(FROM BARRON'S 3/11/13)
With North America producing more crude oil than its pipelines can carry, railroads are stepping in to transport the overflow to refineries that turn it into gasoline and other useful products. That should add to their profits for years -- and create an opportunity for stock investors. Companies to favor include Canadian Pacific (ticker: CP), Union Pacific (UNP), and Norfolk Southern (NSC).
Oil drilling in the U.S. has transformed from hit-or-miss exploration to sure- thing production. Energy companies once relied on finding reachable pools of underground crude. Today, armed with new technology, they can simply squeeze the stuff out of pulverized shale using hydraulic fracturing, even if the deposits can't be reached from above. Volumes are gushing. Earlier this year, U.S. oil production topped seven million barrels per day for the first time since 1993. Analysts expected it to hit 10 million by 2020. For comparison, Saudi Arabia, the world's largest producer, puts out just over nine million barrels per day, albeit of purer crude.
Surging oil output has done wonders for pipeline operators and their investors. Kinder Morgan Energy Partners (KMP), one of the largest players, has done more than twice as well as the Standard & Poor's 500 index over the past five years, returning an average of 13.3% a year. Increasingly, rails are getting a piece of the action, too. Originations of crude-oil shipments by rail soared 200% last year, according to Credit Suisse.
That's surprising, considering that trains are much more expensive than pipelines. Transporting a barrel of crude from the oil hub of Hardisty in Alberta, Canada, to the U.S. Gulf Coast, a major refining center, costs $7 to $ 11 using pipelines, but as much as $14 to $21 by rail, according to BMO Capital Markets. Every nickel per barrel matters for refiners, so under normal circumstances they'd balk at paying rail prices.
But North America's production glut has left landlocked crude some $20 per barrel cheaper than the imported stuff shipped to coastal refineries. Refiners are happy to pay $10 extra for transport to get the discount. And what rails lack in pricing, they more than make up for in availability. Pipelines take years to build and can run up against environmental squabbling. Train tracks are already laid, and no one complains about adding more cars and extra offloading facilities.
Rails carry so many different goods that oil still accounts for less than 1% of carloads, but it's lucrative. For example, oil will contribute 6% of Canadian Pacific's earnings per share this year and 3% for Union Pacific's, according to BMO. Berkshire Hathaway's (BRKA) rail, BNSF, is probably enjoying the biggest boost; it controls 82% of capacity for oil in the booming Bakken field in North Dakota. Rails should collect growing profits from oil as production rises -- especially because cheap crude has set off a resurgence in energy-intensive businesses like manufacturing and chemical production, creating more growth in rail volumes. But not all rails will benefit equally. Credit Suisse transportation analyst Allison Landry expects Canadian Pacific, Kansas City Southern (KSU), and Union Pacific to get the biggest earnings boost. Fadi Chamoun at BMO likes Union Pacific, along with CSX (CSX) and Norfolk Southern.
Canadian Pacific is uniquely positioned in that it can originate oil shipments from both Bakken shale and Canada's oil sands. The oil sands have three to four times the output potential of Bakken. And while rail's share of Bakken oil is expected to peak in late 2014 as new pipelines come online, pipeline capacity for Canada won't surge until 2015 at the earliest, and only then if the Keystone XL extension gets a timely nod from regulators. Even after Keystone, Canada will likely produce far more oil than pipelines can carry, and rails there have a key competitive advantage. The oil sands produce thick bitumen, which must be diluted to flow through pipelines, and then have the diluent removed at the refineries. Rails c