The North American rail industry continues to experience a renaissance—in large part because of the continent’s prolific shale plays.

And moving crude oil by rail continues to gain momentum as oil output surges and environmental opposition and regulatory issues delay pipeline projects. At least for now, it seems the crude-by-rail (CBR) movement is here to stay.

“Absolutely, it is predicated on U.S. production growth, which is also predicated on consumption. We believe it is a more permanent part, at least for the foreseeable and investable future,” said Evan Calio, managing director at Morgan Stanley, speaking at Hart Energy’s Crude in Motion conference in Houston late last year.

Calio discussed how the North American rail industry has evolved in recent years, propelling its ability to gain market share in oil- and gas-related business—and offsetting a decline in coal traffic.

“It will be here, and it will be very volatile, and the forecast in term of flows to volumes is predicated on a whole series of assumptions,” he noted.

CBR is particularly popular in shale plays such as the Bakken where pipeline takeaway capacity is simply insufficient, but it doesn’t come without complications.

According to Calio, a number of differentials and limiting factors exist that could effect the future of CBR in all areas of operation. These differentials make it difficult to reliably forecast supply and demand growth. Without adequate supply and demand scenarios, the CBR industry could become more dormant.

Calio listed several market fundamentals, including pipelines (new and planned), refinery turnarounds and expansions, transloading and shipping capabilities and excess takeaway capacity.

On the other hand, with several significant pipelines expected to enter service next year in the middle of the U.S., moving product to the key Cushing, Oklahoma, crude storage and trading hub shouldn’t be a problem, Calio told attendees.

“The industry and people of this state and people in this country, guess what they did? They made significant investments to solve that 300-mile transportation problem,” he said. “This year, with Seaway Twin in the first quarter and [eventually] Keystone XL, you are going to over-solve that problem.” And as more pipeline capacity comes online, CBR may not be needed as much, Calio said, but that’s not necessarily the case in parts of the country. “

As we think about differentials with a lot of these transportation solutions in the near-term, by moving that differential further north, we still think that Bakken will have to move via rail,” he added.

The Bakken shale play has inadequate pipeline and refining capacity, so the booming production must be shipped somehow.

Calio said the future of CBR and the rail industry is difficult to predict because of all the differentials. He compared the various differentials to a frac spread; it can change on a regular basis. If there is an unplanned refinery outage, the frac spread will change.

With reference to Canada specifically, Calio said, “rail may serve as a bridge but not a permanent solution. Rail can serve as a put option until pipelines are built, but rail is unlikely to be enough to clear total production growth longer term.”

In tandem with pipelines

North Dakota rail-export volumes grew from nearly zero in 2008 to some 700,000 barrels (bbl.) per day—or roughly 75% of production—by the summer of 2013. However, when CBR costs versus pipeline narrowed last year from $10 per bbl. in May to $2 per bbl. in September, the railway transportation status quo began to come into question.

Previously, wide price differentials supported CBR as a cost-effective means of moving product. At one point in 2012, prices in the Bakken Red River play topped $40 per bbl. The significant differential incentivized producers to look for alternative modes of transportation to move barrels to premium markets.

"Things were really chugging along, and then the wheels fell off in the summer. People were posing questions: Is rail done? Are pipelines coming back?” Steve Elliot, director of rail business development for Enbridge Pipelines Inc. told attendees at the conference.

According to Elliot, a multimode system like rail “fills the gap between pipelines” and provides optionality. “My belief is that rail is here to stay,” he said.

Although a pipeline company by name, Enbridge has a firm footing in the CBR industry—with three rail projects either recently completed or under way. Projects include the Berthold Station in North Dakota, a second coal-rail repurposing project in Eddystone, Pennsylvania, near Philadelphia, and a third project known as the South Cheecham Rail in Alberta.

“We believe that pipe-rail [transportation] will offer the industry more flexibility and more overall transportation cost than what we see today,” Elliot noted.

Looking at 2014 to 2015, Enbridge thinks the CBR trend will remain strong—to PADD I (Petroleum Administration for Defense District) on the U.S. East Coast and PADD V on the West Coast, in particular.

When Enbridge’s Sandpiper Pipeline enters service between North Dakota and Wisconsin in 2016, the price differentials aren’t likely to erode completely, but they will undoubtedly tighten, according to Elliot.

“Railroads offer flexibility destination-wise that a pipe, once it’s in the ground, can’t offer,” Elliott told attendees. “But I think what pipelines offer, particularly enhanced with rail facilities, is the ultimate flexibility not only for destinations but for ensuring the highest netback for producers.”

Shifting differentials

Spreads of near $30 per bbl. for U.S. benchmark West Texas Intermediate (WTI) versus its European crude counterpart, North Sea Brent, are a thing of the past— meaning tighter differentials for rail with trade closer to variable costs.

As a result, industry players likely will need to rethink the transportation logistics for delivering their product to market, while simultaneously keeping variable costs down and sustaining healthy returns, according to Travis Brock, vice president of commercial development and strategy for Strobel Starostka Transfer.

In response to this unfolding logistics challenge, Brock told attendees at the Hart Energy conference that, moving forward, inevitable changes in the crude oil logistics market mean there will be new “structural price differentials” between the production and market areas, which will evolve as infrastructure is put in place for both pipeline and rail.

“To that point, production prices must drop to open the rail or pipeline arbs [arbitrages] to incentivize midstream solutions to clear those volumes,” he continued. “My take on this going forward is that either the producers or the refiners are going to have to underwrite infrastructure to make it happen. They’ve got the most to gain through these types of solutions, and I think they’re the ones who will have to put the money out or make commitments to help pull it through.”

The initial disruption of historic price marker relationships with the Brent crude price spurred the building of domestic rail terminals as an interim solution for accessing landlocked reserves.

“In 2011, when the shale boom happened, Brent moved on with global pricing and Cushing turned into Hotel California: You can check in anytime you want, but you can never leave,” Brock said.

“The massive price-marker arbitrage that we’ve seen the last couple of years between WTI and Brent, which really financed the first round of crude by rail, made it easy to go spend $30 to $50 million to build a terminal,” he added. “That time is over, and we won’t be seeing that again. That restriction on Cushing has been solved with a pipeline solution.”

And as new opportunities for building supporting infrastructure materialize, the urgency to build rail terminals will likely be missing from the equation this time around. That should drive operating costs down in the long-term, Brock noted.

When the WTI-Brent spreads were wide, he said, companies hastened to build rail terminals in attempt to capture high margins while the arbitrage remained open, but now priorities have shifted.

“I think that in the future, because we don’t have that tailwind behind us, we’re going to have a lot more focus on [rail terminal] efficiency, low costs and sustainability,” Brock added.