Take a Ride
The energy sector is a lot bigger than just companies that explore for and produce oil and natural gas. One of the most overlooked energy sectors of all also happens to be one of the oldest sectors in the US market, the railroads.
At first glance, the rails may not seem an energy group. But consider that the vast majority of all coal moved in the US is transported by rail; in fact, coal is the railroads’ most important freight.
The same is true of ethanol. Ethanol can’t be moved by pipeline because of its corrosiveness; therefore, most of it is carried on trains. And then there’s the corn used to make ethanol. That, too, is transported primarily by rail.
Coal is the fastest-growing commodity, and demand is expected to increase globally over the next two decades. As the main mode of transport for the commodity, railroads will increase increased demand alongside it, whether it be from the US or abroad. See Freight Demand.
Rails are also key transports for the movement of agricultural products, which have seen demand jump recently as well. And the use of such products is set to increase as governments set loftier mandates for ethanol use and additional feed is needed for livestock for meat consumption. See The Agriculture Boom.
A quick look at the business for Union Pacific, the largest US railroad, highlights the bullish trends in the industry. The fact that its costs have been falling and its network reliability is improving is a good sign of things to come. See Putting It All Together.
There are eight railroads worth noting here. I give my analysis of each and am adding one to the Wildcatters Portfolio. See How to Play It.
I’m recommending or reiterating my recommendation in the following stocks:
Dow used to watch the interplay between the Dow Jones Industrial Average and the Dow Jones Railroad Index carefully. His basic theory was that the rails and industrials needed to confirm one another; in a real bull market, both indexes would be expected to continue making increased highs together. When one index topped out, it was an early sign of trouble even if the second index continued to rally.
This basic theory made a good deal of economic sense, at least in the context of the US economy in the early 1900s. The US is now a service-oriented economy, but at the turn of the 20th century, it was far more levered to industrial production. If the industrial economy is strong and US factories are operating near capacity, it stands to reason that those goods being produced need to be shipped. And if consumer spending is healthy, railroads and trucks must be busy moving goods from factories or ports to retailers around the US.
But even in a service-oriented economy, the Dow Theory is still grounded economic rationality. The modern Dow Jones Transportation Average Index includes trucking firms, airlines and package delivery companies. Freight and passenger volumes for these industries tend to vary with the state of the economy.
Lately, however, the traditional relationship between the transports and the broader economy and stock markets has broken down. Check out the chart below for a closer look.
Source: Bloomberg
This chart shows the comparative performance of four key US market indexes over the past year. It covers roughly the entire period since the credit crunch began in earnest. I set each index equal to 100 a year ago; values less than 100 indicate a decline over the past year, while values more than 100 indicate an advance.
The trend here is obvious. The Dow Industrial and S&P 500 are both sharply lower over the trailing one-year period. In late June, both indexes were trading close to fresh 52-week lows.
Meanwhile, the Dow Jones Transportation Average Index actually set a new high in May and is down only slightly on a trailing one-year basis. A quick glance at the chart of the Dow Jones Railroad Index reveals why the transports are outperforming: The Railroad Index has soared nearly 25 percent over the past year, despite the steadily weakening performance of the broader market averages.
The table below shows the current weightings of stocks in the iShares Dow Jones Transportation Average Index.
Source: Bloomberg
As the table indicates, railroads are among the most important sectors inside the Transportation Index, accounting for about 35 percent. Strong performance from the railroads has offset weakness in the airlines and truckers over the past year; the rails are responsible for the Transportation Index outperforming the broader averages.
At the same time, the US economy clearly isn’t in great shape right now. As I’ve highlighted on a few occasions, I believe the US economy is currently in recession.
One of my favorite quick indicators of US economic health is the US leading economic indicator (LEI). Check out the chart below for a look at the current state of LEI.
Source: Bloomberg
The LEI is actually a composite of 10 key economic indicators. The list includes housing starts, consumer expectations, jobless claims and even the performance of the US stock market.
The chart shows the year-over-year percent change in leading economic indicators. As evidenced from this chart, the LEI tends to turn negative just ahead of or coincident with US recessions. The LEI entered negative territory late in 2007 and has shown little or no sign of recovery since that time.
By any historical precedent, this would seem to fly totally in the face of the performance of the Transportation and Railroad indexes. The conventional wisdom would be that a recession in the US means trouble for transports.
I’ve highlighted the rails before in The Energy Strategist, including the July 12, 2006, issue, Beyond Oil and Gas. My long-held thesis on the group has been that the railroads are no longer totally dependent on the US economy for their growth. It’s no longer appropriate to look at this sector as viciously economy sensitive. The traditional relationship between the broader market and the rails has been breaking down for several years, but this trend appears to be accelerating; recent action is by far the most dramatic decoupling witnessed to date.
We’re likely to see further decoupling in coming months. Railroads are a play on three big secular themes: the drive for increased energy efficiency, growth in the US coal industry and the agriculture boom.
As to the first point, railroads are among the most fuel-efficient forms of freight transport available; better still, the rails have been getting progressively more efficient in their use of diesel fuel over the past two decades.
Consider that, in 2007, according to the Association of American Railroads (AAR), the average railroad moved a ton of freight a distance of 436 miles on a single gallon of diesel fuel. That makes freight trains roughly three to four times more fuel efficient than trucks.
And railroads have gradually introduced newer, more-fuel-efficient locomotives and modern technology to monitor and manage fuel use. According to the AAR, in 1980, the average freight train could transport the same ton of cargo only 235 miles per gallon of diesel; between 1980 and 2007, the railroads managed a more than 85 percent jump in fuel efficiency. Check out the two charts below for a closer look.
Source: US Dept of Transportation, Federal Highway Administration, Research and Innovative Technology Administration, AAR
Source: US Dept of Transportation, Federal Highway Administration, Research and Innovative Technology Administration, AAR
To create these charts, I used Dept of Transportation (DoT) data for US railroad ton-miles, the movement of one ton of freight for a single mile. The DoT also offers data covering total fuel consumed by the railroad and trucking industries.
For ease of comparison, I set total ton-miles and fuel consumed equal to 100 in 1980. The trend is clear: Rail ton-miles have surged close to 90 percent since 1980, while the total amount of fuel consumed by the industry has risen only slightly to 4.1 billion gallons of fuel today from 3.91 billion gallons in 1980. That’s a less-than-5-percent jump in fuel consumption for a near doubling in ton-miles.
The picture for the trucking industry is less encouraging. Note truck ton-miles have jumped by more than 100 percent since 1980; however, fuel consumption by the trucking industry has jumped by roughly 68 percent. In other words, like the rail industry, truckers have increased their fuel efficiency, but the gains haven’t been as dramatic.
One of the problems facing the trucking industry and fuel consumption is familiar to all of us who have occasion to commute: US highways are increasingly busy and full. Time spent idling in traffic is extremely wasteful for fuel consumption, so our increasingly jammed highways are trouble for the trucking industry.
In a June hearing before the US Senate, Edward Hamberger, president of AAR, offered some other interesting statistics. The Senate hearing focused on the transportation industry, pollution and global warming.
As for the latter point, opinions vary greatly as to the importance of climate change and the speed at which these shifts are occurring. I’m not a climate scientist, and there are others who are far better qualified to assess those questions than I. The good news is that, as investors, we don’t really need to inject ourselves into this argument.
