Railroad Renaissance

Jim Brown
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If we can't ship by pipeline we will ship by railroad. That appears to be the prevailing sentiment all across the U.S. but now Canada is getting into the railroad mindset.

After repeated delays in getting President Obama to approve the Keystone pipeline the developer, TransCanada (TRP), is considering transporting the oil by rail trains until the pipeline is approved and constructed. The CEO said the U.S. will eventually approve the pipeline, already three years behind schedule, but it could take time. The U.S. is missing out on a substantial amount of cheap oil by delaying the pipeline. We are also risking the chance that China will fund a pipeline through Canada to deliver the oil to the west coast where it can be shipped to China instead of the USA.

TransCanada said customers had approached them about building a rail hub at Hardesty, which is the initiation point of the current Keystone XL project. Exxon, Chevron and Conoco want a temporary way to ship oil from Canada while waiting on the larger Keystone pipeline to be completed.

TransCanada said demand for the pipeline from producers was actually increasing rather than decreasing as a result of the continued delays. The CEO said by the end of 2015 an average of 1.2 mbpd will be transported by rail instead of pipeline.

Rail terminals can be built relatively cheaply and quickly if the participants are motivated. Several of the U.S. refiners have built receiving terminals and expanded others as a result of the massive amount of oil coming by rail from places like the Bakken. However, hardly a week goes by without new of a derailment of oil cars somewhere in the system. Oil by rail will never be as safe and nonpolluting as pipelines but at least it will be flowing into the system.

How much will oil cost? At an analyst meeting in March Chevron said it had modeled its guidance based on Brent crude at $110 per barrel. Their previous projections had been based on $79 per barrel. About the same time Exxon released earnings guidance based on $109 Brent pricing. Since these large energy companies are normally conservative on guidance does this mean they are actually expecting higher prices?

With demand rising and non-OPEC supply expected to increase slower than previously projected the answer is yes. We should expect higher prices in the years to come.

The problem is not a shortage of oil. The problem is "above ground" where government conflicts, mismanagement and civil violence come into play. Numerous producing countries are exporting below their capability because of internal problems. Venezuela, Argentina, Libya, Nigeria, Mexico, etc, are all lagging behind their true production capabilities.

Even production from Russia is slowing because of corruption, lack of investment and poor management.

In a recent Seadrill (SDRL) presentation Here they listed the breakeven prices for oil production from the various regions of the world. The chart below shows the breakeven price in Brent dollars for the various regions and oil types. Middle Eastern onshore oil production still has the best economics with a $27 breakeven price. That means they can make a lot of money at almost any price for crude. However, this only includes the lifting and production costs. In reality Saudi Arabia needs at least $85 and probably closer to $90 today to fund their budgets. That requirement puts an artificial floor under prices because they won't let if fall much below $90.

The width of the boxes shows the portion of global production accountable to each oil type. In the top right corner you can see the North American shale in purple is a relatively small portion of global production with a breakeven price of $65 a barrel. However, because of the rapid depletion and the rising costs of wells it will take prices over $90 to justify new capex investments into these shale fields. FYI, the Onshore RoW means rest of the world.

The end of shale exploration? Last year California was thought to have 13.7 billion barrels of recoverable oil in the Monterrey Shale. The EIA is about to revise that a lot lower to as little as 600 million barrels.

Apparently not all shale fields are created equal. The vast Monterrey Shale has been jostled by earthquakes so much over the last 100,000 years that the shale layers don't line up like a stack of pancakes as in other shale fields. They have been fractured and shifted so much that pushing a drill bit through the sweet spot between the shale layers is proving to be more than current technology can handle. Wells are costly and perform badly.

Chevron (CVX) and Occidental (OXY) are moving their focus away from California. OXY is going to spinoff their California assets and focus instead on the more profitable Permian assets. Chevron said it was going to spend the minimum on California exploration because there was no return on the investment.

