Guiding an Energy Renaissance: Questions and Answers With Michael O'Neill

Tags: Supply Chain Management, Manufacturing, Specialized Logistics

Natural gas drilling site

The emergence of domestically sourced natural gas heralds significant changes in the North American energy market—especially in the way suppliers and producers move product.

Business is booming for the North American energy industry. From the oil fields of west Texas to North Dakota's Bakken shale formation, wells are springing to life and bubbling with economic potential. As the U.S. coal market continues to shrink—a consequence of the economy, environmental regulation, offshore demand, and new energy competition—producers and consumers are turning to cheaper and cleaner natural gas.

New drilling technology is driving down the cost of oil production while unlocking vast natural gas reserves—which, in turn, is driving a conversion from coal to gas. Many expect this energy renaissance will, in time, have a rippling effect across U.S. industries, luring more production back to North America.

At the forefront of this development is Radford, Pa.-based Preferred Sands, a frac sand and proppant manufacturer that operates six plants across Arizona, Minnesota, Nebraska, Wisconsin, and Canada. It supplies materials that help oil and natural gas companies facilitate hydraulic fracturing.

In January 2013, Preferred Sands debuted a full-service bulk proppant distribution system available to industry suppliers. The Preferred Pipeline leverages an extensive rail and trucking network to provide a centralized supply chain structure that offers end users a customized distribution and product fulfillment solution. In effect, Preferred Sands is morphing into an oil and gas third-party logistics provider, orchestrating a collaborative distribution network.

Inbound Logistics recently met with Michael O'Neill, CEO and founder of Preferred Sands, to discuss how the oil and gas industry is evolving and why the Preferred Pipeline is positioned to change the way suppliers and producers distribute product.

Q: How did Preferred Sands get its start?

A: In December 2007, we bought a small sand company in Nebraska that was having problems meeting its contracts, even though the market was hot. We completely retooled the plant, and built up the company in a rebounding market.

Frac sand demand in the United States and Canada was growing, and industry wasn't responding fast enough. To seize that opportunity, we scaled the business and bought five other plants. In 2011, we initiated a strategic planning process, and recognized the greatest long-term need for this market is an efficient distribution channel.

Q: Where is frac sand sourced?

A: The majority of frac sand used in the U.S. oil and gas industry is sourced domestically. Ceramic, artificial frac sand is imported from elsewhere around the world, and targets a particular high-end slice of the marketplace (about three to five percent).

Artificial sand is perfectly round and harder than natural silica. Hot and deep high-pressure wells will generally use ceramic sand. It's the most expensive material you can put in a well, so it's only used when necessary.

For the oil and gas industry, transportation is the largest cost. Labor on a mined product is not a huge piece of the pie, so you're not saving enough money to bring it in from other countries to remain competitive. But for man-made ceramics that carry a lot of labor cost, imports make sense.

The hottest areas for frac sand sourcing are Wisconsin, Minnesota, Illinois, and Ottawa—80 percent of frac sand comes from this region. Other sources include unique pockets such as Arizona and Nebraska.

Q: How has the emergence of natural gas changed distribution dynamics in the oil and gas industry?

A: Oil and gas has always been a boom-and-bust business. When oil hits a certain price, companies can produce all they want and make so much money that distribution costs don't matter. Get the oil to the well, don't ask questions, and don't innovate. Then the market crashes, and all operations shut down.

Investing in infrastructure was risky; it was a stranded cost that might never be recouped. This resulted in fractured distribution channels.

Natural gas changes that dynamic because it's largely a domestic product. World demand and supply creates volatility in the oil and gas industry. A competitive natural gas market will still be cyclical, but it won't be boom and bust as it goes from one market to another. We have a base of business, and it will be predicated by competitiveness and efficiency.

Q: How does the Preferred Pipeline fill this infrastructure gap, and drive efficiency and economy?

A: We recognized a need and opportunity to think through a distribution network that would drive out costs and bring efficiencies to the marketplace. With the fractured system we have, every manufacturer is doing its own thing, but none have the infrastructure to do it right. They don't move enough product to enough places to afford the capital expense.

In some places in the United States, companies are trucking frac sand 300 miles. It's extremely expensive, unreliable, and causes huge cost overruns. Laying out a terminal network for customers that gets inside 75 miles of a well site, takes inventory worries off their hands, and sources from multiple locations to provide a competitive landed cost brings tremendous value.

One year ago, we approached our partners, and some competitors, with a proposition: We can create a North American distribution network better than anything out there, and bring the lowest landed cost to every customer in every market.