The important point is that regulations on carbon emissions have been imposed in many regions of the world, and it’s highly likely that the US will eventually put an emissions-reduction scheme in place. As investors, we can’t ignore these shifting political trends and public sentiment; carbon regulations will have an effect on energy-related stocks.
On the environmental front, rails also seem to have an edge. Check out the chart below based on data from Mr. Hamberger’s testimony.
Source: Statement of Edward R. Hamberger, AAR president and CEO, before the US Senate Committee on Commerce, Science and Transportation, June 24, 2008
In total, the transportation industry accounts for less than 28 percent of total US greenhouse gas emissions, second only to electricity generation at roughly 34 percent. This pie breaks down emissions from the transport industry by source.
As you might expect, the biggest culprit is passenger cars and trucks, accounting for roughly two-thirds the total. The trucking and airline industry rank second and third, with 21 percent and 8 percent of emissions, respectively. Freight railroad is a distant fourth on the carbon emissions front, accounting for only 2.6 percent of transportation-related emissions.
And it’s not just carbon dioxide. According to the same testimony, railroads are the most environmentally friendly form of transport when it comes to nitrous oxides, organic compounds, carbon monoxide and a host of other key pollutants. The bottom line: In an era of high energy prices and increased concern about pollution, rails have an advantage.
Of course, none of this is to say that the trucking industry is about to disappear. Trucks will remain a key part of most countries’ transportation infrastructure. However, rail does have room to grab market share from trucks in coming years, given the current high-fuel-cost environment.
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Source: AAR
Source: AAR
These charts are based on freight data for 2006 for all US Class I railroads; these are long-haul railroad operators. The first pie shows the total freight carried by these rails in terms of total tons. The second breaks down cargoes by revenues generated for the railroad.
Understanding the types of cargoes US rails carry is key to understanding why the industry has become less sensitive to a weak US economic environment. What really jumps out from these pie charts is that coal is a crucial commodity, accounting for nearly 45 percent of total tons and 21 percent of total revenues for Class I railroads.
Other key cargoes include food, farm products and chemicals, accounting for about 27 percent of rail revenues combined. Food and farm products are relatively straightforward terms.
As for chemicals, it’s worth noting that US rails carry the majority of all ethanol transported in the US; ethanol can’t be shipped through pipelines because it’s corrosive and tends to evaporate. Ethanol, for the purposes of this chart, is considered a chemical. Other chemicals include fertilizers, pesticides and petrochemicals.
Miscellaneous mixed shipments make up nearly 15 percent of all cargoes. This category generally refers to what’s known as intermodal transport. Literally, that means cargoes shipped using multiple modes of transport, such as ships, rails and trucks.
Probably the biggest form of intermodal cargo in the US is containers imported from abroad by ship and then transferred to rails for transport within the country. Oftentimes, these containers are filled with consumer goods of some description.
Motor vehicles are also a key product often shipped by rail. Cars and trucks comprised less than 8 percent of railroad revenues in the year 2006.
The key point to note is that demand for some of these key products isn’t driven by the US economy. The most obvious example of this is coal, a commodity I’ve analyzed at great length in past issues of TES. In particular, note the Jan. 2, 2008, issue, Taking Stock of 2007, and the Sept. 5, 2007, issue, Australia, Asia and Coal, for a closer look at the coal industry. The railroad and coal industries can’t be separated; rails account for the vast majority of all coal moved around the US and, for that matter, most foreign countries.
There are a few key points worth noting about the US coal market. First, demand for electricity is less sensitive to economic growth than demand for oil. And because 92 percent of all the coal consumed in the US is used in power plants, this spells relatively steady growth in coal demand. Check out the chart below for a closer look.
Source: BP Statistical Review of World Energy
This chart shows US electricity generation from 1990-2007. Over this time period, US electricity generation grew by more than 37 percent. Even more impressive, electricity output only fell in only one year over this time period. In contrast, US oil demand grew less than 22 percent over the same time period; year-over-year oil consumption actually fell in four separate years over this 17-year time frame.
This same basic trend is projected to continue in the future. The US gets about 52 percent of its power from coal, and the Energy Information Administration (EIA) expects that percentage will increase by 2030. Overall, the EIA is looking for US coal consumption to rise by about 37 percent between 2005 and 2030, while US oil consumption is projected to increase by less than 10 percent.
This steady, long-term increase in coal demand spells growth in demand for railroads to transport coal around the US. Of course, hot summer weather or unusually warm winters can drive variations in coal demand, but short-term gyrations aside, the trend in demand is higher.
But this is really only the beginning. Two additional trends are likely to propel demand for coal transport in coming years: increased western production and export demand.
As to the first point, there are really three main regions of US coal production: Appalachia, the Interior and the West. The map below, taken from the EIA’s annual coal report, offers a good overview of where these regions are located and where US coal comes from.
Source: EIA
This map shows 2006 coal production from each region in short tons. For those unfamiliar with this measure, a short ton is 2,000 pounds or roughly 0.91 metric tons (tonnes). The percentage underneath each production figure is the annual change in production for each region in 2006.
As you can see, the West region, encompassing states such as Wyoming and Montana, is already the largest center of US coal production. The second most-important region is Appalachia, with the Interior ranking a distant third. But what’s equally important to note is that West coal production jumped 6 percent in 2007, compared to a 1.4 percent decline for Appalachia and a small rise in Interior production.
There are a number of reasons for this pattern. One is simply that Appalachia is a mature region for coal production; coal has been produced from Appalachia for well more than a century. That means that coal seams in many areas are getting thinner, deeper underground and tougher to access.
Another issue plaguing the region is labor. Mining coal underground requires significant training and is dangerous work. Miners in the region have experienced trouble attracting and retaining labor; miners also earn top dollar for working in these mines, increasing costs.
Finally, new environmental and safety regulations introduced over the past few years are an issue. These laws have made it tough for some mines in the region to operate profitably. I won’t rehash all of these changes in this issue. (The Nov. 7, 2007, issue, Coal and Services, offers a lengthier summary.) And this isn’t just a one-off trend for 2007 production; check out the chart below.
Source: EIA
This chart shows historical data for US coal production going back to 1970 and EIA projections going forward to 2030. As the chart indicates, the West became the nation’s most important producing region early this decade, and that dominance is forecast to increase steadily in coming years.
In contrast to eastern mines, West deposits haven’t been as fully depleted and are located closer to the surface of the Earth. These seams are easier and cheaper to mine. Although coal from the region typically has a lower heating value—less energy per short ton—much of the coal is extremely low in sulfur content. Low-sulfur coal produces less sulfur dioxide when burned in plants.
But although the West is becoming the most important center of coal production, most of that coal must be transported relatively long distances to regions of heavy coal consumption. Check out the map below.
Source: EIA
This map shows US coal consumption in electric power plants by region. It is clear that the mid-Atlantic, upper Midwest and south Atlantic regions are all heavy coal users. As eastern production declines and coal is sourced from the West, that means this coal must be transported over greater distances. Because the rails handle substantially all coal transport in the US, this means more ton-miles for the rails.
And a second major factor underpinning coal demand is the export market. I highlighted this factor in the Sept. 5, 2007, issue. The basic story is simple: Coal is the fastest-growing fossil fuel in the world. Last year, global coal demand soared 4.5 percent on an oil-equivalent basis, compared to 1.1 percent for oil, and 3.1 percent for natural gas. This is the fifth year running that coal has been the fastest-growing fossil fuel commodity.
