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Could Railroad Companies Lose Their Fastest-Growing Client?

The North American rail industry has been a life raft for oil production. In almost every major shale oil play in the U.S., production has steadily outpaced pipeline capacity. Without enough room in the pipe, many producers have relied on rail to get crude oil to market. This has not only helped bring the U.S. shale boom to where it is today, but it has also padded the balance sheets of several rail companies.

Will oil continue to hop on the train and ride it to profitability? Or will pipelines regain their place as the only place for oil to call home? Let's take a look at some of the developments in the rail business to see where it may be headed.

Getting hitched up
The lack of pipeline is an obvious reason for oil producers to choose rail, but to pin all of rail's success on the oil business on that wouldn't do railroads justice. Rail also provides another element that pipe never has been able to do: a wide array of destination options. EOG Resources (NYSE: EOG  ) , one of the pioneers of moving oil via rail, starting using the rail option back in 2009 to deliver Bakken crude oil. The idea really took off when Bakken crude started going to East and West Coast refineries, where prices for foreign oil were way more expensive than for Bakken. It was a match made in heaven. Refineries got access to cheaper crude, Bakken producers didn't need to compete with the bloated spot markets in the U.S. Gulf Coast, and rail got an additional revenue source. 

This idea has taken off like a bottle rocket. According to the Association of American Railroads, total crude shipped this past quarter was 97,135 carloads, a 166% jump from this quarter last year and the largest jump in crude shipments in over a decade. The largest sources of rail's success has come from a few select places, most notably the Bakken formation and Canadian oil sands. EOG ships 100% of its Bakken crude via rail, and Continental Resources (NYSE: CLR  ) , the top producer in the Bakken, now transports approximately 80% of its crude via rail. 

As much as it has changed the game for refiners, it is also slightly changing the way rail does business as well. Two of the largest crude via rail transporters, Canadian Pacific (NYSE: CP  ) and Canadian National Railroad (NYSE: CNI  ) , both expect to see crude shipments double for the respective companies in 2013, and Canadian Pacific anticipates another doubling to 140,000 carloads by 2015. Canadian National is also planning on bringing trains dedicated to transporting oil exclusively.  

Don't go full steam ahead just yet
While both of these rail companies' plans my sound ambitious, they are also tempering expectations because they realize the weaknesses that rail has over pipelines. Compared to pipelines, rail shipments are like first-class tickets for oil. According to research firm Wolfe Trahan, oil shipments by rail cost about $10-$15 per barrel, depending on the destination vs. $5 per barrel for oil moved by pipe. When rail shipments were taking off, producers and refiners were willing to pay a premium because it still was less than foreign crude prices. As the price spread between domestic and foreign crudes narrows, though, the advantage of oil via rail diminishes.  

The other major threat for rail is increased pipeline capacity, especially in the Bakken and Canadian oil sands. Enbridge's (NYSE: ENB  ) Northern Gateway pipeline, Kinder Morgan Energy Partners' (UNKNOWN: KMP.DL  ) Trans Mountain Pipeline, and Transcanada's (NYSE: TRP  ) Keystone XL pipeline combined could potentially move almost 2 million barrels per day of Canadian oil sands  to either the U.S. Gulf Coast or the Canadian West Coast. All three of these companies' projects are mired in political debate, so the certainty that any of these pipes will get built is uncertain. If one and/or all of them are built, it would take a big chunk out of rail companies' market share. 

Canadian Pacific is not naive, and it has made it clear at its annual meeting that these pipelines will have a significant impact on how the company plans to allocate capital for infrastructure and upgrades. If these pipelines don't go through, though, rail could find itself working with oil a whole lot more in the future. 

What a Fool believes
It's so much easier to get an idea of whether a pipeline project will be completed when it isn't at the center of a political spat. In the case of all three of these pipelines, they are facing some very stiff opposition that could potentially derail these pipelines from being built. If they aren't built, it could be viewed as a win for rail companies. At the same time, though, the higher price tag for oil moved by rail will also make exploration and production companies less excited about growing production. As investors, it might be best to replicate what Canadian Pacific is doing and wait till a definitive decision is made regarding these three major pipelines. 

It's easy to forget the necessity of midstream operators that seamlessly transport oil and gas throughout the United States. Kinder Morgan is one of these operators, and one that investors should commit to memory due to its sheer size -- it's the fourth-largest energy company in the U.S. -- not to mention its enormous potential for profits. In The Motley Fool's premium research report on Kinder Morgan, we break down the company's growing opportunity -- as well as the risks to watch out for -- in order to uncover whether it's a buy or a sell. To determine whether this dividend giant is right for your portfolio, simply click here now to claim your copy of this invaluable investor's resource.

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