The Economics of Flexibility Trump Efficiency - and Risk

This has been called the Attention Economy because in a crowded marketplace, attention is more likely to generate income. But questions are constantly being raised about to what we are paying attention - and for how long.

One manifestation of this concern is that flexibility has become a valued feature of the economic calculus. In a global market, everyone wants to be King of the Better Offer Club: I could sell to you, but that guy over there might offer me more if I wait a nano-second.

It turns out that in substantial corners of that market, flexibility trumps efficiency because it can lead to higher prices. But it may also influence risk analysis - and not always for the better.

A significant example is now evident in the energy markets, particularly with regard to the transshipment of oil. Rail is almost always more expensive than pipelines, but it turns out that rail offers more flexibility so that those better offers have more of a chance of getting generated and then accepted.

The problem is that flexibility may also trump risk. In the case of oil shipped from the booming Bakken fields in North Dakota, the composition of the product makes it potentially more flammable. Given the pressure on profits and the incentives to get the oil to market as quickly as possible in order to realize those higher prices, accidents have occurred with a regularity - and severity - that has caused deaths, generated considerable expense -  calls for greater regulation even in this most free-market of industry segments.

The implication is that any sort of risk-reward and cost-benefit analysis must be holistic and comprehensive if they are to calculate the true net present value of the opportunity. JL

Alison Sider reports in the Wall Street Journal:

Rail is almost always a more expensive way to transport crude than pipelines—as much as twice the price a barrel over similar distances. But rail's greater flexibility to ferry oil to where it fetches the highest price trumped the economics of pipelines

Moving North Dakota's oil riches out of state on trains was supposed to be a stopgap solution until pipelines could be built.

But even as crude gushes from the state's Bakken Shale at a rate of nearly 1 million barrels a day, some pipeline companies are abandoning proposed projects, and it is becoming clear that rail transport won't be a temporary phenomenon.

In January, Koch Pipeline Company walked away from a project because of what it said was tepid interest by local oil producers. A year earlier Oneok Partners  OKS in Your Value Your Change Short position LP canceled plans for a $2 billion pipeline from North Dakota to Oklahoma for the same reason.

Rail is almost always a more expensive way to transport crude than pipelines—as much as twice the price a barrel over similar distances. But in North Dakota's case, rail's greater flexibility to ferry oil to where it fetches the highest price trumped the economics of pipelines, said energy experts.

The abandoned pipeline projects could have tied into existing and proposed lines bringing oil to refiners in Texas and Louisiana, a market already awash in oil from nearby shale fields.

Ethan Bellamy, an analyst at Robert W. Baird & Co., said producers want the ability to sell oil flowing out of the Midwest to the highest bidder—often refineries in Washington state, New Jersey and Pennsylvania that are only accessible by rail.

"Making a pipeline volume commitment is like getting married. Shipping by rail is like a one-night stand," said Baird's Mr. Bellamy. "Right now I suspect producers would rather stay bachelors."

In part, the crude produced in North Dakota is a low-sulfur type that is highly prized right now among East Coast refiners. On average, the state's oil sold for $74 a barrel in January, much less than the about $104 a barrel that East Coast refineries paid to import overseas oil during the same month, according to state and federal data. Even with the between $5 and $15 a barrel cost of shipping crude via train, it still made economic sense to head east.

Greg Garland, chief executive of U.S. refiner Phillips 66, PSX in Your Value Your Change Short position said another factor is most proposed pipelines would run north and south, away from highest demand in the East and West. "We don't think you'll see pipelines going east and west," he said.

Trains also can reach refineries that pipelines cannot, said Tad True, a vice president at True Cos., which operates pipelines in North Dakota and Wyoming. That flexibility means there is little incentive to build or expand lines to carry oil from North Dakota, Mr. True said. His company believes new pipeline construction will largely be to connect the network of pipes already in the ground to rail systems—so they fit together more seamlessly, he added.

Train operators including BNSF Railway Co. and Union Pacific Corp.  UNP in Your Value Your Change Short position moved nearly three-fourths of all the oil pumped in North Dakota in December, according to the latest state estimates. That same month, crude oil flowing through pipelines slumped 2%.

The state agency formed to facilitate pipeline development estimates that even after the handful of new pipelines currently under construction start transporting oil in 2016, well over half of North Dakota's crude oil shipping capacity will remain on the rails.

One major pipeline company hopes to buck the trend. Enbridge Inc.  ENB.T in Your Value Your Change Short position is building a new line that would carry as much as 225,000 barrels of oil a day out of North Dakota when it goes into service in 2016. Marathon Petroleum Corp. MPC in Your Value Your Change Short position , which operates refineries in Detroit, Mich., Canton, Ohio, and Catlettsburg, Ky., has agreed to help foot the $2.6 billion construction bill and provide much of the oil in exchange for a 27% stake in Enbridge's North Dakota pipeline network.

Helping keep hopes alive for more such projects is the congestion and the potential hazards on rail shipments leaving the area. Oil tanker traffic has stressed parts of the rail system unaccustomed to hauling such large volumes of crude. In the past year a string of derailments—one deadly—caused massive explosions.

Last week, the U.S. Transportation Dept. issued new rules requiring that Bakken crude be tested before it is shipped on trains. The American Association of Railroads also agreed to a number of voluntary safety measures. Still, the new regulations aren't expected to be costly or create a burden on oil companies that want to rail North Dakota crude, said Wells Fargo  WFC in Your Value Your Change Short position energy analyst Roger Read.