Back to top

Will Crude Oil Brighten Prospects for Railroads?

Read MoreHide Full Article

A rising population directly translates into an increase in freight demand. According to the U.S. Department of Transportation, each American requires the movement of approximately 40 tons of freight per year across the freight network. Thus, we can see the growing importance of the freight network in our daily lives.

Meanwhile, the railroad industry is set to gain from an improvement in the U.S. economy characterized by increased investments, implementation of safety standards and an improved pricing environment. Moreover, higher than expected second-quarter earnings performance by most railroad operators is expected to continue in the coming quarters. In addition, improving operating ratios driven by better cost-control measures will continue to propel growth for the railroads moving ahead.

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

Crude by Rail: Emerging Market

The transportation of oil happens to be a profitable venture for railroads. However, the development of pipelines has made the transportation of oil from the basins more convenient for most oil companies.

Meanwhile, 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. Pipeline developments also could not keep pace with the increase in oil supply, making railroad even more essential.

We also believe that the present slump in oil prices will have a moderate impact on railroad profitability as most oil producing companies barely slash production volumes in such scenarios. As per the U.S. Energy Information Administration's (EIA) latest Short-Term Energy Outlook, crude oil production will reach an estimated 9.36 million barrels per day in 2015, up from 8.71 million recorded in 2014. Hence, the raised guidance indicates better revenue growth for the railroad industry which is on track to achieve infrastructural growth.

As a result, inadequate pipeline developments have given rise to higher penetration of railroad transportation for crude oil shipping in Canada. Moreover, places like North Dakota, where crude oil production has increased manifold times over the last few years, lack proper pipeline network for oil transportation. Hence, the demand for railroad transport is benefiting from this. According to the North Dakota Pipeline Authority, railroads transported over 60% of the state’s crude oil production, which contains the vast majority of new rail crude oil originations.

In addition, rail transportation is reliable as it offers safety and less spill rate as compared to pipelines. Moreover, rail companies are continuously investing in upgrades to improve safety standards. Moreover, implementation of new rules set by Federal regulators will prevent oil spill accidents and minimize losses.

Rail Investments

As per the Association of American Railroads (AAR), the country’s key railroad operators are expected to invest nearly $29 billion in fiscal 2015. Moreover, such high investments in the U.S. railroad industry will open up employment opportunity for nearly 15,000 people.

Railroads stretch over roughly 140,000 miles of track which require constant monitoring and maintenance. Over the last 30 years, the U.S. railroad industry has spent nearly $575 billion. Investments as huge as these have helped enhance the infrastructure of railway which is needed to compete effectively with other modes of transportation like truck, barges and cargo airlines.  Also, a better rail network has facilitated timely and safe delivery of goods and products to different parts of the U.S.  This has also helped to bring down accident rates considerably.

In order to provide better infrastructural support as well as high safety in Western Canada, the Canadian National Railway Co. (CNI - Free Report) plans to invest C$500 million in railways networks. Moreover, Kansas City Southern (KSU - Free Report) will expend nearly $34.6 million to improve its cross border safety standards and expand capacity. Moreover, Kansas City Southern plans to spend $650–$670 million in 2015 itself. Also, Union Pacific Corp. (UNP - Free Report) plans an investment worth $23 million in New Mexico's transportation infrastructure and $15 million for the rail line connecting the Missouri/Iowa border and Trenton.

However, this sector, characterized by huge capital influx, has been primarily drawing funds through private financing. On the contrary, cutting down on investments will soften the growth prospects for the overall industry.

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 will have to ramp up their investments to meet growing demand.

DOT also believes that almost 90% of the railway capacity needs to be upgraded to meet the expected rise in demand level by 2035. Hence, it is important for railroad companies to balance profit levels while investing in infrastructural development projects.

Currently, the U.S. railroad industry covers less than 50% of the total freight market in America, indicating a huge opportunity for market share expansion. This opportunity can only be exploited through the improvement of railroad infrastructure that caters to the varied requirements of shippers.

Improving Safety Measures: According to the latest rules set by federal regulators, the aging and unsafe tank cars should be replaced within three years to enhance safety. 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 a 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 derailments of crude oil trains 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 instruction, railroad companies will have to furnish detailed shipment-related information within 90 minutes of a derailment, if one occurs. The issue of rail safety has also made the Canadian government take notice. The Canadian government has issued an emergency directive, which is operative till Aug 17, and requires trains to limit speeds at under 40 miles/hour in urban areas as opposed to the previous bar of 80 kilometers/hour.

Thus, we believe that implementation of stringent speed-limit rules will help avoid accidents and also narrow losses arising from derailments.

Duopolistic Market Structures: The freight market is mainly dominated by railroad companies that practice discretionary pricing methods. Hence, unavailability of any proper pricing standard by the controlling body allows rail companies to generate substantial profits by manipulating prices in the duopolistic market.

This is 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. (CSX - Free Report) and Norfolk Southern Corp. (NSC - Free Report) manage the eastern part. On the other hand, Canadian Pacific Railway Ltd. (CP - Free Report) and Canadian National control inter-country rail shipment between the U.S. and Canada.

Discretionary Pricing Power: After the adoption of the Staggers Rail Act in 1980, freight railroad service providers have been enjoying considerable pricing power. The main objective behind the enforcement of the act was to allow rail operators to raise prices on captive shippers like electric utilities, chemical and agricultural companies in order to boost profits. Thus, the Staggers Rail Act has been helping railroad companies in maintaining double-digit profit margin by means of increasing freight rates by nearly 5% per annum, on an average.

Bottom Line

There are various bullish factors that raise investors’ hope about the railroad industry. Union Pacific Corp. (UNP - Free Report) 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.

Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days. Click to get this free report >>



More from Zacks Industry Outlook

You May Like