Is Intermodal the Answer to Railroads' Coal Woes?

The railroad industry is poised to gain from the improvement in the U.S. economy characterized by increased investments, implementation of safety standards and an enhanced pricing environment. Moreover, the impressive third-quarter performance by most railroad operators is expected to continue. In addition, an improvement in operating ratios driven by better cost control will continue to propel growth for railroad operators.

A rising population tends to boost freight demand. According to the U.S. Department of Transportation, each American requires the movement of approximately 40 tons of freight per year, which clearly demonstrates the importance of railroads in the country.

Below, we discuss key factors that investors should consider before investing in the railroad sector:

Intermodal Strength

According to the Association of American Railroads (AAR), in the first 46 weeks of 2015, U.S. railroads reported cumulative volume of 12,815,842 carloads, down 4.9% from the same period last year. However, intermodal units over the same time frame increased 1.9% year over year to 12,311,269, reflecting the strength in the business.

Intermodal continues to generate significant revenues for major U.S. railroad companies. As per the Federal Highway Administration, freight shipments are expected to grow nearly 45% from 19.7 billion tons in 2012 to 28.5 billion tons in 2040. Thus, we expect railroads to increase its focus on intermodal expansion and tap underserved markets with highway-to-rail conversions.

Further, CSX Corp. ( CSX ) plans to mitigate losses in its coal business with increased intermodal growth in 2016. Forging ahead with its plans, the company continues to step up highway-to-rail conversions to gain a significant share of the expected 9 million volumes in the East that are well-positioned for intermodal business. At the end of the first nine months of 2015, intermodal volumes for Norfolk Southern Corp. ( TM ) and CSX improved 2.1% and 4%, respectively, from the figures posted a year ago.

Meanwhile, American Trucking Association (ATA) expects intermodal freight volumes to increase 4.5% every year through 2021 while it will likely improve 5.3% annually post 2021. Such impressive intermodal freights growth will drive business for railroads considerably.

Crude by Rail: Emerging Market

The present slump in oil prices has not had as much dampening effect on U.S. production as many had been expecting some time back. As per the U.S. Energy Information Administration's (EIA) latest Short-Term Energy Outlook, crude oil production is on track to reach an estimated 9.33 million barrels per day in 2015, up from 8.70 million recorded in 2014. It is very likely, however that 2015 will prove to be a near-term peak, provided oil prices don't stabilize or bounce back.

The transportation of oil happens to be a profitable venture for railroads, though pipelines remain the most optimal transportation option for the commodity.

There is no alternative to pipelines and railroads for the transportation of crude oil from key fields like the Bakken Shale Formation in North Dakota and Montana, the Eagle Ford Shale, Barnett Shale and Permian Basin in Texas, and the Gulf of Mexico and Alberta oil sands. Moreover, these oil reserves lack proper pipeline support, which makes railroads an indispensable mode of transportation. Meanwhile, pipeline development has failed to keep up with the increase in oil supply, making railroad indispensable.

Underdeveloped pipelines have also promoted railroad penetration for crude oil shipping in Canada. Moreover, remote places like North Dakota, where crude oil production has increased manifolds over the last few years, lack proper pipeline network for oil transportation, whose development will likely further slow down following the oil slump. This has in turn propelled demand for railroad transport, partly offset by the eventual decline of production from these newer basins should oil prices remain weak.

To add to the positives, rail transportation is reliable as it offers safety and a lower spill rate as compared to pipelines. Moreover, rail companies are continuously investing in upgrades to improve safety standards. Further, the implementation of new rules by the federal regulators will help prevent oil spill accidents and minimize losses.

Growing Rail Investments to Spur Growth

As per the AAR, the major railroad operators in the U.S. are expected to invest nearly $29 billion in fiscal 2015. Such high investments will open up employment opportunities for nearly 15,000 people. Currently, the U.S. railroad industry covers less than 50% of the total freight market in America, indicating huge untapped opportunities for market expansion. This opportunity can only be exploited through the improvement of railroad infrastructure that caters to the varied requirements of shippers.

Railroads cover roughly 140,000 miles of tracks which require constant monitoring and maintenance. Over the last 30 years, the U.S. railroad industry has expended nearly $575 billion to build a better rail network to connect prime business hubs of the country and to assist timely and safe delivery of goods. Such high outlays have also helped railroads gain an edge over other transportation modes like truck, barges and cargo airlines.

Meanwhile, in order to improve the infrastructure and to ensure higher safety in Western Canada, the Canadian National Railway Co. ( CNI ) plans to invest C$500 million in railway networks. Meanwhile, Kansas City Southern intends to spend $650-$670 million in 2015 itself. According to the Department of Transportation (DOT), the demand for rail freight transportation is likely to increase approximately 88% by 2035. In order to cash in on the opportunity as well as to meet the growing demand, Class I carriers will have to ramp up their investments in railroad networks.

Stringent Safety Measures to Offset Loss: According to the latest rules laid out by federal regulators, aging and hazardous tank cars should be replaced within three years as a safety measure. The newer version of the tank cars will be equipped with thicker shells and higher safety shields, thereby providing enhanced fire protection.

In recent times, rail safety has become an area of major concern. The National Transportation Safety Board (NSTB) - an independent U.S. federal government agency - had recommended the use of ceramic thermal blankets to promote safety standards amid multiple cases of crude oil train derailments over the last couple of years.

Also, in Apr 2015, the transportation department issued emergency directives such as restricting the speed limit to 40 miles an hour in urban areas for trains transporting hazardous materials. According to the latest safety standards, railroad companies will have to furnish detailed shipment-related information within 90 minutes of a derailment, if one occurs. Recently, CSX Corp. launched mobile emergency information software - Rail Respond - which will allow public safety departments to get train-list information and the contents of a rail carrier, thereby enhancing its tracking abilities.

At the end of the third quarter of 2015, Accident rate (per million train miles) for Canadian National Railway Company ( CNI ) reduced by 44% year over year to 1.79. Likewise, Union Pacific Corporation ( UNP ) reported a 12% decline in injury rate for the same period. Thus, it is clear that the implementation of such safety standards has helped reduce accidents and losses arising from derailments.

To Sum Up

There are various factors that raise investors' hope on the railroad industry. We are bullish on the intermodal business as it continues to hold the key. Moreover, implementation of various safety standards coupled with making huge investments to improve efficiency will certainly spur growth in the industry. Union Pacific is a safe bet in this respect as the company's earnings have risen significantly over the past 10 years with the top line reporting consistent growth despite lackluster demand and soft economic growth.

Check out our latest Railroad Industry Outlook here for more on the current state of affairs in this market from an earnings perspective, and how the trend is looking for this important sector of the economy now.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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