Can the Rail Industry Tip the Balance in Favor of Oil Producers?

With oil producers in the foreground and influential rail investors in the backdrop, proponents of lifting the export ban have a formidable arsenal.

Mar 20, 2014 at 11:03AM

Continental Resources (NYSE:CLR) is the top lease-holder in the Bakken shale, controlling 1.2 million net acres in the entire region. Depending on which angle you look at it, this has been both a blessing and a curse.

In retrospect, Continental Resources' monolithic acreage has been a blessing. It has placed the explorer and producer in a unique position to cash in on the U.S. oil production resurgence, which has been effected through fracking in shale formations such as the Bakken area. According to recent reports, U.S. oil production came in at 8.08 million barrels a day at the end of February this year. In stark contrast, production for the same period five years ago in 2009 was 5.37 million bpd. Naturally, this uptick in production output has been reflected in Continental Resources' stock, given its firm focus on exploration and production as well as its monumental acreage in the key Bakken shale area. In the past five years to date, the stock has gained around 419%.

However, as things stand, investors seem to have taken the foot off the gas. The stock's gains seemed to have topped off and stagnated for close to three months at a price range intimately close to its 52-week high. This slowdown is primarily because of slower growth in production volumes, not only for Continental Resources, but for the entire upstream sector as well. Investors are worried that the continued low crude oil prices will suppress margins even further, limiting the incentive to produce more.

An entire sector won't risk running into losses -- let's export
It is projected that the cost of production from shale plays ranges between $60 and $70 a barrel. Worse still, estimates from the International Energy Agency show that output from shale plays declines faster than that from conventional plays. It will take 2,500 new wells a year to sustain output of 1 million barrels per day in North Dakota's Bakken shale. Iraq could comfortably do the same with 60 wells.

Thereby, the only way to remain profitable is to have a predictable and favorable crude oil price regime. However, this 'holy grail' has been elusive. Not only have crude oil price futures been on a continual decline (though still above cost of production per barrel) but producers are increasingly hedging against price volatility, indicating that there isn't much hope for favorable prices in future. Kodiak Oil & Gas Corp (NYSE:KOG), a Bakken producer, is expected to hedge between 75% and 90% of its projected production.

With this perspective in mind, the only sure way of making production viable and growing output even more without the risk of supply outstripping demand and pulling down prices, is if oil producers can have a greater control of price movements. As things stand, this can be achieved by lifting the 40-year crude oil ban to allow producers to stabilize the demand/supply equation. In fact, Continental Resources CEO Harold Hamm is leading the charge to urge congress to lift the ban.

Differentiate between taking risks and being risky
When all bets are on, it will be hard to know whether or not the proponents of lifting the crude oil ban will get their way. Opponents of the idea also have a compelling counterargument and, above all, the entire process requires decisive political action, which is hard to get in the current political environment.

Banking solely on the idea that the crude oil ban will be lifted is risky, very risky.

But why are producers so surefooted? And should investors exude the same confidence? Yes, they should.

Big businesses take risks. However, taking risks doesn't mean being risky. There is a difference in that one yields great returns and another yields regrets and potential class action lawsuits from irate investors.

Crude oil producers have a wild card that is slowly coming into clearer focus and that will swiftly turn the tables, allowing them to offload the surplus output to foreign high-paying customers and accelerate production.

Rail is increasingly becoming a fundamental part of the U.S. oil narrative. According to the American Association of Railroads (AAR), crude oil is now a key commodity group for the rail industry. This is because existing pipelines can't sustain the current volumes. According to the AAR, there were 9,500 carloads of crude oil running the rails in 2008. By 2013, this number had exploded to more than 400,000. The rail industry is cashing in on increased transportation demand and should witness even greater growth should the export ban be lifted. This is because more crude oil will be transported to ports to meet foreign demand.

Plus, if you bet against the railroad sector, you are in a sense betting against Warren Buffett. According to a 2013 annual report for investors, Buffett's Berkshire Hathaway disclosed a 90% stake in Marmon Holdings, the parent company of privately owned Union Tank Company. Because Union Tank is private, we can't sneak a peek into its operations. However, American Railcar Industry (NASDAQ:ARII), which is chaired by activist investor Carl Icahn, expanded into leasing tank cars in 2011, just when the oil boom was in its early stages. The company saw a 9.8% increase in gross sales in 2013, leasing a total of 3,780 railcars in the fourth quarter compared with 2,190 a year earlier.

Final Foolish thoughts
With oil producers in the foreground and influential rail investors in the backdrop, proponents of lifting the export ban have a formidable arsenal. The proponents are taking aim with a bazooka while the opponents are taking aim with a sling shot. Should the ban be lifted, players such as Continental Resources will make gains commensurate to the high risks they have taken.

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Lennox Yieke has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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