How Oil Gets From the Ground to the Tank

A lot of work goes into getting oil out of the ground and into your tank, and a huge and expensive leg of that journey is transport.

In this clip from Industry Focus, Motley Fool analyst Sean O'Reilly and contributor Adam Levine-Weinberg take a dive into the oil transportation world. Find out how expensive it is for big oil players to ship their oil around; whether it's more lucrative to use planes, trains, ships or trucks for oil hauls; where pipelines fit into the transportation picture; why it might be cheaper for American oil companies to get oil out of Iraq than oil out of North Dakota; and more.

A full transcript follows the video.

This video was recorded on June 22, 2017.

Sean O'Reilly: We talk about oil a lot here on this show, for obvious reasons. If I'm in the Permian Basin of West Texas or up there in South Dakota, and I strike oil, yay, me -- how am I going to get the oil to Houston?

Adam Levine-Weinberg: Oil is definitely a very specialized market within shipping. As you mentioned before, pipelines are an option, and that's something that doesn't exist for most other goods. So you have pipelines, you have trucks with tanker cars on them, you have rail tanker cars, and lastly you have ships. If you're somewhere that's landlocked like the Permian Basin, then ship is out. So you're left with pipeline, road, and rail. Road, as is the case for other shipments, the prices go up very significantly as distance gets longer. So just going a few hundred miles could cost you about $20 a barrel.

O'Reilly: Which is huge.

Levine-Weinberg: When oil was over $100 a barrel, that was big, but it wasn't so big that it never made sense. It usually didn't make sense, but it was still possible to make that work in some specialized cases. Today, if the global market oil prices are $45 a barrel, you just can't pay $20 a barrel. So you have to either get it onto rail or into a pipeline. Pipeline obviously depends on where is the nearest pipeline? Getting that pipeline infrastructure into the right places is very important. Rail has often, at least in the last five to 10 years, tended to be the first option when you're just opening up a new area for drilling. But once a new find becomes big and is producing a lot of oil, then somebody is going to build a pipeline in there, or at least try to build another pipeline in there, because it's a lot cheaper.

O'Reilly: Right. That was the one standout negative in Burlington Northern's results that we saw last week, when Taylor and I were talking. Buffett bought Burlington Northern during the financial crisis and immediately became a huge part of operations. The balance sheet exploded, because that's a large fixed asset. And it was minting money with the surge in shale for three years, up until 2012. Then things started to go south in 2014 in particular, and nobody was shipping oil on it. It's making less money than it did three years ago. There was only one culprit, and it was that the oil sector wasn't going so great. What does it cost for these pipelines? What does a pipeline company charge you?

Levine-Weinberg: A general rule of thumb is that pipelines tend to be about $3 to $4 a barrel. That's what you're going to pay. And it will go up for longer distances, but not by that much. Obviously, pipelines, there's a high fixed cost of putting the pipeline in the ground, but the cost of actually operating it, the variable cost, is quite low. So that makes it the cheapest way of getting oil around on land. Shipping overseas is actually cheaper. You can get a barrel of oil from the Persian Gulf to the U.S. for something like $2 a barrel in shipping costs. So it costs less to go from somewhere like Iraq to the United States than it would cost to get something from North Dakota down a pipeline to Houston.

O'Reilly: Wow. And not only that, but you hear all these stories about people storing oil offshore in these ships just because it's cheaper than storing it in Houston or Cushing or something.

Levine-Weinberg: In part because there's been this rise in oil production in the U.S., you haven't had as much of this intercontinental shipping of oil. And as a result, there's too many oil tankers out there. They're so cheap to rent that you can actually just use them as floating storage.

O'Reilly: I cannot believe it's that cheap. I really can't. $2. Wow!

Levine-Weinberg: Yeah. The even more expensive option is rail. Rail is going to set you back at least $10 a barrel if you want to go from something like North Dakota, the Bakken, to New York. This is why BNSF is making so much money. If you look back four or five years ago, they were doing a lot of these shipments out of the Bakken formation, in that region, to Houston, to New York, replacing a lot of that oversees crude. It was still a lot more expensive, the shipping. It would be about $10 a barrel, compared to $1 to $2, but it worked out because the Bakken crude was selling at such a discount compared to world markets due to that transportation issue. So it's really good while it lasts, but the problem is, it's so expensive comparatively to ship crude by rail that it's always giving companies an incentive to not ship crude by rail, to find other ways, specifically to build pipelines. So I don't know that it's ever going to come back, at least in that particular area, to the way it was five years ago, because even if the oil market picks up again, they've built pipelines up in that area now, so more of that crude oil is going to be going by pipeline rather than going by rail in the future. I think if there's a next big boom for crude by rail, it's going to be someplace we don't know about yet, to be honest.

O'Reilly: That's a really good insight. Even with oil where it is right now, I think it was about six months ago, maybe even a year ago, Kinder Morgan (KMI -0.56%) got final approvals for a $4 billion pipeline expansion up in Canada for the tar sands. And this is not the cheapest oil to make, and they were getting it to the western coast just above Seattle. And it was like, wow, if they're doing that for this oil, what reason would rail have to be used there? Crazy. Very good. You get the last word, Adam. Anything cool that you want to share for investors looking at the transportation sector?

Levine-Weinberg: I think we've basically covered it. If you take it from the view from 30,000 feet, the cheapest way to move stuff around is usually by ship. If not, it's going to be by rail. After that, you have auto. The most expensive is by air. But what actually makes the most sense from an economic perspective really depends on other factors, such as how big your shipment is, which will impact the cost of the pricier methods like air shipping and how time sensitive your shipment is. If you really need to get there soon, then obviously air can be well worth the cost. And that's why companies like FedEx and UPS do as well as they do.