As you might expect, much of that jump in demand is powered by rapidly rising demand in China, India and other emerging markets. China alone builds a new coal-fired power plant roughly once a week just to keep pace with demand; that’s equivalent to adding electric capacity equal in size to the entire UK each year. Both India and China are heavily dependent on coal-fired plants for their power.
According to the EIA, China currently generates 271 gigawatts (GW) of coal-fired power capacity. To meet growing needs, China will need to add nearly another 500 GW by 2030, tripling coal-fired capacity. As the chart below shows, Chinese and Indian electricity demand looks like it will continue to rise sharply over the next 20 years.
Source: EIA
The question is, of course: Where will all this coal come from? China is both the world’s largest producer and consumer of coal; last year, the nation also became a net importer. Despite significant reserves and production capability, China just can’t keep pace with its own demand. India, too, will need to accelerate coal imports to meet future growth in demand.
Asia’s growing demand for coal imports is having severe ramifications for the rest of the world. Traditionally, Indonesia and Australia have been the main exporters in the region both for thermal coal and metallurgical (or coking) coal used to manufacture steel. But even these countries are having trouble ramping up production fast enough to meet demand; Australia has experienced considerable difficulty with railroad and port infrastructure needed to support growth in the industry.
And remember that Europe is also a major coal importer. Although many investors assume that Europe has eliminated coal-fired power capacity entirely, nothing could be further from the truth.
According to the International Energy Agency’s statistics for 2005, Germany generated 49 percent of its power from coal-fired plants, compared to less than 4.5 percent for wind power. The UK has systematically replaced coal-fired plants with natural gas facilities but still gets roughly a third of its electricity from coal. Finally, Poland, like many other countries in Eastern Europe, is even more coal-dependent, generating 92 percent of its power from coal.
With limited domestic coal production, most of these countries are heavily reliant on imports.
The US is truly the Saudi Arabia of coal, with some 245 billion metric tons of proven reserves; nearly 30 percent of all global proven coal reserves are in the US. The US dwarfs the world’s second-largest reserve holder, Russia, by nearly 100 billion metric tons of reserves. At current production rates, the US has enough proven reserves of coal to last 234 years. And, remember, these are just proven reserves.
The US is one of the only countries with the ability to ramp up coal production and exports enough to meet growing global coal demand. Check out the chart below for a closer look.
Source: EIA
This chart shows US coal exports by quarter. The uptrend in exports is clear: The EIA expects overall coal exports to grow to more than 76 million tons in 2008, up from less than 60 million in 2007. And the EIA has been revising its expectations higher in recent months; it’s quite likely exports will rise even further than anticipated.
Not only are exports beginning to surge, but European and Asian buyers are willing to sign long-term supply deals at attractive prices with the US miners just to guarantee coal availability. Clearly, railroads are in high demand to ship all that coal out of mines to coastal ports.
Bottom line: Demand for US coal and coal freight has little to do with the US economy. Instead, these trends are driven by the combination of strong economic growth abroad, coupled with secular shifts in domestic coal production.
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Another major component of the rails’ revenue is agriculture. This includes the movement of agricultural commodities such as grains, as well as agricultural chemicals such as ethanol and fertilizer. And agriculture and energy have become increasingly interrelated in recent years; growing demand for biofuels such as ethanol and biodiesel has become an important driver of pricing for agricultural commodities.
I covered the agriculture and biofuels industries in the April 2, 2008, issue, Growing Fuel; I won’t bore readers by repeating those arguments. Suffice it to say that there are two trends driving a global agriculture boom: food upgrades in the developing world and the biofuels boom.
The basic story behind biofuels is government subsidy. In the waning days of 2007, the US passed a new law called the Energy Independence and Security Act of 2007. A 2005 act required that the US use some 7.5 billion gallons of ethanol by 2012; for reference, in 2007, the US consumed some 6 billion gallons of ethanol. The new bill more than doubles the total mandate to 15.2 billion gallons by 2012. In addition, the new renewable fuel standard extends the mandates for another 10 years, requiring the nation to boost biofuels consumption to 36 billion gallons by 2022.
Some of this growth will eventually come from cellulosic biofuels made from nonagricultural commodities such as switchgrass. Check out the chart below for a near-term perspective.
Source: EIA
This chart is based on data and projections from the US Dept of Agriculture (USDA). The chart shows that the nation will continue to see growth in corn demand, and much of that corn will be needed to meet growing ethanol mandates.
The scariest part about this chart is that, although the USDA long-term projections were published in February 2008, the estimates were based on data finalized in late 2007, before the Energy Independence and Security Act of 2007 was passed into law. Therefore, these estimates are based on the much-lower mandates from the 2005 act.
All too often, pundits make the argument that greater food consumption in the developing world is the primary driver of agricultural demand. This is partly true; the more important effect is a shift in consumption patterns.
In the world’s least-developed countries, the primary component of the average consumer’s diet is basic cereals; wheat and rice are two common examples. Consumers in these countries eat very little meat, dairy or other processed foods. As a nation becomes wealthier, however, the average consumer’s diet changes and diversifies away from basic cereal consumption.
The biggest component of the shift is meat. The average American consumes nearly 124 kilograms of meat per year (275 pounds of direct meat consumption), compared to less than 55 kilograms per year (121 pounds) in China. But Chinese meat consumption is up from 45 kilograms a decade ago; as China’s growth continues, look for meat consumption to continue to grow as well.
Shifting diets in the developing world have a profound impact on global demand for agricultural products. Consider that increased meat, dairy and animal products consumption spells increased demand for livestock. Feeding livestock requires large amounts of grain and meal. Simply put, it takes 8 to 10 pounds of grain and feed to produce 1 pound of meat. Of course, these figures vary depending upon the type of meat produced, but an 8-to-1 ratio is a decent rule of thumb.
Another way to look at this is the amount of land required to produce meat to feed a single consumer compared to vegetables or grains. According to British consulting firm Bidwells Agribusiness, it takes more than 8,170 square meters of land to produce beef to feed one person. Producing potatoes requires just 274 square meters. Meat production is far more land intensive.
As meat consumption rises, the effect on grain and land demand rises at an even faster pace. With literally billions of consumers in the emerging markets now starting to demand more processed, meat-based foods, there’s an ever-expanding wall of demand for products such as soybeans, corn and wheat.
At any rate, the global boom in agriculture demand has pushed the prices of all sorts of agricultural commodities higher. Once again, the rails are a key player in the agriculture boom; most agricultural commodities are moved via rail.
And ethanol actually offers railroads a triple-win situation. Rails transport raw corn from farms to ethanol production facilities and ethanol itself from those production facilities to blending terminals.
In addition, one by-product of ethanol production is dried distiller’s grain (DDG), used in animal feeds. Trains are used to transport this product as well.
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It also offers a convenient example of the bullish forces at work for the rails, particularly in the coal and agriculture industries. Check out the chart and table below for a closer look at the breakdown of Union Pacific’s business.
Source: Union Pacific 10-K 2007
Source: Union Pacific 10-K 2007
This chart shows the percentage of total revenue Union Pacific derives from each of its main operating segments. The table shows year-over-year growth in total revenues, carloads and average revenue per car for each segment of the business.
Total carloads is a measure of how many revenue-producing train cars travel over Union Pacific’s network. It measures the volume of product shipped. Average revenue per carload is an indication of Union Pacific’s pricing, or how much it’s able to charge to ship a carload of commodity.
