Consistent with the current macroeconomic trends, railroads
started the year on a mixed note. Going by the rail traffic report
for the first quarter 2013, growth in automotive and petroleum
products' shipments was steady while coal and grain shipments
continued to cast a shadow over the rail freight industry.
According to the Association of American Railroads' (AAR) rail
traffic report, cumulative performance of the North American
railroads (including U.S., Canadian and Mexican railroads) have
fallen 1.5% year over year in the first quarter of the year. The
biggest contributor to this decline was grain, which dropped 11%.
Coal volumes followed closely, falling around 7%.
Going by the quarterly performance of the class 1 railroad, we see
continued lower volumes from most of these carriers. One of the
largest class 1 railroads in North America --
Union Pacific Corp.
) -- registered first quarter volume decline of 2% year over year.
Another major railroad
) also reported a similar level of decline in its volumes. Going
forward, Canadian counterpart,
Canadian Pacific Railway Ltd.
) also experienced lackluster growth trend with flat volume growth
on a year-over-year basis.
However, railroad operators like
Kansas City Southern
Norfolk Southern Corp.
Canadian National Railway Company
) have shown modest volume growth, mainly driven by the emerging
automotive business and rising petrochemical shipments.
Notably, despite mixed carload results, these carriers have mostly
generated positive earnings in the reported quarter. The primary
catalyst to this bottom-line performance was operational efficiency
even in times of low market demand. Rising employee productivity,
deploying fuel-efficient locomotives and undertaking railroad
safety measures are some of the key drivers of profitability even
in adverse market conditions.
Rail carriers like Canadian Pacific recorded operating ratio
improvement of 430 basis points year over year. Continued focus on
maintaining asset efficiencies, safety measures and increased
productivity have been the prime contributors to Canadian Pacific's
success in the first quarter. There are several other near-term
growth catalysts in the railroad industry.
Rising Contribution of Petroleum Product Shipment
According to the AAR report, rail traffic from petroleum products
has seen a whopping 46% growth in the three-month period ended Mar
30. According to the Energy Information Administration's (EIA)
reports, U.S. crude oil exceeded 7 million barrels per day
production, representing record growth since the last two decades.
Further, in 2013, long-term projections of EIA suggest that this
growth may also go up to 10 million barrels per day over a period
of 2020 to 2040.
As a result, this surge represents a potential opportunity for
revenue accretion, which the railroads are trying to tap with
infrastructural development. According to industry sources, the
role of crude oil as a revenue contributor has grown by leaps and
bounds in a four-year span from a mere 3% to 30% of the oil and
petroleum products shipment by railroads.
Despite the fact that rail-based crude transportation costs five
times more ($10-$15 per barrel), crude shippers are compelled to
rely on rail-based transport. This is due to the lack of pipeline
infrastructural support in key oil and gas fields like Bakken Shale
Formation in North Dakota and Montana, Eagle Ford Shale, Barnett
Shale and Permian basin in Texas, the Gulf of Mexico and Alberta
oil sand fields in Canada.
In 2012, Canadian National Railway, which operates along the
Western Canada (Alberta region) to the Gulf Coast, has shipped
approximately 30,000 tank cars of volumes of crude oil, while its
counterpart Canadian Pacific shipped 53,000 tank cars of crude
during the same period. Another giant railroader, BNSF Railroad of
Berkshire Hathaway Inc. (BRK-B), which serves the North Dakota
region reportedly earned $272 million from crude shipments last
year by shipping approximately 100 million barrels of oil.
In the coming days, we expect railroads to accelerate their
investment in order to create adequate service capacity for the oil
and gas markets. Canadian Pacific projects crude shipment to reach
up to 70,000 oil-tank cars by the year-end and move to 140,000 by
the end of 2015. This kind of exponential growth in crude oil
shipments is taking place across the rail industry. Consequently,
we expect petroleum shipments to remain favorable and emerge as a
significant revenue contributor in the long term.
Currently, Mexico is a growing market for automotive production and
assembly given the lower cost of production there. As a result,
markets sources predict that in the coming years, auto
manufacturers are expected add capacity to accelerate manufacturing
by 600,000 additional vehicles per annum. In the first three months
of 2013, auto shipments by rail in Mexico increased 4.6% while in
the U.S., auto shipment via rail rose about 2%. This
counterbalanced the 1% drop in rail auto shipments in the Canadian
We believe upcoming plants by
Honda Motor Co., Ltd.
Nissan Motor Co.
), Mazda and Audi would further boost auto production in Mexico.
