Editor’s Note: This is the second in a multi-part series examining the fundamentals behind the structural transformation of the U.S. oil market and the downstream logistics challenges that are resulting.

Nearly 150 years after trains first revolutionized the U.S. oil trade, crude is hopping the rails once again as operators, producers and traders try to cash in on the biggest domestic price gap in decades.

Although still relatively small, shipments of oil in rail tankers may have already doubled from a year ago, according to several media reports citing industry estimates. And the number of shipments is forecast to surge as producers, railways and storage firms establish as many as a dozen crude-by-rail terminals – allowing oil from an oversupplied U.S. Midwest to flow to destinations where it captures a higher price – including the Gulf Coast.

The motive: Light, sweet crude sold for about US$81 per barrel (/bbl) at well in the Bakken shale of North Dakota recently. After a 1,600-mile rail journey south – at an estimated (early February) cost of $7/bbl – the same oil could fetch $104/bbl in Louisiana, according to a February 4 Reuters report.

Several factors have contributed to a steep discount in prompt West Texas Intermediate (WTI) prices relative to prices for WTI in future month contracts – known as contango – compared with prices for other crude oil grades, including the negative trans-Atlantic spread to North Sea Brent.

At the Midwestern “PADD 2,” WTI inventories are backing up at the key Cushing, Okla., terminal – the delivery point for the NYMEX’s benchmark WTI crude futures contract. Although the landlocked oil hub consists of several large southbound pipelines, the lines end in a cul-de-sac, and there isn’t adequate pipeline capacity to the Gulf Coast.

Cushing tanks held a record 37.7 million barrels of oil, according to the U.S. Energy Information Administration’s weekly supply report for the week ended February 11.

Further exacerbating the situation are rising North Dakota oil production and the opening of two pipelines from Canada – one on April 1, 2010, and another on February 8, 2011. Meanwhile, two pipelines (Seaway – 430,000 barrel-per-day (b/d) capacity and Capline – 1.2 million b/d capacity) bring oil up from the U.S. Gulf Coast to the Midwest.

The Dawn Of The Oil Age

Wooden rail tankers were first used in 1865 to serve the oil fields of Pennsylvania. Four years later, cast iron tankers would replace the wooden tanks. Capacity was about 3,500 gallons per car, the railroads had about 52,000 miles of track, and a typical coast-to-coast journey on the Transcontinental Railroad could take up to eight days.

In 1888, tank car companies began to supply oil tank cars directly to the oil industry, instead of the railroads. Capacities ranged from 6,000 gallons to 10,000 gallons. Thirteen years later in 1901, gushers at Spindletop in Beaumont, Texas, spurred the development of rail lines to serve wells and refineries of Texas and Oklahoma. In 1903, there were more than 10,000 tank cars in operation and more than 260,000 miles of track.

At the height of the rail tank car era in the 1930’s, 140,000 tank cars carried 103 commodities, in addition to oil, to market. In developing his then-small oil company into a monopolistic force in the industry – Standard Oil – John D. Rockefeller called rail tank cars his “secret weapon.”

Cheaper pipelines would eventually gain the upper hand in the oil markets. In several months, a big trunk pipeline can reverse the direction of its flow, but unlike rail routes, it can’t divert to different markets.

Rail Loads May Narrow WTI Discount

For shippers, producers and oil traders trying to avoid Cushing offers, turning thousands of miles of flexible U.S. rail routes into a lucrative oil transport option for the first time in decades yields major rewards.

“If you can get Bakken crude to Louisiana, you get LLS (Light Louisiana Sweet) prices for it,” Bill Swan of U.S. Development Group told Reuters on February 4. “Rail shipments are just starting to take off and have lots of room to grow.”

At least four shipping sources said it costs as little as $7/bbl to send crude from Bakken to St. James, according to Reuters. The price is for batches of 60,000 barrels or more on unit trains of 100 cars. Smaller loads on manifest cars reportedly cost around $11/bbl. Handling and gathering can add another $5/bbl, but the economics “remain compelling due to huge oil price spreads.”

Some might say it’s the kind of arbitrage that big oil traders such as BP and Vitol live to exploit.

Delivering less oil from the Gulf would appear to be part of the solution in reducing the mammoth glut at Cushing. But ConocoPhillips – one of the Seaway pipeline owners – has said it is not interested in reversing the line (see GRFT 2/18/2011). Until other solutions are found, rail transportation and trucking may help close the gap.

And although rail shipments are gaining traction, they remain modest and untracked for now by the EIA, which does release pipeline and barge flows.

Currently, estimated crude-by-rail volume is about 100,000 b/d, according to the Reuters report quoting several crude shippers. Based on data from the Association of American Railroads, that’s up from around 38,500 b/d in 2010.

Upending Old Trade Patterns, Creating New Ones

Whether by rail, pipe, barge, tanker ship or truck, southbound shipments should eventually narrow the gap between U.S WTI futures – the world’s most-traded oil contract – and Europe’s Brent. The London-traded crude is at its biggest sustained premium against WTI – an advantage that peaked at nearly $16/bbl on February 16 – versus an average premium of 63¢ in 2010. Historically, Brent traded at a discount to WTI in order to move foreign crudes trans-Atlantic to satisfy U.S. demand.

With no new southbound pipelines from Cushing planned until at least 2013, crude-by-rail may transform the U.S. oil market logistics in the near term. The massive discounts for inland U.S. crudes have upended old patterns of trade and created new ones. Rising U.S. demand and declining production have drawn European barrels stateside.

But Europe and U.S. buyers have little impetus to move crude this way now and instead of pulling barrels north, North American shippers and operators are scrambling to push them south.

According to EIA data, record crude volumes are reaching the Gulf Coast by pipeline, and industry sources cited in several media reports say pipeline capacity is maxed out. Existing pipelines running south from PADD 2 to PADD 3 have shipped nearly 165,000 b/d in recent months – triple the average from the previous decade – according to the EIA.

In November 2010, 316,000 b/d reached PADD 3 from other U.S. regions by pipeline, barge or tanker, EIA data shows. That was up from 184,366 b/d in October 2010 and nearly quadruple the average 84,465 b/d during 2009.

PADD 3 refiners processed about 300,000 b/d of Canadian crude in October 2010, according to the EIA, which lists ExxonMobil Corp. as the top processor.