How New Rail Regulations May Spur Midstream M&A | White & Case LLP International Law Firm, Global Law Practice

How New Rail Regulations May Spur Midstream M&A

Over the past several months we've seen a rise in mergers and acquisitions among midstream energy firms. A variety of factors will likely push more firms to consider M&A, but one factor stands out: new regulations surrounding how to transport crude oil by train.

Critics say these new rules don't go far enough, and recent events haven't alleviated their fears.

 

New Regulations in Effect, but Critics Say More are Needed

Concern about train wrecks involving crude oil heightened after a oil crude train explosion in 2013 killed 47 people in Lac-Mégantic, Quebec. On May 1 of this year, the US government announced new regulations requiring greater fortification of tank cars in an effort to lessen the severity should a crude oil car derail and catch fire. The rules include:

• Enhanced tank car standards and a risk-based retrofitting schedule for older cars carrying crude oil and ethanol;

• Braking standards for certain trains to potentially reduce the severity of an accident and the "pile-up" effect;

• Operational protocols for trains transporting large volumes of flammable liquids, including routing requirements and speed restrictions;

• Sampling and testing measures to improve classification of energy products placed into transport.

Critics say these new rules don't go far enough, and recent events haven't alleviated their fears. Less than a week after the new US regulations were announced, there was another fiery accident involving tank cars carrying crude from the Bakken. The latest crash was the fifth since February and the eleventh in North America in the last two years involving oil transport by rail. As a result, Congress continues to introduce new, more stringent bills, including one by Senator Maria Cantwell of Washington, that would immediately remove more than 37,000 railcars, including the older DOT-111 model, from service.

The new rules make any train infrastructure improvements more expensive.

 

New Infrastructure Sorely Needed

Even before the latest regulations and proposed new laws, the need for new and updated infrastructure was acute. The new rules just make any train infrastructure improvements more expensive. Retrofitting will cost about $15,000 per DOT-111 railcar, or about $1.1 billion for the entire fleet. In addition, installing new braking systems could cost about $10,000 per tank car. Some non-jacketed cars that carry crude have until 2020 to be retrofitted, and jacketed CPC-1232 cars have until 2025. All told, the new train regulations alone are expected to cost an estimated $2.5 billion over the next two decades, with retrofitting and retiring old cars consuming about two-thirds of this cost. Some non-jacketed cars that carry crude have until 2020 to be retrofitted, and jacketed CPC-1232 cars have until 2025. There is some question whether railcar manufacturers even have the capacity to retrofit (or build new cars) fast enough to meet the deadlines.

Rail may be more flexible, but the new regulations and car retrofitting may make expanding pipelines, or even building new ones, better options than upgrading rail infrastructure.

 

Remaining Questions Complicate Calculations

While the onus to comply with the new rules is on midstream companies, it is unclear where potential liability rests. If there's a future train derailment, are the midstream firms liable even if the train cars meet the new standards? It is unclear how to mitigate risk without more accurately identifying who owns it. What will Congress mandate next? There is no shortage of bills, and the Inspector General is now investigating the latest set of DOT rules to determine whether they adequately meet Congressional mandates.

In an atmosphere of significantly rising costs, mergers and acquisitions are sure to play center stage.

 

All of This Leads to M&A

Oil and gas companies must study the new rules and evaluate whether their current business models are right for the new environment. Some companies may have the financial wherewithal to go it alone, while others may have to look for partners. Still others are buying their MLP subsidiaries to lower the cost of capital. This could be an opportunity for new players to enter the market for owning and leasing new tank cars. There certainly is no shortage of potential investors in the midstream space.

Some companies may opt to invest in pipeline transport instead. If that doesn't occur, it will create a significant opportunity for rail transport. In such case, companies good at rail logistics and leasing would have an inherent advantage.

 

Opportunity Knocks

Credit is another piece to the puzzle, as railcar replacement raises the potential for significant asset finance opportunities. The crude tank car industry lends itself nicely to asset financing because of its physical collateral. The new mandate for massive capital expenditure in crude oil railcars could give forward-thinking lenders a head start into this new market. Companies will scramble to comply with regulations while trying to anticipate new laws.

The one common component to all of this is the increased cost. In an atmosphere of significantly rising costs, mergers and acquisitions — particularly in the midstream space — are sure to play center stage.

 

This article was originally published in Oil & Gas Monitor.