strategic scenarios in crude-by-rail

Strategic scenarios and decision points in crude-by-rail (CBR): planning for when the train stopsJade Rodysill, Principal, Ernst & Young LLPAlex Fleming, Senior Manager, Ernst & Young LLP

Strategic scenarios and decision points in crude-by-rail (CBR): planning for when the train stops

Why

Performance forces

VisibilityVelo

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Volatility

What

Performance issues

Optimize

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How

Performance path

Leadership

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Technology PeopleMetrics

ProcessesOrganization

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Vision and strategy

We’ll explore CBR quickly, considering the forces influencing it, the issues impacting it and the elements needed to leverage it.

EY’s performance agenda is a framework for driving issues-based conversations leading to strategic decisions that we’ll use today

VisibilityVelo

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Volatility

Performance forces


Rail has proven itself a viable alternative to pipelines and continues to grow in importance, despite high-profile regulatory concerns

► There is no disagreement that rail has become the primary alternate to pipelines in North America.

► Regulatory concerns may slow this evolution or make infrastructure investments more costly, but they don’t appear to fundamentally change the equation at this point in time.

► The primary drivers of its viability are the regional pricing differentials, rail’s ability to access non-traditional routes to market and compliant tank car capacity.

Market situation in crude-by-rail

Source: Association of American Railroads

Source: Energy Information Administration


Argus

The industry and transportation providers have responded strongly, making and planning significant investments in CBR

Railway Age

Argus

“Valero Energy Corp. plans to purchase 2,000 tank cars. …The company also plans to invest up to $280 million in building a crude oil "topper.” … Valero hopes for delivery of the 2,000 railcars this year.”

BNSF

“BNSF is spending $220M in 2013 on CBR-related infrastructure in North Dakota alone. BNSF will be moving 750,000 bbls/day by the end of 2013, or 10% of all the oil in the U.S.

American Metal Market

“The story of rail freight car build rates is all about tankers. Tank cars – … which carry chemicals, liquids and pressurized gases – account for about 80 percent of new rail car orders and order backlogs. In the first half of this year, 12,967 tank cars were delivered, 26,211 new orders were placed and 61,350 were on backlog.”

Council on Foreign Affairs

“Crude oil exports could generate upward of $15 billion a year in revenue by 2017 at today's prices, according to industry estimates.”

Railway Age,

“The fall in coal shipments is partly linked to the abundance of domestically-produced natural gas, another product of the fracking process, in the US market. This has resulted in a dramatic fall in prices from a high of $US 13 per million British Thermal Units (mBTU) in summer 2008, to a low of just below $US 2 in April 2011 and $US 3.29 in August 2013.

“This is a trend that has hurt all of the Class 1s, but has been partly offset by success elsewhere. ‘Crude by rail is backfilling 50% of our coal losses,’ Matt Rose, BNSF CEO, says. ‘We have never seen a business that has grown so fast.’ ’’

“Houston, 21 May (Argus) — Marathon Oil is now shipping more Bakken shale crude production by rail than by pipeline as the US independent is readily finding rail takeaway capacity in North Dakota.

Last month, 58% of the company's Bakken crude oil production traveled by rail and just 8% moved by pipeline. The remainder stayed in local markets, according to Marathon Oil data. In February, 40% of Marathon's production to market was traveling over rail.

“Overall, more than 70% of Bakken crude production moves by rail, whose optionality and market reach has given it an advantage over pipelines.”


Market pricing currently drives the demand for crude oil shipment by rail, but several forces could alter viability and timing

► Excluding limiting hydraulic fracturing, crude oil pricing differentials, economic business cycles, and environmental permitting are known to drive the economic viability of CBR, but other potentially influential factors are emerging.

► Three other forces are expected to influence CBR viability over the next 2-5 years: ► Export demand for crude oil (velocity)► Recovery/relative change of natural gas

pricing (volatility)► Extent of safety regulation (volatility)

► Significant shifts in any of these areas, or a multiplicity of combined effects, could make crude-by-rail a more challenging proposition.

► The following research is underway and outside participation is welcomed.

Performance forces for CBR value chain

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NG/oilNG/coalpricing

Crude export

Safety regulation

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In one dimension, the ability to export crude oil will systemically change pricing, transportation flows and Gulf Coast economics

There are three strata stemming from the “ban” on exporting crude. This is the first dimension of our proposed framework.

► If the ban is overturned, the United States could experience a shift to market-driven exports, driving demand to produce and ship more crude, namely from east to west.

► If the ban is overturned or navigated subject to limitations or licenses are required to export crude oil, a mild shift in the crude market could open up to global markets and increase Gulf Coast pressure (see WTO).

