The federal government recently published a safety alert, warning that oil produced in the Bakken region is more flammable than traditional crude benchmarks. The announcement came after a string of rail accidents involving Bakken crude resulted in explosions, raising serious concerns regarding public safety.

In order to prevent such mishaps, the Department of Transportation has advised railroad operators to remove hazardous materials and gases from Bakken crude before transporting it. Fearing that this might inflate rail transportation costs and impact oil supply, shares of Kodiak Oil & Gas (NYSE: KOG), Continental Resources (CLR) and Oasis Petroleum (OAS) were sold by investors and speculators. What should be your next move? Let's find out.

Root of the problem
Bakken crude is known for its hydrocarbon-rich composition and high calorific value. The North Dakotan crude benchmark is generally lighter than other heavy crude benchmarks, making it easier to refine and convert into popular petroleum products like gasoline and diesel. The problem, however, lies with its mode of transportation.

Federal agencies stated that transporting Bakken crude is unsafe without the proper removal of hazardous materials and gases from liquids. Pipeline operators have the required infrastructure to test liquids and remove hazardous gases from them. However, railroad operators – which collectively transported about 70% of the crude produced in the Bakken region last November – lack such infrastructure.

The obvious solution would be to retrofit railcars so that minor accidents don't result in explosions. But the solution, unfortunately, isn't that simple.

Gordon Delcambre, a spokesperson of the Hazardous Material Safety Administration, believes that it will take at least a year for federal regulators to order railcar upgrades. Even after the regulation is introduced, the retrofitting of all the railcars operating in the Bakken region will take another 10 years while incurring up to $5 billion in costs.

With the option of retrofitting cars seemingly unfeasible, I believe that the federal authorities are left with only two options.

1) They can permit the unrestricted transportation of Bakken crude via rail. Meanwhile, rail operators can build the required infrastructure to separate gases from liquids. This move will jeopardize public safety.

2) They can introduce stringent regulations to ensure public safety. However, the movement of Bakken crude via rail maybe permitted only after hazardous gases have been removed from liquids.

If the federal authorities go with the second option and limit rail transportation, Bakken oil producers won't be able to move about 30% of their product to the market. This can result in a supply glut in North Dakota, and consequently, oil prices in the region will decline. So, top oil producers in North Dakota are exposed to a great deal of risk.

Susceptible to Bakken downfall
In case of a supply glut, I believe Oasis Petroleum, Continental Resources and Kodiak Oil will be severely hit. All three companies have made large investments in the region, with a primary goal of increasing their Bakken oil production.

Oasis Petroleum, for example, spent about $1.52 billion last year to increase its North Dakotan acreage by 51.3%. With about 492,000 acres of leased land, management expects to boost its overall production by about 22%. In addition, the company is spending $1 billion annually to consistently grow its production in the region.

Similarly, Kodiak Oil & Gas is also betting on the North Dakotan oil boom. The company currently owns about 192,000 acres in the region, and is investing $1 billion every year to increase its acreage. On the back of its recent $660 million worth of asset acquisition, management aims to hike its overall production 20% by the end of fiscal year 2013.

On the other hand, Continental Resources is the largest oil producer in North Dakota. With 1.2 million acres of leased land, its Bakken oil production stood at 94,500 barrels of oil equivalent during the previous quarter – representing 67% of its total production. Management has earmarked $2.5 billion for fiscal year 2014, to drill 120 wells in the Bakken region and hike its overall production by 28%.

Final words
From what I understand, if federal agencies introduce stringent regulations to ensure public safety, Bakken oil transportation via rail can suffer over the short-medium period. Keeping that in mind, investors might want to avoid investing in Oasis Petroleum, Kodiak Oil, and Continental Resources due to their huge exposure to North Dakota.