The facilities would also bode well for automotive shipments. Based
on these proposed expansion plans, finished vehicle production in
the Mexican market is expected to reach 3.5 million units in 2015,
up about 35% from the 2012 production level.
The growth will provide carriers like Kansas City Southern, which
operates across the Gulf of Mexico, ample opportunities to ship raw
material into Mexico and return the finished products to the
domestic market as well as to the U.S. and Canada. The increase in
automotive production is also giving rise to new steel plants and
processing centers across the company's service networks. These
steel plants are likely to bring opportunities for steel shipments
and other related products.
However, in the coming year, the growth can be slightly muted by
the onslaught of the fiscal cliff. According to market reports,
auto sales may see single-digit growth due to a change in consumer
behavior owing to the U.S. tax policy changes. If the situation
improves on the macro front, there should not be a cyclical
downturn in the way of automotives.
The railroad industry is gaining largely from the ongoing
conversion of traffic from truckload to rail intermodal. Intermodal
is gaining popularity among shippers given its cost effectiveness
over truck. On average, railroads are considered 300% more
fuel-efficient than trucks, and we believe that intermodal will
play an important role in driving the rail industry based on the
growing awareness among shippers about its benefits.
Currently, rail intermodal accounts for over 20% of the railroads'
revenue, second in line after coal. In the coming years, we expect
this contribution to only rise given the growing dependence of
shippers on intermodal services.
Apart from these positives, other factors likely to have a material
impact on Railroads' near-term, top and bottom line growth include:
Coal represents important commodities and accounts for over 40% of
railroad tonnage. According to EIA reports, coal production hit
lows of 9.9 million short tons (MMst) in first quarter 2013,
representing a steep decline from 22.7 MMst in the year-ago
quarter. As per AAR reports, coal shipments by rail also continued
to decline 8% in the U.S. market. The decline was partially offset
by 11% and 9% growth in rail shipments in the Mexican and Canadian
Domestic coal demand, of which utility coal accounts for
approximately 93%, is witnessing persistent declines. Lower natural
gas prices imply that gas is largely substituting the demand for
utility coal. Additionally, higher stockpile levels have resulted
in lower utility coal demand. Besides, natural gas prices,
another important factor that resulted in the decline of
coal-powered plants are the environmental issues associated with
However, in 2013, coal consumption in the domestic market is
expected to grow 7% year over year to 948 MMst and reach up to 957
MMst in 2014 on the back of rising natural gas prices.
On the export front, the scenario remains entirely different. After
reaching highs of coal export in 2012 (126MMst), EIA projects U.S.
coal exports to decline 15% year over year to 107 MMst in 2013.
However, 2014 may show modest improvement with exports of 109 MMst.
Factors like an economic overhang in European markets, lower U.S.
coal pricing, higher stockpile levels and increased exports from
Indonesia as well as a recovery in the Australian mines are the
primary reasons for the expected decline.
Since 2012, the Grain market has been experiencing lows due the
drought in the Mid-West markets. The outlook for 2013 is also not
encouraging enough to elevate rail freight shipment from its
According the rail traffic report of AAR, North American grain
shipment registered a decline of almost 11% in the first three
months of 2013, which was partially offset by 24.6% growth in
Mexican grain shipment. In April, the U.S. Department of
Agriculture (USDA) released the World Agricultural Supply and
Demand Estimates (WASDE) report, which states that total U.S. corn
demand, will go down by 11.1% from the year-ago level.
U.S. corn exports will hit a low of 48.2% from last year with
use of ethanol decreasing 9.2%. We believe that the impact of
lowered estimates would be felt on railroad shipment as rail
freight serves the majority of export shipment in the crop market.
Investment in development and expansion plans remain critical when
analyzing railroads prospects. These capital investments are a
double-edged sword. While the investments put significant stress on
margin performance, forgoing these would result in a loss of growth
Railway investments are paramount given the evolving supply chain
management and increasing role of airfreight carriers in offering
freight transportation services. These investments build the
required infrastructure needed for railways to stay afloat in a
competitive environment not only within the railroad industry but
also with other modes like truck, barges and cargo airlines.
As a result, investments in infrastructural projects have been an
integral part of railroads development. However, this sector,
characterized by huge capital influx has been drawing funds
primarily through private financing.
As a result, investment plans when undertaken can have a
considerable impact on the liquidity position of the company and
may lead to a highly leverage balance sheet. According to AAR
reports, railroads invest approximately 17% of their annualized
revenue, which compares with only 3% of average U.S. manufactures'
revenue on capital expenditures.