► If the ban is maintained, crude will flow based on capital investment, spot price differentials and other dimensions.

Export of crude oil

Mar

ket-d

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ex

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Case 1

Case 2

Case 3

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Ban on crude oil export is overturned.

New global markets are available.

East-to-west pipeline capacity is limited.

Demand forcrude-by-rail increases.

Distillates will increase as crude price drops and Europe stays tight


In a second dimension, the price of natural gas has a direct impact on the viable capacity for CBR

A next dimension in our framework is that of natural gas pricing, breaking a natural gas price recovery into three tiers:

► A negative-to-flat price recovery would continue to incentivize utility companies to fuel plants with natural gas over coal due to the lower input cost. Rail capacity will not be reduced by incremental coal volumes as a near-term metallurgical coal recovery appears weak.

► A marginal recovery could see rail shift some capacity back to coal, holding current crude differentials steady. If spreads loosen, rail capacity tightness could drive higher rates.

► A significant recovery in natural gas prices could shift measurable rail capacity to coal as coal plants ramp up output and increase rates, certainly for less- dense lanes.

Pricing of natural gas

Negative to flat

Marginal recovery

Case 2 Case 3Case 1Significantrecovery

The natural gas power plant tipping point fluctuates around US$4.75.1

34 existing or planned LNG export terminals as of October 2013. 2

Cheniere Sabine will be the #3 user of natural gas behind only California and Texas in the U.S. 3

Price of natural gas

Volume of natural gas production

Pipeline capacity

Cost of using coal

1 “Cheap Illinois coal slows U.S. switch to cleaner gas,” Chicago Tribune, 20 September 20132 Itochu Group, November 20133 Cheniere, November 2013


Finally, developments in rail regulation reforms will influence how efficiently and effectively crude moves via rail

Extent of safety regulation A third dimension in our framework looks into the extent of rail safety regulation.

► New “stopgap” safety regulations put in place will marginally increase the overall costs of rail.

► New equipment regulations could see current capacity dip as older tank cars are replaced by newer, reinforced tank cars. With more than 61,000 tank cars in manufacturers’ backlog,1 the real impact varies based on the extent of the regulation.

► To address recent incidents, additional regulations could include changing routes in and around populated areas, replacing equipment faster, and implementing other measures that could dramatically increase rail rates and cycles times.

1 American Metal Market, Sept. 2013.

75% of the rail fleet hauling crude are DOT-111 tank cars that were built before the revised 10/11 code

$1B to retrofit the 300k+ balance

New costs to the rail sector

Passed regulation

Limited routes/compliance

New equipment regulations

New safety rules

New safety rules

New equipment regulations

Case 2 Case 3Case 1Limited routes/compliance


When assembled, the framework provides a means by which to understand scenarios and begin thinking of relevant indicators

Performance issues for clients in the market

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Strategic impact combinationsNG/oil

NG/coalpricing

Crude export

Safety regulation

Negative to flat

Not allow

ed (status quo)

Export of crude oil


Marginal recovery

Significantrecovery

Market-driven

exportLim

ited export

Light ramp

Extent of safety regulation

Oil Plays

Pipelines Marginalized

Backswing to Gas Plays

Controlled Ramp

Coal Breakpoint

Capacity Constrained

Rig Capacity Limited

Rail Capacity Case


Each stakeholder can assess and then focus on those scenarios with the greatest probabilities and consequences

The framework has 27 scenarios, with varying degrees of relevance. Let’s look at a few illustrative cases.

Case A: regulatory backlash with coal recovery

Case B: natural gas demand explosion (via LNG export, transportation and power generation) with crude export

Case C: limited crude export and new tank car requirements, with low natural gas prices

Case X: innovation - fundamental disruptive change in crude oil packaging or format for transport

Primary scenarios and black swan

Export of crude oil


Extent of safety regulation

Negative to flat

Marginal recovery

Significantrecovery

Market-driven

exportLim

ited export

Not allow

ed (status quo)

Light ramp

Rig capacity limited

Rail capacity case

New equip. regs.

New safety rules

Limit routes/compliance

New equip. regs.

New safety rules


New equip. regs.

New safety rules


Leadership

Execution


Processes Organization

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Performance path


To close out our discussion today, we’re suggesting focus in four areas to complement the use of the decision framework

The performance path – steps for execution

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Key Capabilities

Monitoring & Analysis

Process Integration

Network Perspective


Capabilities should be institutionalized to sense, respond and ultimately leverage the CBR opportunity and its inherent volatility

CBR is a newer business practice for most organizations touched by it. Based on observations of and input from a number of key players in CBR – carriers, 3PLs, driller, OFS companies, IOCs, and even inbound players like frac sand companies – a shortlist of key capabilities has been developed.

