The oil and gas industry has done a 180-degree turn from a year ago with prices for gas, liquids and crude all having reversed, while the number of active drilling rigs has also fallen greatly around the U.S. and Canada.
Once a hot industry, oil production has quickly cooled off in the past year with crude by rail (CBR) serving as a prime indicator of the impact of these rapid changes. Just a few years ago, rail was not a major part of the oil industry, but that changed when transportation-disadvantaged regions like the Bakken and Western Canada became focal points for producers.
Suddenly everyone in rail was interested in the oil industry and vice versa.
Sand, then oil
Initially, rail was used by crude producers not to haul production, but to transport frack sand to infrastructure-constrained regions. For an 18-month period beginning in 2012, there was a nearly perfect symbiotic relationship as railroads brought up frack sand to enable production out of these regions and then took that production to market.
For crude oil, pipelines promised to provide cheaper shipping rates, but would take five to six years to be constructed and required long-term service agreements. Bakken and Canadian producers needed transportation solutions immediately and couldn’t wait for pipe construction. In addition, Bakken producers were unsure of the decline rates in the play, which made them hesitant to sign long-term deals.
“Crude production levels out of North Dakota were 150,000 barrels per day (bbl/d) for 30 years before it experienced off-the-charts growth for a year-and-a-half. Producers had to find a way to transport these extra volumes quickly,” Dan Lippe, managing partner, Petral Consulting Co., told Midstream Business.
Flexibility with a price
The sudden decrease in volumes shipped by rail brought about by low crude prices highlights the flexibility of rail transportation. Unlike pipelines, railroads don’t require any sort of volume commitment. This makes it easier for producers to pull back shipments when the price spreads between imported crudes, such as North Sea Brent, and domestic crudes, including the benchmark West Texas Intermediate (WTI), are not in their favor.
“You can ship one day and not the next. No harm, no foul,” Logan Purk, senior analyst–equity research, Edward Jones, told Midstream Business. “First and foremost, crude by rail is very dependent on the spreads that producers can capture and right now they’re not in the producers’ favor, which has driven a lot of the volume decline.”
Prior to the downturn in crude prices, there was a great deal of investment in rail in various parts of North America. Investors assumed that the window of opportunity for CBR was a small one that would close once pipelines were developed into these transportation-constrained regions. However, nobody was predicting the window wouldn’t just shut quickly, but never really open in many cases.
Heavy investments were made to help transport Western Canadian and Bakken production to the Gulf, East and West coasts. The Gulf Coast is the largest refining hub in North America and a natural home to heavy Western Canadian crude.
However, the differentials with heavy Mexican Mayan crude have seen this production pushed out of the market. By the time that prices do improve and this Canadian crude can once again compete on the Gulf Coast, pipeline capacity to the region will have increased and likely shut the door on rail.
Pipelines win
“Pipelines are going to win every time on a head-to-head basis because their costs are quite a bit lower from Western Canada to the Gulf Coast,” Taylor Robinson, president of PLG Consulting, told Midstream Business.
Robinson noted that Western Canada has been a major disappointment to investors with more than 1 million bbl/d of new terminal capacity announced in the region prior to the price downturn, but only 150,000 bbl/d is used at this time.
“When the original forecasts for crude by rail were made in early 2014, we didn’t really discuss oil prices because they were not expected to decrease significantly. Everyone was trying to grow as fast as they could. It’s difficult to see that Western Canadian crude-by-rail volumes will ever hit that 1 million bbl/d capacity level,” Robinson said.
Bright spot
It’s not all bad news when it comes to Canadian crude as Canadian Pacific Railway Ltd. reported record crude shipments in September. The company was able to secure these record levels because of competitive pricing relative to pipeline costs. Company officials pointed out that it is likely that crude shipments will be lower in the fourth quarter due to weaker spreads, though they are not as bad as in the summer.
It is rare for railways to begin to cut costs, even on a temporary basis as the aforementioned rates appear to be, but it is indicative of the reality facing railways, which have been experiencing decreased shipment volumes for coal.
“There has been some strategic pricing relative to pipeline capacity and the ability to put that freight on the rail vs. the pipeline. Obviously, in a more robust environment, we would be extracting a greater rate of return on the business, but we are covering our cost of capital. We are making money. We are not doing this for practice. It is revenue we otherwise wouldn’t see on the rail, so I think it’s the right thing to do,” Keith Creel, president and COO of Canadian Pacific, said during the company’s third-quarter earnings call.
Coastal opportunities
As it currently stands, West Coast rail operations are running at high levels and can expect a future increase as it will be difficult for any pipelines to be built over the Rockies. Rail is constrained along the West Coast because of struggles to build new terminals to handle the influx of volumes out of the Bakken and Western Canada.
The East Coast has large refineries in Pennsylvania, Delaware and New Jersey, but large pipelines developed to handle new crude production are unlikely to make their way to these large metropolitan areas.

