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Will Railroads Survive the Coal and Oil Onslaught?

Zacks Equity Research

Lower coal shipments and the slump in oil prices have been major dampeners for the freight railroad industry. Owing to the mature nature of the industry, railroads require steady investments to keep abreast of the latest developments, which in turn exposes it to external as well as internal challenges.

Also, rail companies need to access the capital market on a regular basis which raises the chances of default. Moreover, the cyclical nature of business coupled with stringent government regulations and volatile exchange rates continue to raise caution.

Below, we discuss key factors that investors should consider before putting in their money into railroad stocks:

Low Oil Price

Crude, which forms a major indicator of global economic growth, faced a major setback when the commodity touched a 13-year low of $27 a barrel in Feb 2016. Lower fuel prices for such a long period continue to put pressure on revenues earned through fuel surcharge. As per the U.S. Energy Information Administration's (EIA) latest Short-Term Energy Outlook, crude oil production will reach an estimated 8.6 million barrels a day in 2016, lower than 9.43 million recorded in 2015. Hence, the soft guidance hints at lower revenue growth for the railroad industry.

The extended slump in fuel prices is likely to hurt profits for railroad operators. Moreover, the price decline is sure to intensify competition as trucking companies are poised to enjoy the cost advantage in such a scenario.

Meanwhile, the EIA expects oil production across the seven major shale-drilling regions in the U.S. to decline for the sixth straight month in April which may impact oil transportation through rail.

Further, widespread pipeline development across oil fields may replace rail as a source of crude transportation, thereby intensifying competition for rail operators.

Dull Coal Outlook

Coal is an important revenue driver for railroad operators. Meanwhile, EIA issued a dismal coal production outlook for 2016. Production in the year is projected to fall 12.4% on an annual basis to around 784.1 MMst, thus resulting in the highest decline since 1958. Also, export is likely to deteriorate 13.4% year over year to 64.1 MMst over the same time frame.

Coal forms a key element for electricity production as well. However, the collapse in fuel prices has made natural gas a more economic option for electricity generation. As per EIA, coal consumption dropped 13% in 2015, mainly triggered by a 13% decline in electric power sector consumption.

Moreover, stringent regulatory measures to control emissions are hampering the unrestricted use of thermal coal for electric power generation. Coal consumption in the electric power sector is expected to decrease by 29 MMst or 4% in 2016 owing to mild winter conditions and the ongoing competition within natural gas producers.

Revenues for most rail companies were affected by sluggish coal demand in the fourth quarter of 2015. CSX Corporation (CSX) and Union Pacific Corp. (UNP) reported a 13% and 15% decline in revenues from the year-earlier quarter, owing to a 32% and 22% decline in coal volumes, respectively.

Failed Mergers

Canadian Pacific Railway Limited (CP) recently terminated its efforts to merge with VA-based operator Norfolk Southern Corp. (NSC). Though Canadian Pacific Railway had intended to sign a cash-and-stock merger deal with Norfolk Southern, the latter rejected the offer after a thorough evaluation.

A successful merger between Canadian Pacific and Norfolk Southern would have created over 33,700 miles of transcontinental track, thus improving connectivity between three major tidewater transport hubs which include the Pacific Ocean in British Columbia, the Atlantic Ocean and the Gulf of Mexico.

Moreover, it would have sidelined the busiest Chicago hub, thereby allowing timely delivery of goods to vendors with fewer stops and at a competitive rate.

One of the major reasons behind the rejection of the proposed deal was the close scrutiny by different regulatory bodies as the U.S. railroads are subject to the jurisdiction of agencies like the Surface Transportation Board (STB), the Federal Railroad Administration (FRA) and other state and federal regulatory bodies. Hence, the transaction would have taken nearly two years to clear all hurdles, thereby significantly disrupting regular operations for both the carriers. Such restrictions are a major reason why there has been no merger or acquisition in the U.S. railroad industry in the last 15 years.

Soft Agricultural Shipment View

After recording exports worth $140 billion in 2015, The United States Department of Agriculture (USDA) expects agricultural exports to fall by $14.7 billion to $125 billion in 2016 from the previous year. A decline in agricultural exports may impact railroad companies. In addition, the USDA believes that U.S. will witness a 40% decline in surplus to nearly $6.5 billion, the lowest since 2006. At the end of the fourth quarter of 2015, agricultural business volumes for Union Pacific Corp. declined 5% year over year.

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.

Rail operators have already invested nearly $6 billion while developing PTC and it is believed that by the time the technology is fully deployed, these operators will be spending more than $4 billion. However, the safety of the new braking system is in question as the Association of American Railroads (AAR) believes that the brakes to be installed under PTC guidelines have not been proven to be efficient enough to reduce damages. Moreover, the new rule will make crude oil transportation by railroad transportation an expensive affair.

We also believe that the implementation of the GROW AMERICA act may certainly improve the safety standards of railroad operators. However, the need to invest in advanced research work associated with it may drive costs.

To Conclude

Currently the railroad industry is grappling with multiple concerns. Major railroad operators continue to witness a decline in both the top and the bottom line owing to energy issues. Meanwhile, it is to be seen whether railroad companies succeed in braving the prevailing headwinds.

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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