After three years of planning, nearly $4 billion in capital investment and a year of legal disputes and protests, the Dakota Access Pipeline began transporting crude oil from the Bakken Shale region of North Dakota to the Gulf Coast last month. The move came just two months after President Trump issued the permits for the even-more-contested Keystone XL pipeline, which, if completed, would link the Canadian tar sands to U.S. consumption and export markets.
With a capacity of half a million barrels of oil a day, the delayed arrival of the Dakota Access Pipeline will once again make pipelines the dominant way to transport oil out of the upper Midwest into coastal refining regions. For oil producers and refiners, who will benefit from lower transportation costs, this is a great outcome. For environmentalists and tribal leaders, who argued that the pipeline would generate local and global environmental risks, the pipeline’s arrival is surely a disappointment.
Protesters aren’t the only ones who are unhappy with the new pipeline’s arrival. Joining them is the railroad industry, which stands to lose what was until recently a sizable business transporting crude oil out of the Bakken into refining regions. However, the rail industry has good reason to remain optimistic since it offers something pipelines can’t: flexibility in a perpetually volatile market.
Until the beginning of last year, the majority of crude oil produced in the booming Bakken region was transported by rail to refining centers in the Gulf, East and West coasts. At its recent peak, crude-by-rail carried about 10% of U.S. oil production, up from less than 1% in 2010. Though there is no reliable long-term data on crude-by-rail, it is quite possible that the last time the rail industry transported as much crude oil as it does today—20% of Bakken production and 4% of total U.S. production—was during the Standard Oil era of the early 20th century.
The recent re-emergence of crude-by-rail is a bit surprising. The rail industry charges higher prices than pipeline operators do, and anti-competitive practices by the rail industry during the Standard Oil era are arguably why pipelines got built in the first place. So why did producers and refiners choose a more expensive, less competitive option? One answer is that pipelines take a long time to build, and these days, any new fossil fuel infrastructure faces environmental opposition. Maybe the return of crude-by-rail was simply a stopgap: pipeline investment would (and did) eventually come, and in the meantime trains were better than nothing.
This “easy” answer, however, ignores crude-by-rail’s fundamental benefit: flexibility. Crude-by-rail allows producers and refiners to deliver to, or source from, more than one location. Today, crude oil produced in the Bakken is now being refined in diverse regions—from Pennsylvania to Texas to Washington—thanks to the extensive nature of the existing rail infrastructure. Because of this existing infrastructure, all that is needed to start transporting crude by rail are loading and unloading stations—clearly quicker and cheaper to build than pipelines, and requiring limited long-term commitment from producers and refiners.
In contrast, customers of the new Dakota Access Pipeline can only ship crude oil along a single route. And, because pipelines are so costly to build, these customers have agreed to use it every day for the next 5-10 years.
In this way, crude-by-rail’s flexibility can be more economically efficient than pipelines, at least in the short run. Coastal refiners can use Bakken crude only when it is cheaper than imports, and producers can always ship output to the location with highest demand. Dakota Access Pipeline customers, on the other hand, will be paying to use the pipeline even when prices in the Gulf are lower than prices in markets reachable by rail.
How valuable is this flexibility? I used data on rail and pipeline transportation costs from Genscape, and oil prices in different markets reachable by pipeline and rail from Bloomberg to calculate how often and by how much Bakken producers got a better price for their output due to rail’s flexibility. Between late 2010 and the end of 2016, crude-by-rail’s flexibility provided producers with an added $0.50 a barrel, on average, compared to a hypothetical world where they could only send output to the East Coast—the first major crude-by-rail destination for Bakken crude—or consume it locally. Fifty cents a barrel might seem small relative to average “local” oil prices available to Bakken producers during that time of $78 per barrel, but it’s important to remember that producers had average break-even costs of roughly $61 per barrel at the time, so this option value increased per barrel margins by about 3%.
Rail’s flexibility is also valuable to refiners. Consider a hypothetical East Coast refiner that historically imported crude oil from the North Sea. In the last decade, it has sometimes been cheaper to instead transport crude oil by rail from the Bakken. For these refiners, having the option to use crude-by-rail was worth about $1.90 per barrel over the same time horizon, which is a huge fraction of the typical refining margins of $5-10 per barrel.
At times, the value of this flexibility was even higher. For example, from mid 2011 to mid 2012, pipeline bottlenecks caused large differences in prices across locations in the United States. Being able to ship to whatever location had the highest price was worth about $1.80 a barrel, so during a time when the best “local” oil prices averaged $96 per barrel and break even costs averaged $90 per barrel, option value increased per barrel margins by thirty percent. At the same time, the value of flexibility to refiners was worth more than $5 per barrel. For both producers and refiners, the value of this flexibility eventually dissipated in 2014, when several Midwestern pipeline expansion projects went into service, eliminating the previously large price differences across locations. With these price differences gone, rail’s flexibility was no longer needed.
Though the value of rail’s flexibility was eventually eclipsed by the lower cost structure of new pipelines, the long history of volatile price differences across refining regions means that flexibility will likely return as a source of value for the oil industry in the years to come. In fact, the recent news that prospective customers of the Keystone XL pipeline might actually prefer that flexibility and cost structure is perhaps the first sign that the future of crude-by-rail remains bright.