Strategic planning and S&OP process

Sector familiarity Logistics execution

Leadership needs to have visibility to the many variables driving price and demand.

Market forecasting► Rail, truck, pipeline and

barge► Transportation

infrastructure► Future infrastructure plans► Cost per BOE

► Price drivers of crude oil and natural gas

► Economics of gas vs. coal► Regulatory reform for

export of crude oil and natural gas

► Oil and gas end users► Drilling capabilities

and cost► Refinery capacity► Regulations and reform

Fleet management► Fleet size optimization► Buy vs. lease► Fuel management► Maintenance strategy► Fleet retirement

Performance path to competitive advantageLeadership

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1


Forward-thinking stakeholders can leverage their capabilities to then turn market information into actionable insight

Market factors► Price of crude► Price of natural gas► Price of coal► Domestic demand for

natural gas► Domestic demand for

crude► Global demand for crude► Pipeline capacity► Rail/tank car capacity

Market indicators► Logistical

infrastructure cost► Industrial demand for

resources► Resource supply► Export capability

Export potential/volume capabilities

Relative pricing indicators/regional variation

Aspects and degrees of safety regulation

Monitoring a variety of indicators allows for more comprehensive discussions and analytics when forming and executing a strategy.By identifying key influencers, multiple scenarios can be reviewed and modified to address future needs and business models.

2


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Export potential/volume capabilities

Relative pricing indicators/regional variation

Aspects and degrees of safety regulation

CBR Scenarios

Rail Volume Leverage

Rail Modal Premium Unit Train Discount Safety Parity


Management structures must include a clear process to continue regular monitoring and escalate tripwires for action

Performance path to competitive advantageDrive insights into executive decision-making cycle

Adopt KPIs and tripwires in functions to respond

Formalize execution of planning cycle

Develop basic monitoring capabilities

Sales and operations planningS&OP governance and decision making

Demand review Supply alignment Issue review and resolution Action planning

Demand management

Product innovation Product life cycle management

Price and promotion planning Demand planning

Supply management

Inventory deployment planning

Supply network planninginventory production materials

Site planning and scheduling

Logistics planning

CollaborationC

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uppl

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Supply chain execution

Integrated business and operations planning (IB&OP)

3

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Integrated Planning Example

Buy/Lease Fleet Sizing Fleet Allocation


Upstream operations Downstream operationsMidstream operations

The new rail paths to market are more than just that; they have implications that ripple across the oil and gas value chain


Execution



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4

Exploration and production

Offshore fields

Collection terminal

Primary distribution terminal

Secondary distributionterminal

Consumer retail

Bulk export to foreign markets

Denotes flow of petroleum products

Note: Inbound and outbound materials/chemicals, services and people flow between support facilities and upstream, midstream, and downstream operations

Refineries/petrochemical plants

Exploration and production

Onshore fields (e.g., tar sands, shale plays)

Foreign imports Processing

plants Liquefaction

Regional transload facility

Industrial wholesale

Markets

Pipeline networks

Pipeline, rail, road

Tanker, pipeline, rail

Tanker, pipeline

Tanker, pipeline, rail

LNG tanker

Pipeline


Road


Tank

er,

pipe

line,

rail

Pip

elin

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Regasification

Pipeline networks

Pipeline

Pipeline

Rail

Proppant inbound

Mine/proppant producer

Rail

Road

Railcar equivalents per well increased from 30 to almost 50 from 2011 to 2012

>= 1,200 TLs of water in and >= 500 TLs of wastewater out

Frac sand logistics networks and unit train buys

Dirty gas substitution for diesel; truck regulation


In conclusion

► Relative pricing of hydrocarbons, regulatory changes and market shifts that impact rail utilization are driving new scenarios that players must recognize and cultivate capabilities to facilitate competitive response.

► Our framework presents several combinations of options that can drive planning efforts, but organizations cannot ignore “black swan” potential. Integrating these scenarios into planning processes is vital.

► Leadership must build and ingrain the organization, processes, metrics, technology and people to enable sustainable competitive advantage and drive its own performance agenda.


EY Advisory’s Oil & Gas and Supply Chain practices are actively working with our clients to tackle these issues

For more information, please reach out to:Jade Rodysill – [email protected] Alex Fleming – [email protected] Franks – [email protected] Perrine – [email protected]

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strategic scenarios in crude-by-rail

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