Railroads Hit by Coal Concerns

After lower coal production forecasts by U.S. Energy Information Administration (EIA), railroads are again worried 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 now limit their carbon-dioxide emission to 1,000 pounds per megawatt-hour. Power plants fueled by natural gas have already met these standards but 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.

As a result, new power plants either have to be fueled by natural-gas or incorporate technologies like catalytic converters and smokestack scrubbers that limit carbon emission.

According to EIA, coal accounts for approximately 42% of electricity generation in the U.S., which has around 1,470 generating units, of which over 70% are more than 30 years old.

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 significant headwinds for the railroads that derive more than 40% of their total freight volumes from this single commodity.

Railroads, which transport nearly two-third of the coal shipment, are most likely to be impacted by the implementation of the new regulation that could result in a gradual decline in domestic coal demand. According to 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 - Analyst Report), NorfolkSouthern Corp. (NSC - Analyst Report), CSX Corp. (CSX - Analyst Report)) and Canadian National Railway Company (CNI - Analyst Report), Canadian Pacific Railway Limited (CP - Analyst Report) and Kansas CitySouthern (KSU - Analyst Report) 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 growing demand for U.S. export coal in the global markets on the back of higher steel production in the Asian countries.

On the other hand, 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 weather that required lesser electricity consumption.

With the recent development in terms of EPA regulation, we can only expect utility coal scenario to further worsen, creating significant headwinds for the railroads.

However, rising demand for U.S. metallurgical exports, freight shipment in agricultural, industrial products like automotives, chemical and fertilizers alongside rapidly growing requirement for petroleum products and ethanol can play 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 connecting Port of Prince Rupert in British Columbia with Calgary and Edmonton intermodal terminals in order to tap potential 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 initiative indicate that freight railways have started focusing on new business opportunities in other commodity segment considering the current market scenario. These are likely to bode well for near-term growth despite the negative impacts of lower coal volume. 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 National that retains a Zacks #2 Rank (Buy).