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Canadian Crude Gets Railroaded

By Ari Charney on April 2, 2013

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One of the most difficult aspects of investing is anticipating how and when businesses or industries will adjust to operational hurdles. After all, even some of the worst setbacks can be overcome with a little human ingenuity–or just a bit of common sense. That means investors must distinguish between those situations that are likely to persist well into the future and those that are merely transitory.

The latest such example is the volatility in Canada’s oil-price differential. Canadian crude oil has long traded at a discount to the North American benchmark West Texas Intermediate crude (WTI). Indeed, over the four years spanning 2008 through 2011, Canada’s benchmark Western Canada Select crude (WCS) sold for an average of $15.21 per barrel less than WTI–a discount of about 17.9 percent.

Part of this long-term differential stems from the fact that crude produced from Alberta’s oil sands is a heavier grade than US crude, which makes it’s more expensive to refine than the light, sweet crude represented by WTI. Though Canada does produce lighter grades of oil, heavy crude accounts for roughly two-thirds of its oil exports.

Late last year, the oil-price differential widened significantly, as rising light crude production from prolific US shale plays caused a bottleneck at key pipelines. The resulting traffic jam crowded out Canadian crude from reaching US refineries. That situation worsened toward the end of the year, as takeaway and refining capacity became even more scarce due to maintenance problems at pipelines and refineries.

The good news is the oil-price differential appears to have peaked in December, when WCS sold for $33.63 per barrel less than WTI, a 38.1 percent discount. Then in February, the spread quickly began to narrow until it fell to a low of $14.25 last week. That’s just 14.7 percent less than WTI, a spread that’s 3.2 percentage points less than the average discount that prevailed in the aforementioned four-year period that ended in 2011.

So what happened? Faced with limited pipeline access and rising inventories, Canadian oil producers began transporting crude south via railroad and trucks. According to National Bank Financial chief economist Stefane Marion, crude shipments by rail were up 47 percent during the first three months of 2013 versus the prior-year period. And this activity is expected to ramp up as the year progresses. In fact, analysts forecast that trains could be moving more than 250,000 barrels of crude per day from Canada to US refineries by the end of the year.

Unfortunately, this surge in energy shipments has already been largely priced into the stocks of the two Canadian railroads benefitting from it. Shares of Canadian Pacific Railway Ltd (TSX: CP, NYSE: CP) have jumped 31.7 percent year to date, while Canadian National Railway Co’s (TSX: CNR, NYSE: CNI) stock has gained 13.5 percent since the beginning of the year.

Canadian National transported more than 30,000 carloads of crude last year, and management believes that number could double in 2013. As such, the company plans to spend CAD1.9 billion this year on capital expenditures, part of which will go toward maximizing its opportunities in the energy market. Thus far, revenue ton miles for petroleum products have increased 12.1 percent year to date versus a year ago.

While Canadian National’s network has strong exposure to the oil-producing region of Northern Alberta, Canadian Pacific has a similar advantage in the Bakken. The latter company shipped 53,000 carloads of crude in 2012, and management believes that number could rise to 70,000 carloads by the end of this year. By 2016, Canadian Pacific expects current volumes could double or even triple.

Eventually, of course, pipeline infrastructure will catch up to the glut of production, so the mode of transportation used to export Canadian crude to the US could shift once again. But growth in Canadian oil production could still mean that railroads will remain an important part of getting energy commodities to key US markets. ITG, a New York-based brokerage, predicts that crude shipments by rail will still increase by about 600,000 barrels per day over the next four years, even if major pipeline projects, such as Keystone XL, are finally built.

In the meantime, Canadian National raised its dividend by 14.7 percent in January and Canadian Pacific appears poised to boost its payout in July. Even so, both stocks are currently rated “hold.”

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