First oil

We’ve divided up our oil and gas industry neatly into three sectors: upstream, midstream and downstream. Upstream encompasses the industry segment from the prospect to the pipeline. Midstream covers field processing, gathering and pipeline networks that are needed to transport the produced oil, gas and natural gas liquids to the downstream refining and petrochemical plants. The downstream sector refines crude oil into petroleum products, such as gasoline, diesel and aviation fuel, and even asphalt. Petrochemical plants produce a wide range of chemicals, fertilizers and plastics.

The reality is that all of these segments form one economic stream. The industry dynamics are such, that if there is a pull on the upstream side, there’s a tug across the midstream to the downstream end, and vice versa. Often, there can be conflicting economic interests, resulting in a fratricidal tug-of-war. A perfect example of this dynamic is the highly beneficial, yet highly disruptive effect of shale E&P.

Looking for oil in all the odd places. If the shale plays were in the traditional petroleum provinces, there would have been fewer disruptions to the midstream sector, other than having to increase the capacity of the existing pipeline infrastructure. However, independent operators have uncovered highly prolific shale plays in geographically diverse areas, such as central Pennsylvania (Marcellus), southeastern Ohio (Utica), North Dakota (Bakken), South Texas (Eagle Ford) and British Columbia (Horn River). Building pipeline networks from these isolated locations has provided the midstream sector with major expansion opportunities.

Since it takes a few years for the midstream businesses to build new pipelines, shale operators have resorted to shipping their crude via rail. U.S. Class I railroads originated just 9,500 carloads of crude oil in 2008. In 2012, they originated nearly 234,000 carloads and likely will have originated around 400,000 carloads in 2013. Investment guru Warren Buffet seized upon this trend in late 2009 by acquiring BNSF railroad. Now, with all the rail-borne crude shipments, it seems Buffet made out like a bandit.

Refining turnaround.  Before the shale revolution, the refineries on the U.S. Gulf Coast had configured their infrastructure to process heavy crudes from Mexico and Venezuela. Lacking sufficient domestic heavy crude refining capacity, Mexico exported its Mayan crude to the Gulf Coast refineries and imported their refined products. The increasing supply of light, sweet crude from the Bakken and Eagle Ford shale plays has thrown a wrench into this arrangement. The refiners are now trying to absorb as much of this light oil as possible by blending it with the heavy crude. There’s a limit to the blending, because above 55% light oil, the heat exchangers start fouling with paraffin.

The obvious solution, of course, is to export the shale oil to refineries in Europe and other parts of the world that are set up to process light oil. However, there is a ban on the export of U.S. crude oil, a legacy of the 1973 OPEC energy crisis.

Tug of war. This refining bottleneck brings us to the conflicting economic interests between the shale producers and the Gulf Coast refiners. The shale operators would like to create an export market for their crude. To this end, they’ve begun a lobbying effort to lift the export ban.

Opposing this effort are refiners, such as Valero, who prefer to keep U.S. crude oil prices low and export the refined products, such as petroleum, diesel and fractionated natural gas liquids, including ethane and propane. There is no ban on refined products.

It remains to be seen how this economic tug of war will play out, and if and when the advantage might shift from the downstream to the upstream end.