But we need more product. We can't do it with only our volume. We need to be on every rail line. By collaborating with other suppliers, and running their volumes through our system, we can bring a competitive cost on every product to every location in the United States. We can have product to customers when they need it, just in time.

When you are pumping a commodity, prices change. Greater attention is paid to just-in-time expediency. Customers need to watch their landed costs; they can't afford to carry their own fractured distribution network. That was the inspiration.

Q: Specifically, how does the Preferred Pipeline meet the demand-driven, just-in-time transportation and logistics needs of well sites?

A: Companies that own and operate wells often have sites in a few different basins in the United States—some oil, some gas, some natural gas. They constantly balance where return on capital is best served. They move back and forth based on commodity prices, trying to get the best value and drive profitability.

Oil companies generally don't have long-term plans, given the market's volatility. The days of consistently ordering supplies two weeks in advance, waiting for product to arrive, then delivering to the well are almost over. Programs change, so it's tough to lock into a long-term forecast. This allows more flexibility to make decisions based on the market—for example, if they suddenly get a good bid to take on a new basin in lieu of another.

We call it the 'pipeline' because that's what you need to get oil and gas out of a region. But in order to get it out of the region, you need a pipeline of products coming in. We stock materials in the market to create a better balance between supplies inbound to well sites and product moving out.

Limited infrastructure on the outbound side often changes a market rapidly. If a pipeline fills up, and suddenly a company can't crack a well because it can't send product anywhere, it will shift to another place with better infrastructure. That just-in-time inventory—a pipeline of product coming in that matches the outflow—is very important.

If a company needs an item last-minute because a job comes up, it has to go out to a broker in the market and pay a premium. That's the price of doing something quickly. With the Preferred Pipeline, this just-in-time need comes up every day. Instead of paying a huge premium, it's part of the package.

Q: What types of manufacturers and suppliers are you targeting?

A: We're looking for companies that provide bulk products, such as fluids and cement, because that is the nature of our distribution. We are adding some warehouse capabilities where we can distribute smaller quantities. But these types of shipments can generally be delivered via UPS or another, more efficient means.

Frac sand suppliers are also potential customers. We sometimes share a customer with a competitor. A contract may have been signed at a time when sand was scarce, so customers weren't overly concerned that they were using two different sources—even though distribution costs were greater because they had to pay a switching fee on the rail line, for example.

Working with a competitor, we can swap product so that it moves single line direct to the end location, and the rest of its product follows accordingly. By combining and rationalizing the two legs—what I call 'trading the sand'—we enable customers to knock $10 to $12 off the total cost, saving the manufacturer money and making the marketplace more competitive.

The costs are not coming out of anyone's margin. Rather, it's driving efficiency in a market where companies need to reduce costs to remain competitive.

Q: How do shippers use the Preferred Pipeline?

A: In some cases, other companies sell us the product, and we carry it and re-sell it. Alternatively, we provide it as a service where they sell it directly and we manage all the railcars, movements, and transloading.

Q: From a transportation perspective, are there more opportunities to match inbound and outbound flows, and better utilize equipment and assets, by leveraging this collaborative distribution network?

A: Yes. We're seeing a shift, for example, from coal-fired plants to gas-fired plants. Shipping sand replaces shipping coal. It's not 1:1, but it's making up the difference. This boon has been great, but it's hurting the railroads on the coal side; shipment volumes have dropped. Sand, cement, and fluid movements have picked up some of that slack.

With inbound and outbound, we ship from Nebraska and Wisconsin. We ship from places where traditionally most of the product moving out of the region was grain. Agriculture is very seasonal. So an increase in frac sand and other commodities helps railroads flatten out demand spikes. Even in Texas, you have a lot of fertilizer coming in and grain moving out. Frac sand runs year-round, and balances out that seasonality. We have brought a lot of business to the Nebraska Central Railroad, which was fully dominated by grain. Being able to bring in a crew, and operate year round, helps them operate more efficiently.

Q: Where does Preferred Sands go from here?

A: The pipeline and technology will drive our business. Manufacturing will feed product through it. This market needs to become more efficient, and that will drive purchasing decisions. We have to run our plants as efficiently as possible, and focus on the margins that make us most competitive.

Kodak invented the digital camera but didn't want to bring it to market because it was afraid it wouldn't be able to sell film. That example happens over and over again. Having the most efficient logistics network is the single most important value we can bring to our customers. In some cases, it will make competitor product as a manufacturer more attractive. In the near term, we will become more agnostic in terms of what manufacturing plants we use, and let customers dictate the market in terms of their specs and cost needs.