Declining Spreads Are a Big Concern for Oil and Rail Companies

Since the recession, there has been a noticeable pricing gap between West Texas Intermediate crude, a lighter grade of oil used as the benchmark for pricing in the U.S., and Brent crude, the European crude benchmark of light sweet crude produced from the North Sea.

Historically, these two oil types have traded almost in tandem with one another. However, the recession and subsequent economic and supply troubles of the U.S. and Europe changed all that.

Source: Energy Information Administration.

Because of decreased production in the U.S. and supply issues in Europe, Brent crude was at one time valued at $28 more per barrel than WTI. Some had actually questioned the importance of WTI in terms of overall global pricing given the strength that Brent had been exhibiting.

This gap, while troublesome for midstream companies that had developed intricate transmission, pipeline, and storage systems that delivered oil assets to Cushing, Okla., the major oil hub of the U.S., turned out to be a boon for many independent oil companies operating in the oil-rich Bakken shale and Permian basin. It also was also a big help at just the right time for the railroads as commodity shipments like coal have dropped off a cliff because of cheaper alternative energy pricing. With oil companies looking to pump up their profits, they turned to railroad companies to ship their oil past Cushing to Louisiana terminals, where they could receive the higher Brent crude price, pay the rail company for shipping, and still walk away with a higher price than WTI in almost every instance.

This has been a lucrative practice for both oil and rail companies, but it may be on the verge of collapsing.

A disappearing spread
According to the Energy Information Administration, last year the U.S. produced an average of 6.5 million barrels of oil per day! That's the quickest rate of production we've witnessed since the mid-1990s, according to a report by The Wall Street Journal. Furthermore, production in May came in at 7.4 million barrels per day, the fastest monthly rate in more than two decades.

As the Obama administration has pushed for greater reliance on domestic oil, U.S. oil and gas companies have responded in record fashion. With the transmission, storage, and pipeline infrastructure in place now that simply wasn't there even five years ago, refiners across the U.S. have been able to use their capacity to refine more domestic WTI and less imported Brent crude. The end result has been an incredible tightening of the spread between Brent and WTI.

Oil producers are losing their free money
One of the biggest losers of the tightening Brent-WTI spread will be oil and gas drillers that operate in liquid-rich shale assets that historically had delivered production to Cushing, specifically the Bakken and Permian basin.

The Bakken, as my Foolish colleague Matt DiLallo recently pointed out, has seen total oil reserve estimates jump from a range of 3 billion to 4.3 billion barrels five years ago to a current estimate of 7.4 billion. A liquid-rich region like this is highly sought after by oil drillers who want to lessen the impact of still relatively inexpensive natural gas prices. The biggest name in the Bakken, and largest leaseholder, is Continental Resources , which has been shipping close to two-thirds of its Bakken production by rail to Louisiana.

A really intriguing deal was actually forged by refiner Phillips 66 , which struck a five-year deal to ship 50,000 barrels per day of Bakken refined oil to New Jersey. For a refiner that relies on nimbleness and the ability to adapt production based on spreads and demand, this is a risky gamble that WTI will remain cheaper than Brent for quite a long period of time. It could wind up being a gamble that could backfire.

In the Permian Basin, Occidental Petroleum has been a big rail transport beneficiary, since it produced as much oil in 2011 as the No. 2, No. 3, and No. 4 producers combined! Being able to pilfer a few extra dollars per barrel can mean hundreds of millions of dollars extra for companies like Occidental with huge oil exposure.

The biggest demand shock, though, could come from railroad companies, which have relied on this spread to drive petroleum transports.

Source: Ron Reiring,

Railroad companies have seen declining demand for coal transports across the board, which is disconcerting since it can account for up to 30% of revenue for some companies. Coal, a "dirtier" fuel source, is being replaced with natural gas and other alternative energies by electric utilities looking to cut their long-term production and environmental costs. Furthermore, relatively weak U.S. economic growth coupled by austerity measures in Europe isn't exactly creating a situation where the rails are seeing consumer goods shipping demand pick up.

Notable railroads that could be hit by a slowdown in oil transports because of a declining spread include Canadian National Railway , Union Pacific , and Berkshire Hathaway subsidiary BNSF.

Canadian National may get a bit of a pass since it's developing railway networks, which could be crucial in the transport of oil extracted from Canada's oil sands, but it nonetheless will feel a pinch being one of the Bakken's prime oil-by-rail shippers.

Union Pacific has even more riding on petroleum transports. CEO Jack Koraleski is expecting oil shipments to rise by as much as 40% this year. This may not happen if the Brent-WTI spread tightens further, which could leave Union Pacific in a short-term bind. You see, increased lumber shipments have also been its other recent boon, and with interest rates rising rapidly of late, that too may come to a grinding halt in the form of slower homebuilding efforts.

Even railway giant BNSF could feel the pinch, although I highly doubt Warren Buffett will bat an eye, with a portfolio of nearly 60 well-diversified investments.

How to play this move
I certainly wouldn't suggest trying to fight this shrinking spread, nor would I suggest abandoning your rail investments, either, since crude transport represents, in most cases, only a small (but growing) portion of their income. I also don't think, without a major surge in WTI, that we'll see a big price difference in the oil drillers themselves. I mean, what they lose from the Brent difference they gain from cheaper shipping costs, since they can sell at the wellhead or in Cushing, which is often a lot closer than Louisiana.

The smart way to play tightening Brent-WTI spreads is by investing in midstream companies that have the pipelines and storage network to handle a boom in oil production. There are frankly too many to list, so consider this a "to be continued" for a few days, when I'll name a few midstream companies that have my undivided attention.

If you're on the lookout for some currently intriguing energy plays, check out The Motley Fool's "3 Stocks for $100 Oil." For free access to this special report, simply click here now.

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Fool contributor Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.The Motley Fool owns shares of, and recommends, Berkshire Hathaway. It also recommends Canadian National Railway. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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