Let’s briefly examine the trends in each of these main segments over the past few years:
Energy—Union Pacific’s energy segment is its largest by revenue; it accounts for just shy of 20 percent of the company’s business. Union Pacific earns about $1,364 on average per energy carload.
Coal transport from a region of the West known as the Powder River Basin comprises the majority of Union Pacific’s energy transport business. As noted earlier, strong demand for coal transport has made this segment a real bright spot for the railroad in recent years. Overall revenues in the segment rose 15 percent in 2006 and 6 percent in 2007.
This growth is due to a combination of growth in volume shipped and higher prices. Total carloads grew 5 percent in 2006 and were roughly flat in 2007. The flat performance in 2007, however, wasn’t a function of demand: Severe storms in the first quarter of last year affected mine production from Union Pacific’s key areas of operation.
But what’s more impressive than carload volume is Union Pacific’s ability to boost prices. The railroad’s average revenue per car—the total revenues the railroad earned per carload—surged 9 percent in 2006 and 6 percent in 2007.
Some of this is because Union Pacific has enacted fuel surcharges that help it recover the lion’s share of its increasing diesel fuel costs. And some of this was pure pricing gain; Union Pacific’s pricing power is a symptom of strong demand for coal transport.
Better still, Union-Pacific still transports coal under contracts signed years ago at lower freight rates. As these contracts expire, Union Pacific should see strong pricing gains as it signs new deals.
Agriculture—Agriculture accounts for about 16 percent of Union’s revenues and is its most profitable business lines in terms of average revenue per car, generating $2,880 on average per carload.
This segment is roughly 80 percent grain and grain products (like ethanol) shipments. As noted earlier, this business has also seen strong growth in recent years. Total revenues soared 22 percent in 2006 and 8 percent in 2007.
This growth is mainly a function of rising prices. Total agricultural carloads rose 5 percent in 2006 and fell 2 percent in 2007, but average revenue per car rose a very healthy 16 percent in 2006 and 11 percent last year. Again, stronger pricing is a function of high demand for shipments and a limited number of railroads capable of handling all that demand.
The recent floods in the Midwest are expected to have an impact on second quarter 2008 volumes for Union Pacific. However, underlying volume and pricing trends remain positive this year as agricultural prices and export demand have actually accelerated.
Industrial—Industrial products account for around 19 percent of total revenues and offer above-average profitability at $2,347 per carload.
Industrial products include lumber, construction products, steel and paper. The trends in this business aren’t particularly positive; in particular, the housing bust has brought a severe slowdown in demand for construction-related products and commodities such as lumber.
Total carloads declined 4 percent in 2006 and another 8 percent last year. However, despite the drop in volumes, Union Pacific has been able to push its costs higher and enact fuel surcharges. With average revenue per car rising 17 percent in 2006 and 7 percent last year, Union Pacific managed 13 percent overall revenue growth in its industrial segment for 2006 and only a slight drop in 2007.
There’s little sign of improvement to come in this business. This is a traditionally economically sensitive part of the rail business.
Chemicals—The chemicals segment makes up 14 percent of revenues and also offered a high revenue per carload of $2,471 in 2007.
This segment is dominated by petroleum-related products, fertilizers, plastics and soda ash, a commodity in high demand abroad. This is another solid, growing business for Union Pacific. Demand for fertilizers is booming because of rising prices for agricultural commodities. And shipments of petroleum-related chemicals have also remained firm.
Noncyclical demand for many key chemicals Union Pacific ships has meant steady volumes in this segment over the past two years; in 2007, carloads actually rose 4 percent. And Union Pacific has demonstrated pricing power in chemicals. The combination of solid volume growth and rising prices meant that chemicals showed the highest total revenue growth of any segment last year.
Intermodal—Intermodal comprises 17 percent of Union Pacific’s revenues, though it only produces about $850 in revenue per carload.
This business is driven by imports of goods from abroad, primarily Asia. Volume growth in this segment is clearly slowing as a weakening US economy gradually reduces imports. This trend will likely continue this year. Union Pacific has managed to offset slowing volume growth with some price increases.
Overall, this rundown of Union’s business illustrates that the majority of the company’s segments aren’t particularly sensitive to US economic growth; some, such as coal and agricultural shipments, are driven more by overseas demand.
Even more important, even in segments showing flat or falling volume growth, Union Pacific has been able to boost pricing. This is a phenomenon many analysts call the railroad Renaissance.
In short, weak returns and profitability throughout much of the ’80s and ’90s meant that railroad operators didn’t invest much in expanding their networks. Much of the cash they did invest was directed at improving fuel efficiency or taking other steps to cut costs.
But as demand for coal, agricultural products and other forms of transport surged after 2000, network capacity quickly hit a wall. With capacity constrained and demand for shipments rising, railroads for the first time in decades had real power to raise prices.
This pricing power should continue; in order for the rails to invest the capital needed to expand their capacity, they’ll need to earn a decent return on their investment. Most of the big rails have begun to plow some of their free cash flow into expansions.
A final trend is worth noting: The railroads are taking steps to cut their costs and improve the traffic flow across their lines. For example, a few years ago Union Pacific began implementing what it calls its Unified Plan.
Among other things, a big piece of this is implementing what’s known as a scheduled railway. Traditionally, companies would contract with a railroad to ship a few cars’ worth of goods to a certain destination. The railroad would take on the goods and store them in a terminal or depot at a switching yard.
The railroad would then wait until other cars destined for similar locations could be assembled; railway managers would try to assemble full trains before sending shipments along to their destination. The idea was that no train would move until it reached a certain tonnage or full train length.
The idea of this traditional model was that it would be more fuel and labor efficient to fill a train with cars before sending the shipment along the line. But there are some big problems with this methodology. First and foremost, it doesn’t result in particularly good service for customers. Goods routinely waited in depots while trains were assembled, sometimes for days.
But there are other logistical problems involved. For example, teams of locomotives, engineers and other employees tended to stack up at certain switching yards waiting for trains to be assembled. Meanwhile, other yards were empty because trains weren’t moving across the network efficiently.
The solution to this problem is to analyze what sort of shipments move across a railroad at a given time of year. Usually, computer systems are able to manage projected traffic flow and predict what sort of shipments and routes will be most in demand. Then the railroad schedules trains to leave from a certain start point to a particular destination at an exact time—so-called scheduled service. The railroad moves trains according to schedule even if they’re not full.
At any rate, Union Pacific has implemented a scheduled railway, adopted a sophisticated computer system and locomotives designed to reduce fuel consumption, and added to capacity on parts of its network where there are visible bottlenecks. The result: Union Pacific’s costs have been falling, and network reliability improving. These steps have also added to profitability.
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A few key metrics of railroad efficiency are worth watching. First up, velocity is a measure of how quickly a railroad’s trains move across its network. The faster the velocity, the more capacity a railroad can handle and the higher potential profits. Another way to look at this is that, by making operational improvements, a train operator can move more goods without hiring more employees or buying new locomotives.
Second, the operating ratio is one of the most commonly quoted measures of railroad financial performance. It’s a measure of operating expenses as a percentage of total revenues. The lower the operating ratio, the more efficient the railroad.
