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Crude-by-rail becomes a victim of oil price swings.

Rail was seen as a lifeline for Canadian oil producers in the absence of new pipelines, but narrowing spreads between Canadian oil and global benchmarks in recent months are turning the business model uneconomic in an already-depressed price environment.

“Right now, there are very few movements of crude by rail coming from Western Canada into the Gulf Coast, because it just does not make sense economically,” said Bridget Hunsucker, an analyst at Genscape, which tracks weekly oil carloads across North America.

Before oil prices sank, Canadian producers shipped oil on rail to fetch much-higher West Texas Intermediate oil prices on the U.S. Gulf Coast than they could at the Hardisty terminal in Alberta. The business made sense even after taking into account transportation costs as high as $21 per barrel of oil by rail, compared with $7 via pipeline.

In addition, transporting much-needed diluents back from Houston to Alberta transformed the oil-by-rail business into a roaring growth segment for midstream and rail companies.

But that business model is eroding. While crude prices fell 48% last year, that’s not precisely what triggered the collapse — it’s the narrowing of Western Canada Select’s discount to under $13 compared with WTI and Mexican Maya that’s derailing the business.

Pipeline utilization in the Bakken shot up to 80% by the end of December, compared with 50% at the start of 2014, as producers jumped from rail to pipeline to preserve margins.

“That would be similar for WCS, and as that [price gap] narrows, people gravitate to pipe if they can,” says Jenna Delaney, an analyst with Bentek Energy, a forecasting unit of Platts. “Of course those barrels — if they need to move — are still going to jump on rail. It just won’t be an economic move,” Ms. Delaney said.

Oil-by-rail picked up steam in recent years, as flagship pipelines such as Keystone XL and Northern Gateway became mired in controversy. But after growing 10-fold between 2012 to 2013, volumes

Canadian crude oil exports by rail — not counting domestic hauls to refineries — grew to just over 182,00 barrels per day by the third quarter, compared to around 165,000-bpd at the start of 2014, the latest available figures from the National Energy Board show.

Rail cars carrying crude fell to 13,773 units last November, compared to 15,672 during the same month in 2013, according to Statistics Canada.

“The volumes have been fairly flat. I think the forecast was for fairly dramatic growth, but there has been a cutback on growth projections,” according to John Zahary, CEO of midstream company Altex Energy Ltd.

The meagre growth in rail volumes comes at a time that new facilities are opening up. USD Group LLC opened a terminal in Haridsty last June with capacity for two 120-railcar unit trains, equivalent to 172,639-bpd.

“Even though there was new capacity, industry volumes did not rise, which means other terminals saw less volume ... You see contraction of margin in absolute dollars,” Mr. Zahary said, noting that his company has seen fairly flat volumes and is protected by take-or-pay arrangements.

Altex’s seven terminals in Western Canada have a combined capacity of 75,000-bpd, but volumes stand at around 35,000-bpd.

“We are not at full capacity, some of which are market reasons. Some customers have committed the space but are not moving [volume],” said Mr. Zahary, who previously ran Harvest Operations Corp. and Sunshine Oil Sands Ltd.

Canadian Pacific Railway Ltd. has reduced its forecast for crude oil shipments this year, although it still expects the segment to grow around 25-30%. Canadian National Railway Co., which expects its oil business to grow 35%, says there is little clarity around the oil market at the moment.

“This is why we have reduced our expectation in terms of this market, but the investments are being put in place, and the markets will need those services and we think they will need them, not only in 2015, but also for the long term,” CN chief executive officer Claude Mongeau told analysts during a conference call in late January.

The start of Enbridge Inc.’s Illinois-to-Oklahoma Flanagan South and Enterprise Products Partners’ Oklahoma-to-Texas Seaway, which opened up another 1 million-bpd of pipeline capacity, has also cooled producers’ interest in oil-by-rail.

Still, the capacity keeps coming. Altex is building a unit train terminal in Lashburn, Sask. that would take the company’s capacity to 110,000-bpd.

Plains Midstream Canada expects its unit-train terminal in Kerrobert, Sask. to commence operations in mid-2015, while CP also expects Imperial Oil Ltd. and Kinder Morgan Inc’s 210,000-bpd terminal to come on stream by the first half of the year.

TransCanada Corp. CEO Russ Girling forecasts oil terminal loading capacity in Western Canada to reach 2 million-bpd from its current level of 1.2 million-bpd, and plans to build loading terminals around the company’s storage facilities.

But rail costs are rising for producers. MEG Energy Corp. blamed rail as the primary reason for transportation costs rising $1.82 per barrel in the fourth quarter, compared to $0.51 per barrel during the same period in 2013.

Rail companies are also looking to raise rates for crude transportation. In addition, new safety rules in light of Lac Mégantic tragedy could also cost the wider economy $60-billion, according to the Railway Supply Institute Committee on Tank Cars.

Despite the challenging economics, producers continue to invest in new rail capacity as an insurance policy.

“We are not expecting to see rail entirely disappear over the next couple of years due to the pipeline constraints — and because of arbitrage economics that would pop up in different markets,” Ms. Delaney says.