“As long as crude by rail can compete with a healthy Brent-WTI spread, Bakken crude shipped by rail will have a home on the East Coast because the refineries there are mainly light and love the quality of the crude,” Robinson added.
However, until recently about 70% of all Bakken crude was transported to the East Coast, where it is getting pushed out in favor of cheaper Brent. “The Bakken is getting hurt by the recent Brent-WTI spread because it’s not high enough, and it’s making it difficult to compete on the East Coast,” Robinson said.
Headwinds and tailwinds
Canada has had an interesting role in the growth of crude by rail. The country has traditionally been an energy-friendly country, but it has been experiencing a lot of political and community pushback toward several high-profile pipeline projects. Some observers speculate the new Liberal government will be less friendly toward the oil business.
Consequently, CBR is a larger make-up of the transportation mix in Canada with crude representing about 8.5% for the Canadian Pacific compared to under 3% for the Union Pacific, the biggest U.S. railroad.
The pushbacks have come not only from environmentalists, but also from aboriginal groups that hold the rights to lands that these systems would have to traverse. At the same time, rail is also facing a political battle in Canada due to the 2013 accident that devastated the town of Lac-Mégantic, Québec.
A potential tailwind for the industry would be if the U.S. ban were lifted on crude exports. Though there isn’t a great route for exports out of the Bakken and Western Canada, the regions could stand to gain on a secondary basis.
“Higher crude prices and a lift of the ban would raise all of the boats and help crude by rail in an ancillary way. The Eagle Ford could be a great place to export from but the Bakken could backfill from regional use that the Eagle Ford was supplying. Regions depending on crude-by-rail transportation will struggle to make an impact because you have to be extremely competitive and rail isn’t the cheapest route. This change in policy would help crude by rail, but not by a large volume,” Robinson said.
There is a further note of caution for rail transportation from Western Canada and the Bakken when it comes to the potential for the long-delayed Keystone XL Pipeline to actually receive approval, as Robinson stated that a pipeline that large would deeply undercut the economics of rail shipments. President Obama rejected a permit application to build the pipeline, but TransCanada was reported to be reviewing its options and could continue to pursue the project.
Eyeing the Northeast
Despite the price downturn, Alan Shaw, Norfolk Southern Corp.’s executive vice president and chief marketing officer, noted positives surrounding the energy and rail industries.
“We benefit from the movement of crude oil to the East Coast refinery complex as well as increased natural gas drilling within the Marcellus-Utica region, driving inputs of sand and pipe and outputs of natural gas liquids. While reduced commodity prices have tempered 2015 growth, this will continue as a significant market for us,” he said during the company’s second-quarter earnings call.
He specifically noted that the Marcellus-Utica would be a point of strength due to the activity and fractionation capacity in the region.
“There is additional capacity coming online in the fractionator area also with current fractionators expanding,” Shaw said.
The propane game
The transportation of NGL, specifically propane, out of the Marcellus has been increasing for railways as the product is long in the region. However, supplies are so large that this past spring Norfolk Southern had to embargo the Hattiesburg, Miss., terminal due to too many inbound rail cars to the Targa Resources Inc. and Enterprise Products Partners LP hubs in the region.
In many ways the transportation of propane is a short game for both the railways and producers, according to Lippe.
“It costs about 25 to 30 cents per gallon to put propane in rail cars for six months a year. The railroads hate seasonal businesses—they want year-round businesses and propane and butane are not year-round business for them. That makes for expensive shipping rates, and that’s an area that cries out for multipurpose pipelines to be built,” he said.
It is unlikely that rail will be long-term shippers of Appalachian production, but rather remain an important shipper of production from regions like the Bakken to Northeast refineries. This is because it is very difficult to build pipelines into the Northeast and much easier to build pipelines out of the region. “The places where rail becomes important is where you can’t build a pipeline,” Lippe added.
Long-term outlook
Though CBR shipments are down this year, Purk said that there is still some room for growth. He added that it’s likely that CBR will remain a solid segment of the rail industry going forward. It may not enter the massive carload category held by products like grain and coal, but if it keeps up at a modest pace, CBR could grow to 5% to 10% of rail industry volumes shipped in the country.
“There will be continued investment going forward, but the market we’re in now, with volumes softer, I don’t think the rails will spend significantly to build out a product that is suffering on the demand side,” Purk said.
There may not be much discussion about the need for more rail infrastructure to handle production. The industry will need to develop more inbound rail-handling capability if the volume of liquids keeps increasing to the Gulf Coast.
“In a perfect scenario where we have all of the necessary pipeline infrastructure in place, crude by rail becomes a supplement to that product so pipelines meet most of the demand, but when there’s a price spike you can easily switch to rail and turn it off when you don’t need it,” Purk said.
CBR may never reach the heights that were initially predicted by many, but it is also here to stay even as more pipelines are developed.

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