have been the biggest beneficiaries of the oil boom so far. BNSF last year transported 650,000 barrels of oil per day, up from virtually nothing five years ago.
Pipeline companies will obviously favor pipelines over railroads, but environmentalists don’t love pipelines, and pipelines require a ten-year buying commitment from the refiner.
Of all these parties, refiners are the key players. Some of them — the ones that have refineries closest to the Bakken — want oil price differentials to stay high, thus allowing them to earn high refining (crack) spreads. For other refiners pipelines will make more sense. However, the construction of a new pipeline requires those ten-year buying commitments, and that has not happened lately. In fact, we are seeing refineries buying their own railcars. The more railcars refiners buy, the less likely they’ll be to commit to the building of new pipelines, and it’s unlikely we’ll see a multibillion-dollar pipeline built on spec.
This picture is further complicated by the fact that the oil coming out of the Bakken is light crude, whereas most coastal refiners have upgraded over the years to process heavy oil. It is now uneconomical for them to process light crude.
The more I’ve learned about this market, the less clear it is to me that pipelines or railroads will be the long-term solution. The economist in me says that that pipelines are a more efficient way of transporting crude and thus should win in the long run, while the pragmatist in me looks at what is happening in the real world and concludes that railroads will play a bigger role in the future of oil transport.
Is Trinity the best way to play this new oil boom? You decide.