Canadian National’s (CN) proposal to ship oil sands production south to the US and west to British Columbia’s ports hasn’t generated much buzz in an environment where most observers have been focusing on the number of project cancellations in the energy space during the last six months.

Nor is it a particularly novel approach: During Canada’s first drilling rush after the 1947 Leduc discovery, before the first long-distance pipeline was built three years later, trains carried the black gold from Edmonton to bigger markets for processing.

But it does hold promise, as far as potentially moving oil sands product more economically than can be done via pipeline and to the extent that product can then be moved to Asian markets.

CN opened discussions with Alberta’s provincial government about its “Pipeline on Rails” six months ago. CN management argues that shipping by rail can be done faster and cheaper than via pipeline–and the tracks are already in place, obviating the need for a costly pipeline buildouts.

Though his government hasn’t conducted its own study, Alberta Energy Minister Mel Knight said the proposal is feasible. Mr. Knight said the government and CN had “very good meetings,” and said the Pipeline on Rails is “more than economical on a comparison to pipelines.”

The initiative has also drawn praise from energy executives. “This is a great idea,” said Connacher Oil & Gas (TSX: CLL, OTC: CLLZF) Vice President Cameron Todd. “They’re a breath of fresh air. These [oil sands plants and railways] are very complementary technologies.”

CN’s economic feasibility study concludes that Canadian oil producers and their customers are paying CAD17.95 per barrel to ship oil from Alberta to US gulf coast refineries. Freight rates covering track and rolling stock expenses are forecast to be competitive with tolls for shipments on new pipelines from Fort McMurray to the Gulf Coast.

Any pipeline company would, of course, take issue with CN’s assertions. But until pipeline capacity is, in fact, expanded, CN management may be able to compete with existing pipelines on price while transporting up to 4 million barrels of oil a day. Affording cheaper access to the Gulf Coast as well as access to Canada’s west coast–for eventual shipment to California refineries or to Asia–means smaller producers will enjoy greater flexibility.

The estimated cost of building lines to ship 4 million barrels a day from the oil sands to the Gulf Coast is USD24.7 billion. A proposed increase in capacity to the west coast adding 600,000 barrels a day is another CAD4 billion. Such efforts would take years to complete.

In 2004, Enbridge (TSX: ENB, NYSE: ENB) inked an agreement with PetroChina (NYSE: PTR) to build a 400,000-barrels-per-day pipeline from Edmonton to the west coast port of Kitimat, British Columbia, to export synthetic crude from the oil sands to China and elsewhere in the Pacific and a 150-million-barrel-per-day pipeline running the other way to import condensate to dilute the bitumen so it will flow. The estimated cost: USDD2.5 billion. That project is on hold, a consequence of the economic downturn.

The CN study suggests rail is cheaper and faster–dramatically so if it’s diverted to Canada’s west coast for shipment to Asian markets. CN’s rail proposal eliminates the significant capital and financing costs involved with increasing pipeline capacity.

Costs of restoring CN’s network to a condition that would support the Pipeline on Rails are estimated in the millions, not billions, of dollars. CN is offering deliveries via the old railway branch line between Edmonton and Fort McMurray, which it recently bought from short-haul specialists Athabasca Northern Railway and Lakeland & Waterways Railway. The Pipeline on Rails is essentially new work on old track; with about CAD135 million in improvements to strengthen the line and its safety systems, heavy trains carrying diluted bitumen or synthetic crude will be able to average 40 kilometers an hour between Fort McMurray and Edmonton. The track could eventually be extended into the bitumen mining district north of Fort McMurray if industry demand merits such a step.

By the end of the year, CN hopes to be shipping 10,000 barrels a day on the line between Edmonton and Fort McMurray. CN believes it can ramp up that rate to 300,000 to 400,000 barrels a day, with a medium-term goal of up to a million barrels a day on the existing network. Eventually, CN hopes to move 4 million barrels.

The Pipeline on Rails will deliver oil sands production through the use of insulated and heatable railcars or by reducing its viscosity by mixing it with condensates or diluents.
Scaling up to 4 million barrels is simply a matter of adding cars; current rail capacity is sufficient to handle such volumes.

Alberta and Saskatchewan now depend on the US as their export market. Efficient rail transport could provide immediate cash flow to producers that would otherwise have to wait for the completion of incredibly costly upgraders and/or pipelines–or simply shut in their wells.
Access to the west coast also means access to world markets; a 2004 National Energy Board report on the challenges and opportunities in the oil sands said the US historically has absorbed any additional production of crude oil from Canada. But it concluded that “additional markets will be required to keep pace with oil sands expansion.”

The urgency to lock up and develop access to Canada’s oil sands has abated amid this recession. Output forecasts have been revised downward, and projects have been shut in, as is the case with all types of petroleum generation in recent months.

But the number “174 billion” isn’t going away. That’s the estimated number of barrels resting in the oil sands region, which makes Canada home to the second-largest known reserves on the planet, behind Saudi Arabia.

But the purchase of an additional 10 percent interest in the proposed Northern Lights oil sands project by Sinopec (NYSE: SHI) suggests renewed interest by the Chinese. Total (NYSE: TOT) sold the stake for an undisclosed amount; as a result of the transaction, Total and Sinopec will each hold 50 percent of Northern Lights, a proposed mining project in northern Alberta that was once expected to cost CAD10.7 billion for a mine and upgrader. The Chinese could make further moves in the oil sands because they believe oil prices will rebound, while the cost of investing has declined from two or three years ago, when the sector was booming.

China doesn’t have much refining capacity for the heavy oil such as that produced from the oil sands, but has significant plans to build new refineries. Before it starts construction, it wants to know what the crude is going to look like and how its going to get it home.

This is the second time Total has sold a piece of its oil sands holdings to an Asian firm. In November 2007, Total sold a 10 percent stake in its Joslyn oil sands project to Japan’s INPEX Corp (Tokyo: 1605, OTC: IPXHF).

Whether CN’s Pipeline on Rails sparks a new round of large-scale investment in the oil sands by Chinese, Japanese, Indian and other oil-starved countries as well as oil companies is an open question. It certainly changes the decision-making process, however, because it could have a significant impact on reducing total costs.

And it could help Canadian National replace some of the freight it’s lost due to the economic downturn.