Source: Bloomberg, Company Accounts
All of these railroads are in the How They Rate Table, and I’m adding Norfolk Southern to the Wildcatters Portfolio this issue. Here’s a quick rundown of several of the stocks in the table and my current take on each:
Union Pacific—I highlighted Union’s business at some length in my general commentary above. The railroad benefits from a huge network concentrated in western states near key, fast-growing coal producing regions.
One point to note is that Union Pacific’s operating ratio is higher than most of the other rails in the above table. This means its costs are high relative to revenues. The railroad has seen a gradual improvement in this ratio over the past few years, thanks in large part to the cost-saving initiatives that are part of its Unified Plan. As recently as 2005, Union Pacific’s operating ratio was closer to 87.
Union has plenty of additional room to cut costs, and management has proven it’s capable of improving the operating ratio over time. I expect that Union Pacific will gradually close the cost gap with its competitors. In fact, in May, the rail announced a target of reducing its operating ratio by 700 basis points (7 percent) over the next five years. This cost structure improvement should power earnings growth in the mid-teens for the foreseeable future.
Union Pacific also benefits from the fact that nearly a quarter of its freight contracts are scheduled to be repriced over the next five years. As these contracts are repriced, Union will be able to push big fare increases. I’m adding Union Pacific to the How They Rate Table as a buy. Also note that this rail is a major holding inside Gushers Portfolio holding iShares Dow Transport Average (NYSE: IYT).
Burlington Northern Santa Fe—The nation’s second-largest railroad also has an enviable track network in the West, particularly in the prolific Powder River Basin. The railroad is well placed to handle the west-to-east coal trade. And Burlington also has a large weighting in the agricultural freight business.
The one point that bothers me about Burlington is its above-average exposure to intermodal and consumer-oriented revenues. In 2007, some 36 percent of revenues came from consumer-related businesses, much of this representing goods shipped from Asia into the US. This could be a drag on growth potential if the US consumer and US dollar remain weak. I’m rating Burlington Northern Santa Fe a hold within the How They Rate Table.
CSX Corp—Unlike Union and Burlington, CSX covers the eastern half of the US with its 22,000-mile network. CSX has the highest weighting in coal of any stock in the above table. It also stands to benefit handsomely from the coal export story.
The US historically directs its exports to Europe; until recently, Asia wasn’t a major importer from the Americas. Therefore, many of the key coal export ports for both thermal and metallurgical coal are located along the eastern half of the US.
In addition, while overall coal production is declining, it’s still an important production center, particularly for high-grade met coals. In fact, Appalachian met coal is among the highest quality found anywhere in the world and fetches high prices on the export market. CSX is well positioned to connect Appalachian mines with East Coast export fac
At first glance, the rails may not seem an energy group. But consider that the vast majority of all coal moved in the US is transported by rail; in fact, coal is the railroads’ most important freight.
The same is true of ethanol. Ethanol can’t be moved by pipeline because of its corrosiveness; therefore, most of it is carried on trains. And then there’s the corn used to make ethanol. That, too, is transported primarily by rail.
In This Issue
Because the US economy is more service oriented, previous correlations to the US stock market and transports no longer apply. Railroads aren’t totally dependent on the US economy for support, either. And as one of the more environmentally friendly modes of transport, rails look set to prosper as more emissions regulation comes down the pike. See Independent Movers.Coal is the fastest-growing commodity, and demand is expected to increase globally over the next two decades. As the main mode of transport for the commodity, railroads will increase increased demand alongside it, whether it be from the US or abroad. See Freight Demand.
Rails are also key transports for the movement of agricultural products, which have seen demand jump recently as well. And the use of such products is set to increase as governments set loftier mandates for ethanol use and additional feed is needed for livestock for meat consumption. See The Agriculture Boom.
A quick look at the business for Union Pacific, the largest US railroad, highlights the bullish trends in the industry. The fact that its costs have been falling and its network reliability is improving is a good sign of things to come. See Putting It All Together.
There are eight railroads worth noting here. I give my analysis of each and am adding one to the Wildcatters Portfolio. See How to Play It.
I’m recommending or reiterating my recommendation in the following stocks:
- Norfolk Southern (NYSE: NSC)
- Union Pacific (NYSE: UNP)
- Burlington Northern Santa Fe (NYSE: BNI)
- Canadian National (NYSE: CNI)
- Canadian Pacific (NYSE: CP)
- CSX Corp (NYSE: CSX)
- Genesee & Wyoming (NYSE: GWR)
- Kansas City Southern (NYSE: KSU)
Independent Movers
Conventional wisdom states that the transportation industry is deeply cyclical. In fact, this is the basic concept that underpins the famous Dow Theory invented by Charles Dow, founder of The Wall Street Journal and creator of the Dow indexes.Dow used to watch the interplay between the Dow Jones Industrial Average and the Dow Jones Railroad Index carefully. His basic theory was that the rails and industrials needed to confirm one another; in a real bull market, both indexes would be expected to continue making increased highs together. When one index topped out, it was an early sign of trouble even if the second index continued to rally.
This basic theory made a good deal of economic sense, at least in the context of the US economy in the early 1900s. The US is now a service-oriented economy, but at the turn of the 20th century, it was far more levered to industrial production. If the industrial economy is strong and US factories are operating near capacity, it stands to reason that those goods being produced need to be shipped. And if consumer spending is healthy, railroads and trucks must be busy moving goods from factories or ports to retailers around the US.
But even in a service-oriented economy, the Dow Theory is still grounded economic rationality. The modern Dow Jones Transportation Average Index includes trucking firms, airlines and package delivery companies. Freight and passenger volumes for these industries tend to vary with the state of the economy.
Lately, however, the traditional relationship between the transports and the broader economy and stock markets has broken down. Check out the chart below for a closer look.
Source: Bloomberg
This chart shows the comparative performance of four key US market indexes over the past year. It covers roughly the entire period since the credit crunch began in earnest. I set each index equal to 100 a year ago; values less than 100 indicate a decline over the past year, while values more than 100 indicate an advance.
The trend here is obvious. The Dow Industrial and S&P 500 are both sharply lower over the trailing one-year period. In late June, both indexes were trading close to fresh 52-week lows.
Meanwhile, the Dow Jones Transportation Average Index actually set a new high in May and is down only slightly on a trailing one-year basis. A quick glance at the chart of the Dow Jones Railroad Index reveals why the transports are outperforming: The Railroad Index has soared nearly 25 percent over the past year, despite the steadily weakening performance of the broader market averages.