According to the Department of Transportation (DOT), the demand for
rail freight transportation will increase approximately 88% by
2035. As a result, Class I carriers would have to expedite their
investments to meet this growing demand.
It is estimated that railroads would require $149 billion to
improve rail network infrastructure within this stipulated period.
In respect of current investment requirements, railroads would
invest about $24.5 billion in 2013 according to AAR. This figures
project an escalating trend when compared with recorded investment
of $23 billion in 2012 and $12 billion in 2011 as per AAR.
Given the growing demand and need to upgrade railroad
infrastructure to meet new regulations, deployment of
fuel-efficient locomotives, upcoming rules on track sharing,
railroad safety and high-speed rail services make it mandatory for
railroads to infuse more capital on development projects. According
to DOT, almost 90% of the railway capacity needs to be upgraded to
meet the expected rise in demand level by 2035. Hence, for
railroads it is important to balance profitability levels while
investing in infrastructural development projects.
Currently, the U.S. railroad industry dominates less than 50% of
total freight in America , indicating a huge opportunity for
increasing market share. This opportunity can only be exploited by
building railroad infrastructure that caters to the varied
requirements of shippers.
The railroad industry as a whole offers a number of opportunities
that are difficult to ignore from the standpoint of investors.
Discretionary Pricing Power:
The freight railroad operators function in a seller's market and
have enjoyed pricing power since 1980, when the U.S. government
adopted the Staggers Rail Act. The idea was to allow rail
transporters to hike prices on captive shippers like electric
utilities, chemical and agricultural companies in order to improve
profitability of the struggling railroad industry. As a result, of
the Staggers Rail Act, railroads are hiking their freight rates by
nearly 5% per annum on average, while maintaining a double-digit
Duopolistic Market Structures:
Railroads have by and large gained by practicing discretionary
pricing in the freight market. In the prevailing duopolistic rail
industry, railroad operators will be able to reap maximum benefits
from rising prices when the overall demand grows.
This remains evident from the geographic distribution of markets
between major railroads. Union Pacific and Burlington Northern
Santa Fe control the western part of the U.S., while CSX Corp. and
Norfolk Southern control the eastern part. On the other hand,
Canadian Pacific and Canadian National control inter country rail
shipment between the U.S. and Canada.
Despite the above mentioned positives, the freight railroad
industry, like other industries, faces certain external and
internal challenges. These are as follows:
Capital Intensive Nature:
Railroad is a highly capital intensive industry that requires
continued infrastructural improvements and acquisition of capital
assets. Moreover, industry players access the credit markets for
funds from time to time. Adverse conditions in credit markets could
increase overhead costs associated with issuing debt, and may limit
the companies' ability to sell debt securities on favorable terms.
Positive Train Control Mandate:
The Rail Safety Improvement Act 2008 (RSIA) has mandated the
installation of PTC (Positive Train Control) by Dec 31, 2015 on
main lines that carry certain hazardous materials and on lines that
involve passenger operations. The Federal Railroad Administration
(FRA) issued its final rule in Jan 2010, on the design, operational
requirements and implementation of the new technology. The final
rule is expected to impose significant new costs for the rail
industry at large.
The pricing practices of U.S. freight railroads are the major
reasons of friction with captive shippers, who move their products
through rail and do not have effective alternatives. According to
the latest studies by the STB, approximately 35% of the annual
freight rail is captive to a single railroad, allowing it monopoly
The unfair pricing power exhibited by the U.S. railroads has
attracted congressional intervention for exercising stringent
federal regulations on railroads. Congress has discussed railroad
price regulation but has not passed any new rule so far.
U.S. Environmental Protection Agency:
Railroads remain concerned about the proposed regulation by the
U.S. Environmental Protection Agency (EPA) for power plants across
27 states. The proposed guideline -- Carbon Pollution Standard for
New Power Plants -- aims at restricting emission of carbon dioxide
by new power plants under Section 111 of the Clean Air Act. The
standard proposes new power plants to limit their carbon-dioxide
emission to 1,000 pounds per megawatt-hour.
Power plants fueled by natural gas have already met these standards
but the majority of the units using conventional resources like
coal are exceeding the set limit, as they emit an average of 1,800
pounds of carbon-dioxide per megawatt-hour. Railroads, which
transport nearly two-thirds of the coal shipment, are most likely
to be impacted by the implementation of the new regulation that
could pose a significant threat to utility coal tonnage.
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