Life and death in the energy markets

So much that affects railroads is really out of their control. The energy markets are a case in point today. Coal has historically been a bedrock commodity for railroads, and emergence of Wyoming and Montana coal in the 1980s led to just about every railroad being a beneficiary. Then two developments came together last year to alter that status quo. First, approaching regulatory deadlines from the Environmental Protection Agency made it likely that hundreds of older, smaller electrical generating stations using coal would be closed because it will be uneconomic to invest the money necessary to bring them into compliance with anti-pollution regulations. And cheap natural gas brought forth by hydraulic fracturing of shale rock formations and directional drilling suddenly made it cost effective for utilities to adopt gas as fuel in place of coal. The resulting decline in coal shipments hurt all of the big U.S. railroads, CSX Transportation and Norfolk Southern in particular.

Today the tables are turned. As I reported here in mid April, coal is again the preferred source of fuel of those utilities able to easily switch. Natural gas more than doubled in price from a year ago. Apparently, when the cost of natural gas at the wellhead exceeds $3.50 per million Btus, it is at a cost disadvantage to coal. The price of natural gas today is just above $4. Coal carloadings year to date still trail last year’s pace by 4.4 percent, but are ahead of 2012 in the second quarter by 2.7 percent. Analyst Bill Greene of Morgan Stanley says the biggest beneficiaries of higher coal carloadings will be CSX and NS, which makes sense, since they were affected most when the trend was down.

And now let’s look at the oil business. Isn’t that strange, talking about crude oil and railroads, which have had nothing in common for half a century? The emergence of shale fracturing has been in locales (North Dakota, for instance) not well served by pipelines. So today there is a two-year backlog of tank car orders as producers and leasing companies jump into the new habit of shipping crude oil by rail.

Today RBN Energy’s Sandy Fielden penned an interesting analysis of what North Dakota producers net after paying transportation costs to deliver their oil. Let’s assume, as Sandy did (go here to read his piece) that you can choose railroad or pipeline, and can ship to the east, west, or Gulf coasts or to the oil trading hub of Cushing, Okla. Which destination and method of delivery nets the most money?

I thought to myself, whatever the answers are, pipelines will look best because they are less costly than railroads. As prelude, the prices of oil on May 1 were $100 a barrel on the east coast, $102 on the Gulf coast, $101 on the west coast and $91 in Cushing. Here are the per-barrel prices producers fetched minus transportation costs:

Pipeline to the Gulf coast (transportation cost $10 per barrel): $92.

Rail to the west coast (cost $10): $91.

Rail to the Gulf coast (cost $15): $87.

Pipeline to Cushing (cost $6): $85.

Rail to the east coast (cost $16): $84.

Rail to Cushing (cost $13): $78.

What I took from this analysis is that railroads are more competitive with pipelines than I imagined. There are no pipelines to speak of linking North Dakota to the east and west coasts, and a $5 per barrel advantage of pipeline over rail on shipments to the Gulf coast is not really that decisive.

Since May 1, the spread between coastal prices and that in Cushing has all but disappeared, for reasons I don’t pretend to understand. The effect is to shift the transportation advantage to pipelines. But relax, oil by rail is not going to disappear any time soon. There are economic advantages to being able to send a unit train of oil anywhere in North America to take advantage of ever-changing price differentials. Moreover, the North Dakota producers using rail (which is really all of them) are either bound to long-term contracts with leasing companies or have sizable investments in their own fleets of cars. Plus, Sandy of necessity relied upon published rail rates, whereas negotiated contracts for unit train shipments could be less costly.

So here the railroads are in 2013, prisoners of commodity traders, weather patterns, and geopolitical forces, and government regulators. They would be wise, as Canadian Pacific’s Hunter Harrison said at his shareholder meeting last week, to tread carefully and hedge their bets. — Fred W. Frailey

P.S. If you are interested in the economics of the oil and gas business, go here to sign up for weekday briefings from RBN Energy’s people. They cover railroading’s entry into crude oil transportation in great detail, and write in a style that even I can understand.