The table below shows the current weightings of stocks in the iShares Dow Jones Transportation Average Index.
|
iShares Dow Jones Transportation Average Holdings
|
||
|
Company (Exchange: Symbol)
|
Sector
|
Weight in the ETF (%)
|
| Alexander & Baldwin (NSDQ: ALEX) | Marine Transports | 4.4 |
| AMR Corp (NYSE: AMR) | Airlines | 0.8 |
| Burlington Northern Santa Fe (NYSE: BNI) | Railroads | 9.4 |
| CH Robinson Worldwide (NSDQ: CHRW) | Logistics | 5.9 |
| Con-way (NYSE: CNW) | Truckers | 4.5 |
| Continental Airlines (NYSE: CAL) | Airlines | 1.6 |
| CSX Corp (NYSE: CSX) | Railroads | 5.8 |
| Expeditors International of Washington (NSDQ: EXPD) | Logistics | 4.3 |
| FedEx (NYSE: FDX) | Package Freight | 8.7 |
| GATX Corp (NYSE: GMT) | Equipment Leasing | 4.1 |
| JB Hunt Transport Services (NSDQ: JBHT) | Truckers | 3.1 |
| JetBlue Airlines (NSDQ: JBLU) | Airlines | 0.4 |
| Landstar System (NSDQ: LSTR) | Truckers | 4.8 |
| Norfolk Southern Corp (NYSE: NSC) | Railroads | 5.6 |
| Overseas Shipholding Group (NYSE: OSG) | Marine Transports | 7.4 |
| Ryder System (NYSE: R) | Logistics | 6.4 |
| Southwest Airlines (NYSE: LUV) | Airlines | 1.2 |
| Union Pacific Corp (NYSE: UNP) | Railroads | 13.3 |
| United Parcel Services (NYSE: UPS) | Package Freight | 6.5 |
| YRC World (NSDQ: YRCW) | Truckers | 1.7 |
As the table indicates, railroads are among the most important sectors inside the Transportation Index, accounting for about 35 percent. Strong performance from the railroads has offset weakness in the airlines and truckers over the past year; the rails are responsible for the Transportation Index outperforming the broader averages.
At the same time, the US economy clearly isn’t in great shape right now. As I’ve highlighted on a few occasions, I believe the US economy is currently in recession.
One of my favorite quick indicators of US economic health is the US leading economic indicator (LEI). Check out the chart below for a look at the current state of LEI.
Source: Bloomberg
The LEI is actually a composite of 10 key economic indicators. The list includes housing starts, consumer expectations, jobless claims and even the performance of the US stock market.
The chart shows the year-over-year percent change in leading economic indicators. As evidenced from this chart, the LEI tends to turn negative just ahead of or coincident with US recessions. The LEI entered negative territory late in 2007 and has shown little or no sign of recovery since that time.
By any historical precedent, this would seem to fly totally in the face of the performance of the Transportation and Railroad indexes. The conventional wisdom would be that a recession in the US means trouble for transports.
I’ve highlighted the rails before in The Energy Strategist, including the July 12, 2006, issue, Beyond Oil and Gas. My long-held thesis on the group has been that the railroads are no longer totally dependent on the US economy for their growth. It’s no longer appropriate to look at this sector as viciously economy sensitive. The traditional relationship between the broader market and the rails has been breaking down for several years, but this trend appears to be accelerating; recent action is by far the most dramatic decoupling witnessed to date.
We’re likely to see further decoupling in coming months. Railroads are a play on three big secular themes: the drive for increased energy efficiency, growth in the US coal industry and the agriculture boom.
As to the first point, railroads are among the most fuel-efficient forms of freight transport available; better still, the rails have been getting progressively more efficient in their use of diesel fuel over the past two decades.
Consider that, in 2007, according to the Association of American Railroads (AAR), the average railroad moved a ton of freight a distance of 436 miles on a single gallon of diesel fuel. That makes freight trains roughly three to four times more fuel efficient than trucks.
And railroads have gradually introduced newer, more-fuel-efficient locomotives and modern technology to monitor and manage fuel use. According to the AAR, in 1980, the average freight train could transport the same ton of cargo only 235 miles per gallon of diesel; between 1980 and 2007, the railroads managed a more than 85 percent jump in fuel efficiency. Check out the two charts below for a closer look.
Source: US Dept of Transportation, Federal Highway Administration, Research and Innovative Technology Administration, AAR
Source: US Dept of Transportation, Federal Highway Administration, Research and Innovative Technology Administration, AAR
To create these charts, I used Dept of Transportation (DoT) data for US railroad ton-miles, the movement of one ton of freight for a single mile. The DoT also offers data covering total fuel consumed by the railroad and trucking industries.
For ease of comparison, I set total ton-miles and fuel consumed equal to 100 in 1980. The trend is clear: Rail ton-miles have surged close to 90 percent since 1980, while the total amount of fuel consumed by the industry has risen only slightly to 4.1 billion gallons of fuel today from 3.91 billion gallons in 1980. That’s a less-than-5-percent jump in fuel consumption for a near doubling in ton-miles.
The picture for the trucking industry is less encouraging. Note truck ton-miles have jumped by more than 100 percent since 1980; however, fuel consumption by the trucking industry has jumped by roughly 68 percent. In other words, like the rail industry, truckers have increased their fuel efficiency, but the gains haven’t been as dramatic.
One of the problems facing the trucking industry and fuel consumption is familiar to all of us who have occasion to commute: US highways are increasingly busy and full. Time spent idling in traffic is extremely wasteful for fuel consumption, so our increasingly jammed highways are trouble for the trucking industry.
In a June hearing before the US Senate, Edward Hamberger, president of AAR, offered some other interesting statistics. The Senate hearing focused on the transportation industry, pollution and global warming.
As for the latter point, opinions vary greatly as to the importance of climate change and the speed at which these shifts are occurring. I’m not a climate scientist, and there are others who are far better qualified to assess those questions than I. The good news is that, as investors, we don’t really need to inject ourselves into this argument.
The important point is that regulations on carbon emissions have been imposed in many regions of the world, and it’s highly likely that the US will eventually put an emissions-reduction scheme in place. As investors, we can’t ignore these shifting political trends and public sentiment; carbon regulations will have an effect on energy-related stocks.
On the environmental front, rails also seem to have an edge. Check out the chart below based on data from Mr. Hamberger’s testimony.
Source: Statement of Edward R. Hamberger, AAR president and CEO, before the US Senate Committee on Commerce, Science and Transportation, June 24, 2008
In total, the transportation industry accounts for less than 28 percent of total US greenhouse gas emissions, second only to electricity generation at roughly 34 percent. This pie breaks down emissions from the transport industry by source.
As you might expect, the biggest culprit is passenger cars and trucks, accounting for roughly two-thirds the total. The trucking and airline industry rank second and third, with 21 percent and 8 percent of emissions, respectively. Freight railroad is a distant fourth on the carbon emissions front, accounting for only 2.6 percent of transportation-related emissions.
And it’s not just carbon dioxide. According to the same testimony, railroads are the most environmentally friendly form of transport when it comes to nitrous oxides, organic compounds, carbon monoxide and a host of other key pollutants. The bottom line: In an era of high energy prices and increased concern about pollution, rails have an advantage.
Of course, none of this is to say that the trucking industry is about to disappear. Trucks will remain a key part of most countries’ transportation infrastructure. However, rail does have room to grab market share from trucks in coming years, given the current high-fuel-cost environment.
Back to In This Issue
Freight Demand
And superior energy efficiency is only one small reason for the strong performance of rails stocks and the recent decoupling of the rails and broader averages. Consider the charts below.Source: AAR
Source: AAR
These charts are based on freight data for 2006 for all US Class I railroads; these are long-haul railroad operators. The first pie shows the total freight carried by these rails in terms of total tons. The second breaks down cargoes by revenues generated for the railroad.
Understanding the types of cargoes US rails carry is key to understanding why the industry has become less sensitive to a weak US economic environment. What really jumps out from these pie charts is that coal is a crucial commodity, accounting for nearly 45 percent of total tons and 21 percent of total revenues for Class I railroads.
Other key cargoes include food, farm products and chemicals, accounting for about 27 percent of rail revenues combined. Food and farm products are relatively straightforward terms.
