Railroads Perform Despite Coal Woes

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Despite the ongoing uncertainties surrounding the demand for U.S. coal, railroads delivered stellar performances, backed by pricing and volume gains. According to market reports, North American Class 1 railroads registered substantial growth of approximately 29% in their first quarter earnings.

Railroads transport nearly two-third of coal shipments. According to U.S. Energy Information Administration (EIA) reports, utility coal represents approximately 93% of the domestic coal demand and therefore contributes a substantial part of rail-based coal shipments.  

North American railroads like Union Pacific Corporation (UNP), NorfolkSouthern Corp. (NSC), CSX Corp. (CSX) and Canadian National Railway Company (CNI), Canadian Pacific Railway Limited (CP) and Kansas CitySouthern (KSU) enjoyed significant growth in their freight volumes owing to coal shipments. Coal (divided in two categories, metallurgical and utilities) has mostly gained from higher metallurgical coal export owing to the growing demand for U.S. export coal in the global markets, in particular the Asian countries where steel production is on the rise.

However, utility coal volumes, which generated most of the rail freight businesses in the domestic market, continued to produce subdued results governed by negative factors like lower natural gas prices that substituted utility coal, higher stockpile levels and a warm winter. As a result, it was expected that the continued decline in utility coal volumes would take a significant toll on the recovering rail companies. 

Additionally, with the recent development in EPA regulation, we only expect the utility coal scenario to further worsen, creating significant headwinds for the railroads. The proposed guideline -- the 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.

Power plants fueled by natural gas already meet these standards, but the majority of power stations using conventional resources like coal are exceeding the set limit with an average of 1,800 pounds of carbon-dioxide per megawatt-hour.

Although the new rule would not levy on existing power plants, despite their higher carbon emission or on upcoming plants over the next 12 months, it creates major headwinds for the railroads that derive more than 40% of their total freight volumes from this single commodity.

However, rising demand for U.S. metallurgical exports, freight shipment in agricultural, industrial products like automotives, chemical and fertilizers alongside surging demand for petroleum products and ethanol are important catalysts in offsetting dampened utility volumes.

Companies like Canadian National have already started following the business trend by divesting their interest in natural gas and crude oil shipping. Canadian National plans to relocate its Calgary terminal and introduce intermodal services to connect Port of Prince Rupert in British Columbia with Calgary and Edmonton intermodal terminals in order to tap opportunities in the Alberta region, which is one of the largest producers of energy resources like crude oil (conventional and synthetic), natural gas and other gas products.

Further, Canadian Pacific recently announced its multi-year agreement with Unimin Corporation for shipping fracturing sand from Wisconsin, where Unimin’s facility will begin operations by next year, producing two million tons of fracturing sand that it will ship every year to markets like North Dakota, Texas and Colorado.

All these initiatives indicate that freight railways have started focusing on new business opportunities in other commodity segments that will likely bode well for near-term growth despite the negative impacts of lower coal volumes. Additionally, we expect freight rates to remain favorable for the rail carriers, indicating a positive revenue trend.

Currently, we maintain our long-term Neutral recommendation on Union Pacific Corporation, Norfolk Southern, CSX Corp., Canadian National, Canadian Pacific Railway Limited and Kansas City Southern. For the short term (1–3 months), these stocks hold a Zacks #3 Rank (Hold) except for Canadian Pacific, which retains a Zacks #2 (Buy) Rank.

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