Riding The Shale-Rail Connection

Investor's Business Daily

Pipelines have long been the best, cheapest and safest way to move oil or other products from point A to point B.

Unfortunately, pipelines are fixed and the points on the map where oil is produced are changing.

A rising number of U.S. shale oil production areas and an increasing flow of oil sands crude from Canada are rapidly altering the supply picture between U.S. refineries and production regions. The change has fueled excitement over railroads, which increasingly are picking up the slack that pipelines — choked with supply, blocked by environmentalists or just in the wrong place — can't meet.

Kansas City Southern (KSU), Canadian Pacific Railway (CP), Warren Buffett's Burlington Northern Santa Fe and others have quietly gained steam over the past year, moving Bakken Shale oil from North Dakota, Eagle Ford oil from south Texas and Canadian tar sands oil to refineries on U.S. coasts.

"Forget about Keystone. There's just a lot more production than there is capacity to take it away," said Tom Kloza, chief oil analyst for the Oil Price Information Service, referring to the controversial and stalled Keystone pipeline project designed to link oil sands in Alberta with refiners along the Gulf of Mexico.

Railroads are, in addition, benefiting from Detroit's car-building boom: delivering parts, plastic and steel to manufacturing plants, and hauling away finished autos.

In the East, CSX (CSX) and Norfolk Southern (NSC) have taken the lead in upgrading bridges and tunnels in order to snatch more intermodal container business away from trucking fleets. Increasingly, every toothbrush, jug of detergent and bag of dog food on store shelves is moving by rail.

All of that hasn't quite made up for slumping coal shipments, hurt by high stockpiles, cheap and abundant domestic natural gas and stricter emissions standards for power generation plants.

Both CSX and Norfolk Southern cited weak coal movements for fourth-quarter earnings declines. But analysts see earnings up across most of the 10-stock group this year, including estimates for a 77% gain for Genessee & Wyoming (GWR) and a 40% gain for Canadian Pacific Railway.

The group ranked No. 44 out of the 197 industries IBD tracks and has kept a top 50 ranking this year. Collectively, the group's stocks rose 21% year-to-date through the end of March. It then pulled back, following a Canadian Pacific Railway train derailment in Minnesota in late March that spilled about 18,000 gallons of oil, followed by an Exxon Mobil (XOM) pipeline spill two days later.

Shares of Canadian Pacific, with a Composite Rating of 86 from IBD, are up 22% so far for the year. The top-ranked operator in the group, Kansas City Southern, has a Composite Rating of 93. It's up 29% so far this year. Union Pacific (UNP), with a Composite Rating of 91, is up 12% this year.

Black Gold Vs. King CoalAbout 200,000 miles of pipelines carry 90% of the nation's crude and petroleum products, according to government and industry figures. But record production increases — total domestic oil output increased by 780,000 barrels per day last year — have outstripped those pipelines' capacity to move it.

Railroad tanker cars have kept storage farms from bursting their seams and prices viable so that oil producers have not, like shale gas producers, been forced to shut in production.

The amount of oil and related products shipped by rail climbed 48% last year to almost 541,000 carloads. This year, through the end of March, volume was up 57.2% vs. the same period a year ago, according to the Association of American Railroads.

Oil's carload count is still dwarfed by coal. Railroads filled more than 6 million coal cars last year, the AAR data report. But that was down more than 10% from 2011. An unseasonably warm winter in parts of the country and the ongoing glut of natural gas has dulled demand for coal even further.

Coal shipments fell off another 7.9% in the first quarter of this year. Much of the remaining traffic is being moved to ports for export. Rail shipments of autos and car parts was up 16.9% last year, the AAR data show.

The increase in oil-by-rail isn't just a short-term bridge to hold refiners over until more pipeline capacity comes on line, analysts say.

"There will always be, under the current framework, a business for the railroads to participate in around North American energy development," said Matt Troy, a freight analyst with Susquehanna Financial Group.

Moving oil by rail is more expensive. Kloza said it could be 60% more costly than a pipeline, though estimates vary widely.

So pipelines will remain the backbone of the transportation network, and pressure will continue for more of them. And while environmentalists worry about potential spills from an expanded Keystone or other pipelines, Canadian Pacific's March spill shows that transport method is also fraught with hazards.

But there are compelling economics involved with moving oil by train, according to Eric Slifka, CEO of Global Partners (GLP), a midstream petroleum logistics and marketing company.

While more expensive, rail shipping is faster. Oil can quickly be pushed to higher-margin markets. And it's more flexible when production spikes in one region and fields slow elsewhere.

There are also lower permitting burdens, and less upfront cost, including the need to prime a new pipeline with oil to keep pressure high, thereby locking up inventory.

Last month, Global announced a deal with refiner Tesoro (TSO) for that company to build and operate a 7-mile pipeline to get oil to Global's storage tanks and rail heads in Columbus, N.D.

From there, a Canadian Pacific line moved the oil to Albany, N.Y., where Global transfers it to barges to move to refineries in New Jersey and elsewhere in the East.

A nearby Global terminal in Beulah links oil to West Coast refineries along a BNSF line.

"Railroads are cost-efficient and offer a level of optionality that pipelines just cannot match," Slifka told analysts in a conference call in March.

OutlookFor the past two years, Susquehanna's Troy said the story was "West is best." Western coal moved from Wyoming's Powder River Basin is typically cleaner than what's used in the East. That allowed temporary coal rebounds anytime gas prices rose. That and other factors had him bullish on Union Pacific and Kansas City Southern.

But the prospects have shifted, he said.

"CSX and Norfolk Southern are about to see a very powerful combination of coal fundamentals bottoming, intermodal growth accelerating at a very nice incremental margin, and the and oil-by-rail trend beginning to take hold materially over the next 18 months," he said.

He thinks railroads also stand to win over a larger piece of the intermodal shipping containers business. They've raised bridges and other obstacles to allow for double-stacking of those shipping containers, making rail a more cost-effective route for ever shorter runs.

And if pipelines start being built en masse, that's a nice business for railroads as well.

"They get to haul all that material and equipment in and out," he said.

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