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Canadian Oil Rides the Rails

By Chad Fraser on October 9, 2013

Canadian regulators continue to evaluate Enbridge’s (NYSE: ENB) proposed C$5.5-billion Northern Gateway pipeline, which would pump crude from the Alberta oil sands to the Pacific coast at Kitimat, B.C.

The 1,170-kilometer line is important for oil sands producers, because it would carry an average of 525,000 barrels a day, which would be loaded onto tankers and shipped to Asian markets.

However, the project has met resistance from Aboriginal and environmental groups. It’s not clear which way regulators will lean, but the company expects the thumbs-up or thumbs-down by mid-2014. If all goes well, Enbridge says it will have the line up and running by 2018.

CN Rail to the Rescue?

Meanwhile, Canadian National Railway (NYSE: CNR), the country’s largest railroad operator, appears to be contemplating a fallback plan in case Northern Gateway is nixed—or at least it was back in late February. 

According to a September 22 report from the Canadian Press, an internal government briefing note obtained under the country’s Freedom of Information Act indicated that CN was considering shipping crude from Alberta to Prince Rupert, B.C., where it would be loaded onto Asia-bound tankers.

The note, which was dated February 28, 2013, said the company was working with oil sands producer Nexen on the idea at the time. Nexen, you may recall, was taken over by Chinese petrochemical giant CNOOC (NYSE: CEO) last year in a $15.1-billion deal. Notably, CN points out that it would be capable of matching Northern Gateway’s capacity.

CN already has track running to Prince Rupert’s Ridley Island, but there are other stumbling blocks. “The concept would require the construction of an oil trans-loading facility in Prince Rupert, which does not currently exist,” reads the note. In addition, the note points out that there is a 2.5-year waiting period for new tanker cars, which are typically leased to railways.

Oil by Rail Continues to Grow—But Tragedy Weighs

Still, the existence of such a plan speaks to both how much the shipment of oil has grown over the years and the extent of demand for new ways to move Canadian crude to market.

According to recent figures from the Railway Association of Canada quoted in the Calgary Herald, up to 140,000 carloads, or 230,000 barrels per day, of crude oil and bitumen from the oil sands will be shipped by train this year, up from just 500 carloads in 2009.

Shipping oil by rail costs about $5 to $10 more per barrel compared to pipelines that are already built, but the oil trains are helped by the spread between crude prices. If the spread narrows too much, rail becomes less viable compared to pipelines. Right now, for example, the differential between international Brent crude and West Texas Intermediate (WTI) has narrowed to around $6.70, while Western Canada select is sitting at a roughly $33 discount to WTI.

The safety of shipping oil by rail has also been called into question in the wake of the July 6 tragedy at Lac-Mégantic, Quebec, in which an oil train operated by the Montreal, Maine and Atlantic rolled away after it was left unattended for the night. It then sped downhill, derailed and exploded in Lac-Mégantic, killing 47 people.

The incident has spurred calls for tighter rail-safety regulations, which could significantly increase railways’ costs.

Canadian National: A Broad-Based Northern Rail Giant

Canadian National is Canada’s largest railway, with about 20,400 route miles in eight provinces and one territory. It also owns track in the U.S. that extends to the Gulf of Mexico.

The company began life in 1918 as a crown corporation (the term for a state-owned company in Canada) and was privatized in 1995.

While the oil-by-rail boom has grabbed a lot of headlines, it’s important to keep in mind that oil is just one part of most railways’ operations, including Canadian National’s. In the latest quarter, for example, petrochemicals accounted for just 19% of CN’s total freight revenue.

The largest slice came from intermodal, or containers that can be loaded onto ships, trucks or trains (23%), followed by oil, then grains and fertilizers (16%), forest products (15%), metals and minerals (13%), coal (8%) and automotive (6%).

Overall intermodal shipments continue to rise due to the cost effectiveness of shipping goods by train. As a January report points out, railroads are estimated to be around 300% more fuel efficient than trucks. At the beginning of the year, intermodal accounted for 20% of all railroad revenue, second only to coal.

Oil Provided a Second-Quarter Boost

In the second quarter, Canadian National’s revenue from shipping petroleum and chemicals surged 18% from a year earlier. Metals and minerals gained 5%, forest products rose 4% and intermodal gained 3%. Coal revenue was flat, while automotive revenue declined 3%.

It all added up to an overall revenue increase of 4.8%, to C$2.67 billion from C$2.54 billion a year ago. Net income rose 13.6%, to C$717 million, while per-share profits rose 17.4%, to C$1.69, on fewer shares outstanding. Without one-time items, the company earned $1.66 a share, up from $1.50 and topping the consensus forecast of $1.62. Revenue just missed the expected $2.70 billion.

Canadian National’s operating ratio—a measurement of railway efficiency—continues to be the lowest in the industry, at 60.9% in the latest quarter, down from 61.3% a year ago. (Operating ratio is operating expenses as a percentage of revenue.)

Former CN Boss Now Heads Its Chief Competitor

The company faces strong competition from rival Canadian Pacific Railway (NYSE: CP), which is now headed by former CN boss Hunter Harrison after activist investor Bill Ackman pushed for Harrison’s installation as CEO in the wake of a proxy fight last year.

As he did at CN, Harrison is now focused on cutting CP’s operating ratio. CP ended the second quarter with an operating ratio of 71.9%, down from 82.5% a year ago.

CP shares have surged 44% on the New York Exchange in the past year, in the wake of Ackman’s boardroom success and the company’s ongoing restructuring, compared to a 14% gain for CN. However, CN Rail’s shares are less volatile than CP’s with a beta rating of just 0.94 versus 1.53 for CP. (Stocks with a beta rating of 1 are as volatile as the market, while those below are less volatile.)

CN also trades at 17.1 times its last 12 months of earnings, compared to 30.1 for CP. In addition, CN carries a higher dividend yield, at 1.60% vs. 1.10% for CP.

Both companies are in good position to ride a continued North American recovery and expected rises in both oil and intermodal shipments. Investors will get a peek at how both trends are playing out in Canada when the pair report their latest quarterly earnings in two weeks.

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