Canada's crude on the rails

North American rail shipments of crude oil are estimated to have grown by 360,000 barrels per day within the past 12 months to reach 465,000 bpd ? equivalent to the addition of a major pipeline, according to First Energy Capital Corp., or 4% of total North American oil production

Anxious about pipeline capacity, Southern Pacific Resources Corp. (STP) recently threw its full weight behind rail, committing to transport its entire output through Canadian National Railway Co. and its partners.

While rail companies have seen roaring business from their crude-by-rail operations in the past few years, no other oil producer before had committed its entire bitumen output to CN long term, completely bypassing pipelines. It certainly put a dent in the theory that crude-by-rail is a temporary business.

Howard Bolinger, chief financial officer at STP, cites ?future risk of pipeline capacity availability? in Alberta as one of the reasons for the deal.

Under the contract starting in the fourth quarter, the Calgary-based producer plans to truck 12,000 barrels per day from its McKay plant to CN?s terminal in Lynton, Alta., from where it will head south 4,500 kilometres to a terminal in Natchez, Miss. It will then be hauled on barges to Gulf refineries.

STP?s transportation bill will be a whopping $31 per barrel, according to company estimates, but it will still manage higher netbacks ? or revenue minus total cost per unit ? of an additional $18 compared to pipelines as it will fetch Brent prices. The company will also save on diluents as, unlike pipelines, heavy oil transported on railways does not need to be blended with condensate. It typically costs $8 to transport a barrel of oil by pipeline.

STP?s long, multi-transport haul highlights the industry?s desperation to access the market in the face of severe environmental, political and aboroginal opposition to new pipeline proposals at a time when Western Canadian oil production is soaring.

Mr. Bolinger say there will be differential pressures for at least the next couple of years to make rail economical for the company. Brent was trading Thursday at US$114.62 per barrel, compared to WTI?s US$96.01 and Western Canada Select?s US$82.89, highlighting the disconnect between the various benchmarks.

?The reason why the rail market exists for crude oil is not that rail is cheaper than pipeline ? it?s because of the spread in the crude market between Brent-based pricing and WTI pricing,? says Mark Hallman, a CN spokesman. ?For light crudes, rail helps producers access markets that are not pipeline-connected and provides them with waterborne (Brent) netbacks.?

But Mr. Bolinger says the company may continue to look favourably on rail even if the proposed pipelines see the light of day. ?It may be part of our long-term strategy, however, we will continue to evaluate this on an ongoing basis.?

Calgary-based Baytex Energy Corp. also says it?s mitigating its exposure to WCS differentials by transporting some of its 38,500-barrel daily heavy-oil output to higher value markets by railways.

?We are currently delivering approximately 27% of our heavy oil volumes to market by rail and expect to increase rail deliveries to approximately 35% to 40% of our heavy oil volumes by year-end,? the company said in its second-quarter filing.

North American rail shipments of crude oil are estimated to have grown by 360,000 barrels per day within the past 12 months to reach 465,000 bpd ? equivalent to the addition of a major pipeline, according to First Energy Capital Corp., or 4% of total North American oil production.

As a sign of the increasing importance of rail to the energy industry, the Calgary-based energy investment firm initiated coverage on rail companies.

?Just as it was over one hundred years ago, knowing the rail business has become vital to the energy business, and this is why FirstEnergy has initiated coverage of CP and CN,? analyst Steven I. Paiget wrote in an Aug.16 note.

While most oil companies remain reluctant to lock themselves into long-term contracts with rail companies, Canadian Pacific Railway Ltd. and CN are starting to get used to the business and even making investment commitments. CP, which had earlier estimated it would deploy 70,000 carloads to transport oil by 2014, now expects to reach that target a year earlier. The company also has the only direct railway between Calgary and Vancouver.

Meanwhile, CN moved approximately 5,000 cars of crude oil last year and expects to shift more than 30,000 oil-laden carloads in 2012, and has opened terminals in Alberta and Saskatchewan.

The two rail giants are expanding their energy portfolio to include frac, or drilling, sand and have signed deals with sand processing companies over the past few months.

CP has a ?line of sight? to 80% of a targeted $400-million of incremental annual energy revenues, including oil by rail, frac sand, drill pipe and other construction materials.

?We?re going to grow at two times GDP in those markets,? Jane O?Hagan, CP?s executive vice-president and chief marketing officer, told analysts on a second-quarter earnings call.

CN, which benefits from exclusive access to the Alberta oil sands and B.C. Montney gas fields, is investing $35-million to upgrade a 64-kilometre track in northern Wisconsin to move frac sand from a processing plant to shale drilling areas across the United States and Western Canada.

?Over the last three years, CN?s frac sand market has grown nearly 70%, reaching 35,000 carloads and $100-million in revenue in 2011, and we hope that our end-to-end service focus will help us grow this market to become a $300-million business in the next three-to-five year horizon,? says CN?s Mr. Hallman.

CP has invested $90-million to $100-million over the past two years to grow its energy supply chain and its customers are investing $400-million to $600-million in production and terminal facilities, according to FirstEnergy estimates.

If pipeline companies are worried about rail companies eating into their share, they are not showing it.

?Rail is a temporary option but not a long term one,? maintains Philippe Reicher, vice-president, external relations at the Canadian Energy Pipeline Association, which counts TransCanda Corp. and Enbridge Inc. as members.

But there is logistical trouble coming down the pipe: Even if the proposed pipelines are built on time, they won?t keep up with rising Western Canadian production and may effectively be full as early as 2014, says Andrew Potter, managing director, institutional equity research at CIBC World Markets Inc.

?Although the rail financial arbitrage will likely dissipate, we believe there is a permanent role for rail in the North American transportation mix,? Mr. Potter says. ?The advantage that many producers have observed is having more flexibility to reach different markets ? and that is a key offering of rail vs. pipelines.?

Source: http://business.financialpost.com/2012/08/24/crude-on-the-rails-in-for-the-long-haul/

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