Not only is the geology proving impossible to crack the regulations in California are proving to be even tougher. Getting drilling permits is next to impossible and the regulations after you get a permit make it nearly impossible to turn a profit. As a result California is about to lose the $24.6 billion in annual tax revenue it had budgeted and the 2.8 million new jobs. There really is a penalty for being unfriendly to business.

Oil Inventories

In April the API said the U.S. refiners produced an average of 9.79 million bpd. That is a +9.2% rise over 2013 levels. Distillate fuels that include diesel and jet fuel rose +12% to 4.95 mbpd, a record for April. Gasoline consumption rose +2.7% to 9.0 mbpd. Distillate demand rose +8.8% to 4.21 mbpd and the most for April since 2007. Refiners processed 16.1 mbpd and a record for April. Last week U.S. oil production rose to 8.434 mbpd and the highest level since 1988. The sharp rise in U.S. production is keeping our gasoline prices in check even though WTI prices are now over $104. Without this level of production the global price for oil would be well over $110 where it is today.

As a result of the spike in distillate production and gasoline demand oil inventories fell a whopping -7.2 million barrels last week. Refinery utilization remained flat at 88.7%.

I mentioned last week about the discrepancies between inventories, production and utilization from week to week. This is a good example. Utilization was flat but inventory numbers spiked significantly indicating a sharp increase in production. We have to live with these weekly fluctuations and just assume that over the long run everything will even out.

Distillate inventories rose +3.4 million barrels and the largest gain in months. Distillate demand declined 480,00 bpd so that helped push inventories higher.

Gasoline inventories rose +1 million barrels while gasoline demand remained at the highs for the year at 9.17 mbpd.

Imports of crude fell to a multi-month low at 6.47 mbpd while U.S. production rose to another post 1988 high at 8.434 mbpd.

Cushing inventories fell slightly to 23.2 million barrels and another multi-year low. The 20 million barrel mark is assumed to be the minimum operating level and we are getting close.

In the graphic below green represents a recent high and yellow a recent low.

The U.S. was importing about 2.7 mbpd of crude oil from Africa in 2007. That has declined to less than 500,000 bpd as a result of the increase in shale production in the USA. Shale oil from the Permian and Bakken is considered to be the same light sweet crude we were importing from Libya, Nigeria, Algeria and Angola. That oil is now being diverted to Europe. Libyan oil has been off the market since the civil war with the country exporting only about 200,000 bpd compared to the 1.2-1.4 mbpd before the war.

China imported about 1.2 mbpd of LS crude from Africa in the first four months of 2014. Our surplus has allowed China access to the premium crude grades from that region. They are now the world's largest importer of African crude.

Our onshore production is weighing on Brent prices. Countries previously exporting to the U.S. are now looking for other markets. U.S. refiners would still import from Africa if the prices were right compared to WTI prices. That "low bid" from U.S. refiners is keeping Brent prices low. Brent today is $110 and WTI $104.

U.S. natural gas prices continue to remain stubbornly high at $4.40. There was another injection of 106 Bcf into storage last week but that only lifted gas in storage to 1,266 Bcf. Over the next 22 weeks we need to put an additional 3,500 Bcf into storage and at 100+ bcf per week we are not going to make it. If production does not increase rapidly we are going to run short next winter. Buyers and investors have done the math and that is why prices are holding at the current levels. Over the next four weeks injections should increase strongly as the spring weather puts little demand on gas for heating or cooling. Once the summer cooling demand begins in late June we could see prices move higher.


The U.S. markets are closed on Monday. The S&P closed at a record high on Friday and any positive open on Tuesday could cause significant short covering and another spike higher. This could be a pivotal week. With the major indexes trending higher and the Nasdaq and Russell in recovery mode this is the week that a breakout could occur. However, with a mild economic calendar and no material earnings reports, this could also be the week that the summer doldrums begin and the markets decline from their highs. Summer is typically a weak period for equities so be prepared for a strong move in either direction.

Traders currently short and expecting that summer decline could be caught off guard and be forced to cover this week. Traders long and hoping for a breakout could be caught off guard if a summer decline begins. Flip a coin and place your bets.

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Jim Brown

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