As for chemicals, it’s worth noting that US rails carry the majority of all ethanol transported in the US; ethanol can’t be shipped through pipelines because it’s corrosive and tends to evaporate. Ethanol, for the purposes of this chart, is considered a chemical. Other chemicals include fertilizers, pesticides and petrochemicals.
Miscellaneous mixed shipments make up nearly 15 percent of all cargoes. This category generally refers to what’s known as intermodal transport. Literally, that means cargoes shipped using multiple modes of transport, such as ships, rails and trucks.
Probably the biggest form of intermodal cargo in the US is containers imported from abroad by ship and then transferred to rails for transport within the country. Oftentimes, these containers are filled with consumer goods of some description.
Motor vehicles are also a key product often shipped by rail. Cars and trucks comprised less than 8 percent of railroad revenues in the year 2006.
The key point to note is that demand for some of these key products isn’t driven by the US economy. The most obvious example of this is coal, a commodity I’ve analyzed at great length in past issues of TES. In particular, note the Jan. 2, 2008, issue, Taking Stock of 2007, and the Sept. 5, 2007, issue, Australia, Asia and Coal, for a closer look at the coal industry. The railroad and coal industries can’t be separated; rails account for the vast majority of all coal moved around the US and, for that matter, most foreign countries.
There are a few key points worth noting about the US coal market. First, demand for electricity is less sensitive to economic growth than demand for oil. And because 92 percent of all the coal consumed in the US is used in power plants, this spells relatively steady growth in coal demand. Check out the chart below for a closer look.
Source: BP Statistical Review of World Energy
This chart shows US electricity generation from 1990-2007. Over this time period, US electricity generation grew by more than 37 percent. Even more impressive, electricity output only fell in only one year over this time period. In contrast, US oil demand grew less than 22 percent over the same time period; year-over-year oil consumption actually fell in four separate years over this 17-year time frame.
This same basic trend is projected to continue in the future. The US gets about 52 percent of its power from coal, and the Energy Information Administration (EIA) expects that percentage will increase by 2030. Overall, the EIA is looking for US coal consumption to rise by about 37 percent between 2005 and 2030, while US oil consumption is projected to increase by less than 10 percent.
This steady, long-term increase in coal demand spells growth in demand for railroads to transport coal around the US. Of course, hot summer weather or unusually warm winters can drive variations in coal demand, but short-term gyrations aside, the trend in demand is higher.
But this is really only the beginning. Two additional trends are likely to propel demand for coal transport in coming years: increased western production and export demand.
As to the first point, there are really three main regions of US coal production: Appalachia, the Interior and the West. The map below, taken from the EIA’s annual coal report, offers a good overview of where these regions are located and where US coal comes from.
Source: EIA
This map shows 2006 coal production from each region in short tons. For those unfamiliar with this measure, a short ton is 2,000 pounds or roughly 0.91 metric tons (tonnes). The percentage underneath each production figure is the annual change in production for each region in 2006.
As you can see, the West region, encompassing states such as Wyoming and Montana, is already the largest center of US coal production. The second most-important region is Appalachia, with the Interior ranking a distant third. But what’s equally important to note is that West coal production jumped 6 percent in 2007, compared to a 1.4 percent decline for Appalachia and a small rise in Interior production.
There are a number of reasons for this pattern. One is simply that Appalachia is a mature region for coal production; coal has been produced from Appalachia for well more than a century. That means that coal seams in many areas are getting thinner, deeper underground and tougher to access.
Another issue plaguing the region is labor. Mining coal underground requires significant training and is dangerous work. Miners in the region have experienced trouble attracting and retaining labor; miners also earn top dollar for working in these mines, increasing costs.
Finally, new environmental and safety regulations introduced over the past few years are an issue. These laws have made it tough for some mines in the region to operate profitably. I won’t rehash all of these changes in this issue. (The Nov. 7, 2007, issue, Coal and Services, offers a lengthier summary.) And this isn’t just a one-off trend for 2007 production; check out the chart below.
Source: EIA
This chart shows historical data for US coal production going back to 1970 and EIA projections going forward to 2030. As the chart indicates, the West became the nation’s most important producing region early this decade, and that dominance is forecast to increase steadily in coming years.
In contrast to eastern mines, West deposits haven’t been as fully depleted and are located closer to the surface of the Earth. These seams are easier and cheaper to mine. Although coal from the region typically has a lower heating value—less energy per short ton—much of the coal is extremely low in sulfur content. Low-sulfur coal produces less sulfur dioxide when burned in plants.
But although the West is becoming the most important center of coal production, most of that coal must be transported relatively long distances to regions of heavy coal consumption. Check out the map below.
Source: EIA
This map shows US coal consumption in electric power plants by region. It is clear that the mid-Atlantic, upper Midwest and south Atlantic regions are all heavy coal users. As eastern production declines and coal is sourced from the West, that means this coal must be transported over greater distances. Because the rails handle substantially all coal transport in the US, this means more ton-miles for the rails.
And a second major factor underpinning coal demand is the export market. I highlighted this factor in the Sept. 5, 2007, issue. The basic story is simple: Coal is the fastest-growing fossil fuel in the world. Last year, global coal demand soared 4.5 percent on an oil-equivalent basis, compared to 1.1 percent for oil, and 3.1 percent for natural gas. This is the fifth year running that coal has been the fastest-growing fossil fuel commodity.
As you might expect, much of that jump in demand is powered by rapidly rising demand in China, India and other emerging markets. China alone builds a new coal-fired power plant roughly once a week just to keep pace with demand; that’s equivalent to adding electric capacity equal in size to the entire UK each year. Both India and China are heavily dependent on coal-fired plants for their power.
According to the EIA, China currently generates 271 gigawatts (GW) of coal-fired power capacity. To meet growing needs, China will need to add nearly another 500 GW by 2030, tripling coal-fired capacity. As the chart below shows, Chinese and Indian electricity demand looks like it will continue to rise sharply over the next 20 years.
Source: EIA
The question is, of course: Where will all this coal come from? China is both the world’s largest producer and consumer of coal; last year, the nation also became a net importer. Despite significant reserves and production capability, China just can’t keep pace with its own demand. India, too, will need to accelerate coal imports to meet future growth in demand.
Asia’s growing demand for coal imports is having severe ramifications for the rest of the world. Traditionally, Indonesia and Australia have been the main exporters in the region both for thermal coal and metallurgical (or coking) coal used to manufacture steel. But even these countries are having trouble ramping up production fast enough to meet demand; Australia has experienced considerable difficulty with railroad and port infrastructure needed to support growth in the industry.
And remember that Europe is also a major coal importer. Although many investors assume that Europe has eliminated coal-fired power capacity entirely, nothing could be further from the truth.
According to the International Energy Agency’s statistics for 2005, Germany generated 49 percent of its power from coal-fired plants, compared to less than 4.5 percent for wind power. The UK has systematically replaced coal-fired plants with natural gas facilities but still gets roughly a third of its electricity from coal. Finally, Poland, like many other countries in Eastern Europe, is even more coal-dependent, generating 92 percent of its power from coal.
With limited domestic coal production, most of these countries are heavily reliant on imports.
The US is truly the Saudi Arabia of coal, with some 245 billion metric tons of proven reserves; nearly 30 percent of all global proven coal reserves are in the US. The US dwarfs the world’s second-largest reserve holder, Russia, by nearly 100 billion metric tons of reserves. At current production rates, the US has enough proven reserves of coal to last 234 years. And, remember, these are just proven reserves.
