During the past three years, transportation of crude oil via railway in North America has increased dramatically, going from being basically nil in 2010 to more than 600,000 barrels (bbl.) per day currently.

This phenomenon has been driven by the sharp rise in oil production that has caused supply to outstrip the takeaway capacity afforded by the more traditional mode of oil egress, i.e., pipeline. Oil producers have flocked to rail as they seek alternative means to get their stranded crude oil to market—and especially to the locations with premium prices.

Rapid oil production growth in the Bakken continues to outpace the rising pipeline takeaway capacity today. Yet pipeline utilization rates out of the region have been declining since early 2012. More specifically, Bakken producers have been foregoing pipeline service in favor of rail—even though rail is a more expensive means of transport.

Rail’s advantages

Rail offers several significant advantages. First, rail has greater destination flexibility than pipes, enabling producers to easily redirect their products to the markets with the highest prices. In today’s world where regional pricing spreads are volatile, the ability for a producer to reroute from a discounted destination to a premium-priced destination can be material. Underlying this greater flexibility is that sending crude via rail merely requires producers to commit to short-term contracts of one to five years, whereas pipelines necessitate long-term contracts of 10 to 20 years.

Rail is also faster. For example, it takes five to six days for a single train to send oil from the Bakken to the Gulf Coast versus almost 40 days via pipe. The net effect for producers, which can have several hundred million dollars in product inventory, is significantly faster working capital and lower costs for carry and hedging.

Rail provides timing advantages compared to pipelines, not only for upstream producers but from a midstream perspective as well. Pipelines have high upfront capital costs and require extensive regulatory and environmental review, which often cause projects to fall prey to delays and political uncertainty. Meanwhile, rail projects require significantly less time and money to plan and construct.

As rail is more expensive than pipe, railroads will seek locations with the highest netbacks. With most of the forthcoming pipelines being planned to transport oil to the Gulf Coast, the region could become awash in oil.

Raymond James analysts predict a coming glut that will be most pronounced in the light, sweet variety, and that the region’s benchmark Light Louisiana Sweet (LLS) will move to a significant discount to Brent of $5 to$10 per bbl. Currently, LLS trades at a premium to Brent. Arguably, the incentive for Midcontinent producers going forward will be to rail to the remaining Brent-linked markets, the East and West Coasts.

Canadian opportunity

But a big growth opportunity for rail transport is the Canadian market. Heavy crude, such as Canada’s, needs to be diluted before it can move via pipeline, whereas no such measure is required via train. The diluents eat approximately 30% of the shippable volume and are costly as they must be purchased and shipped from other sources. According to Raymond James, the cost savings of pipeline over rail on a diluent-adjusted basis is relatively modest and even favors rail in some instances.

Producers may also have an easier time securing customers on the downstream side with rail because refiners prefer oil with preserved product quality rather than diluted barrels. Most refiners have already embarked on some initiatives to increase their ownership of railcar fleets, and midstream operators have been actively constructing loading and offloading terminals for oil rail capacity.

Pipelines will likely remain the most efficient and dominant means of crude transport for decades to come, but the strength in crude production volumes should support expansion in both rail and pipe. Rail has an opportunity to grow in service of the Canadian oil sands producers and among small to midsized companies with less flexibility to commit to long-term pipeline agreements. From a midstream perspective, several refiners and producers have been expanding their infrastructure around rail as these assets can be housed in master limited partnership structures at attractive valuations.

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