What's bigger than coal in rail's future?

Posted by Fred Frailey
on Tuesday, November 13, 2012

Within eight years, the biggest producer of oil in the world will be … yes, the United States of America. Bigger than Saudi Arabia and any of the other sheikdoms. So says the International Energy Agency, a Paris-based organization that The Wall Street Journal describes as a highly regarded source of information on global energy policies.

Moreover, the IEA also predicts that by 2030 natural gas will be an even bigger source of energy in the U.S. than oil. All this flows from the revolutionary advances in oilfields that combine fracturing of energy-bearing shale formation with directional drilling.

So are you thinking what I'm thinking? To the railroads, the consequences of these developments are life-altering. First of all, today's biggest source of business, coal, will never in our lives be what it is now in terms of car loadings. Cheap natural gas trumps coal on price and environmental cleanliness. Substitution of gas for coal is inevitable and will occur with increasing frequency no matter which political party reigns in Washington. It's a given.

That's the bad news, so to speak. The good news is that a world of opportunity beckons the railroads, if they will only pay attention and act in their own long-term (as opposed to short-term) interests. The oil that is coming from these newly exploited shale formations (and from the Canadian tar sands in Alberta) has to move. But it is being mined in parts of the country (such as North Dakota and south Texas) where the oil industry has not had a big footprint in times past. Pipelines to many of these locales simply do not exist today, nor will they for several more years at the least. Herein lies the opportunity for railroads.

Yes, you can move oil more cheaply through a pipeline than you can aboard a train. So what? You can also move grain more cheaply by barge than you can by train. But look at the reality of the grain market today:

Waterways carry an important but small amount of the grain. Railroads, on the other hand, move by far the largest share to market. They can do this and seemingly defy the laws of economics because they exploited their advantages. Waterways go some places. Railroads go practically everywhere. Waterways are slow, railroads much faster. Waterways don't adapt well to change. Railroads constantly reinvent themselves; just look at the variety of unit grain train services that shippers can choose.

OK, so today the pipelines are caught off guard. Their ability to take oil from North Dakota, for example, is limited. Every incremental barrel brought to the surface in that state today must leave by train. And are North Dakota's railroads willing and able? Oh my gosh, yes! BNSF Railway by itself now has the loading capacity to move more barrels per day (1 million) from North Dakota than the state's drillers can produce. Even when the Keystone XL pipeline is built through North Dakota from Canada, the XL will be able to move only 100,000 barrels a day of the oil produced there.

Up to this point, most thinking about transporting America's growing gusher of oil has been conventional, in-the-box. Not long ago at a reception, I encountered Harold Hamm, founder and chief executive officer of Continental Resources, the biggest oil producer in North Dakota. I asked him what role railroads would play in oil transportation in the future.

"Marginal, very little," he replied dismissively. As soon as pipelines are built to the shale oil fields, that's it for railroads.

And he's right, unless railroads begin thinking outside of the box and seize the day. On the East Coast, in New Jersey and Pennsylvania, oil refining has been a losing bet. Refiners pay the world (Brent) price for their crude oil rather than the far cheaper U.S. (Cushing) price. Why?

Because pipelines that serve places like Texas and Louisiana send the oil to Cushing, Okla., and not to the East Coast.

But the availability of railroads to bring cheap North Dakota oil to the New Jersey and Pennsylvania refineries has changed everything. Instead of closing, these refiners are back in business again. It costs less to pay a railroad to bring this oil to the East Coast than it does to buy it on world markets at the Brent price.

The challenge now to railroads is to perpetuate what the Harold Hamms see as a temporary phenomenon. BNSF Railway needs to think of ways to make itself indispensable to the oil industry for all time. In other words, it and the other big railroads need to persuade the oil producers to become their partners. You do this by devising low-cost transportation solutions to achieve long-term results. The short-term opportunity is to charge every penny possible to desperate oil customers. Do this, and they will flee to pipelines at the earliest possible moment. The long-term opportunity is to provide service to end users of oil that the pipelines are ill prepared to reach.

Can they do this? Of course. It's why waterways don't rule the world despite their cost advantage. You don't move rivers, but you can change the destination of a unit grain train with a single email.

More important, will railroads think and act long term? I think so. I just hope they don't waste precious time coming to this conclusion. —Fred W. Frailey

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