the first article in this series, I described one of the
ideas to come out of my Valuex Vail investing conference. In
this piece I look at one of the presentations from the
conference, which examines the impact of the shale oil
revolution on one manufacturer of railcars, barges and storage
tanks. This presentation, like the WWE presentation in the
previous story, is a perfect example of what Valuex Vail is all
about: the stimulation of thinking.
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, Texasbased
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, Ive 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. Lets say the price of light crude is $75 in
North Dakota and $100 in Los Angeles. Youd 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
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 dont love pipelines, and
pipelines require a ten-year buying commitment from the
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 theyll be to commit to the building of new
pipelines, and its unlikely well 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 Ive 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