The US is one of the only countries with the ability to ramp up coal production and exports enough to meet growing global coal demand. Check out the chart below for a closer look.
Source: EIA
This chart shows US coal exports by quarter. The uptrend in exports is clear: The EIA expects overall coal exports to grow to more than 76 million tons in 2008, up from less than 60 million in 2007. And the EIA has been revising its expectations higher in recent months; it’s quite likely exports will rise even further than anticipated.
Not only are exports beginning to surge, but European and Asian buyers are willing to sign long-term supply deals at attractive prices with the US miners just to guarantee coal availability. Clearly, railroads are in high demand to ship all that coal out of mines to coastal ports.
Bottom line: Demand for US coal and coal freight has little to do with the US economy. Instead, these trends are driven by the combination of strong economic growth abroad, coupled with secular shifts in domestic coal production.
Back to In This Issue
The Agriculture Boom
Although coal may be the largest, single chunk of revenue for most long-haul railroads, it’s far from being the only noncyclical business with which they’re involved.Another major component of the rails’ revenue is agriculture. This includes the movement of agricultural commodities such as grains, as well as agricultural chemicals such as ethanol and fertilizer. And agriculture and energy have become increasingly interrelated in recent years; growing demand for biofuels such as ethanol and biodiesel has become an important driver of pricing for agricultural commodities.
I covered the agriculture and biofuels industries in the April 2, 2008, issue, Growing Fuel; I won’t bore readers by repeating those arguments. Suffice it to say that there are two trends driving a global agriculture boom: food upgrades in the developing world and the biofuels boom.
The basic story behind biofuels is government subsidy. In the waning days of 2007, the US passed a new law called the Energy Independence and Security Act of 2007. A 2005 act required that the US use some 7.5 billion gallons of ethanol by 2012; for reference, in 2007, the US consumed some 6 billion gallons of ethanol. The new bill more than doubles the total mandate to 15.2 billion gallons by 2012. In addition, the new renewable fuel standard extends the mandates for another 10 years, requiring the nation to boost biofuels consumption to 36 billion gallons by 2022.
Some of this growth will eventually come from cellulosic biofuels made from nonagricultural commodities such as switchgrass. Check out the chart below for a near-term perspective.
Source: EIA
This chart is based on data and projections from the US Dept of Agriculture (USDA). The chart shows that the nation will continue to see growth in corn demand, and much of that corn will be needed to meet growing ethanol mandates.
The scariest part about this chart is that, although the USDA long-term projections were published in February 2008, the estimates were based on data finalized in late 2007, before the Energy Independence and Security Act of 2007 was passed into law. Therefore, these estimates are based on the much-lower mandates from the 2005 act.
All too often, pundits make the argument that greater food consumption in the developing world is the primary driver of agricultural demand. This is partly true; the more important effect is a shift in consumption patterns.
In the world’s least-developed countries, the primary component of the average consumer’s diet is basic cereals; wheat and rice are two common examples. Consumers in these countries eat very little meat, dairy or other processed foods. As a nation becomes wealthier, however, the average consumer’s diet changes and diversifies away from basic cereal consumption.
The biggest component of the shift is meat. The average American consumes nearly 124 kilograms of meat per year (275 pounds of direct meat consumption), compared to less than 55 kilograms per year (121 pounds) in China. But Chinese meat consumption is up from 45 kilograms a decade ago; as China’s growth continues, look for meat consumption to continue to grow as well.
Shifting diets in the developing world have a profound impact on global demand for agricultural products. Consider that increased meat, dairy and animal products consumption spells increased demand for livestock. Feeding livestock requires large amounts of grain and meal. Simply put, it takes 8 to 10 pounds of grain and feed to produce 1 pound of meat. Of course, these figures vary depending upon the type of meat produced, but an 8-to-1 ratio is a decent rule of thumb.
Another way to look at this is the amount of land required to produce meat to feed a single consumer compared to vegetables or grains. According to British consulting firm Bidwells Agribusiness, it takes more than 8,170 square meters of land to produce beef to feed one person. Producing potatoes requires just 274 square meters. Meat production is far more land intensive.
As meat consumption rises, the effect on grain and land demand rises at an even faster pace. With literally billions of consumers in the emerging markets now starting to demand more processed, meat-based foods, there’s an ever-expanding wall of demand for products such as soybeans, corn and wheat.
At any rate, the global boom in agriculture demand has pushed the prices of all sorts of agricultural commodities higher. Once again, the rails are a key player in the agriculture boom; most agricultural commodities are moved via rail.
And ethanol actually offers railroads a triple-win situation. Rails transport raw corn from farms to ethanol production facilities and ethanol itself from those production facilities to blending terminals.
In addition, one by-product of ethanol production is dried distiller’s grain (DDG), used in animal feeds. Trains are used to transport this product as well.
Back to In This Issue
Putting It All Together
Union Pacific is the largest railroad in the US and has long been one of my favorites. The company’s network is nearly 33,000 miles long and is concentrated in the West and Midwest.It also offers a convenient example of the bullish forces at work for the rails, particularly in the coal and agriculture industries. Check out the chart and table below for a closer look at the breakdown of Union Pacific’s business.
Source: Union Pacific 10-K 2007
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Growth at Union Pacific by Sector
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|||
|
Sector
|
2007 Revenue Growth (%)
|
2007 Carload Growth (%)
|
2007 Avg. Revenue/Car Growth (%)
|
| Agriculture | 8.0 | -2.0 | 11.0 |
| Autos | 2.0 | -1.0 | 3.0 |
| Chemicals | 9.0 | 4.0 | 6.0 |
| Energy | 6.0 | 0.0 | 6.0 |
| Industrial Products | -2.0 | -8.0 | 7.0 |
| Intermodal | 4.0 | 0.0 | 4.0 |
| Total | 4.0 | -1.0 | 6.0 |
This chart shows the percentage of total revenue Union Pacific derives from each of its main operating segments. The table shows year-over-year growth in total revenues, carloads and average revenue per car for each segment of the business.
Total carloads is a measure of how many revenue-producing train cars travel over Union Pacific’s network. It measures the volume of product shipped. Average revenue per carload is an indication of Union Pacific’s pricing, or how much it’s able to charge to ship a carload of commodity.
Let’s briefly examine the trends in each of these main segments over the past few years:
Energy—Union Pacific’s energy segment is its largest by revenue; it accounts for just shy of 20 percent of the company’s business. Union Pacific earns about $1,364 on average per energy carload.
Coal transport from a region of the West known as the Powder River Basin comprises the majority of Union Pacific’s energy transport business. As noted earlier, strong demand for coal transport has made this segment a real bright spot for the railroad in recent years. Overall revenues in the segment rose 15 percent in 2006 and 6 percent in 2007.
This growth is due to a combination of growth in volume shipped and higher prices. Total carloads grew 5 percent in 2006 and were roughly flat in 2007. The flat performance in 2007, however, wasn’t a function of demand: Severe storms in the first quarter of last year affected mine production from Union Pacific’s key areas of operation.
But what’s more impressive than carload volume is Union Pacific’s ability to boost prices. The railroad’s average revenue per car—the total revenues the railroad earned per carload—surged 9 percent in 2006 and 6 percent in 2007.
Some of this is because Union Pacific has enacted fuel surcharges that help it recover the lion’s share of its increasing diesel fuel costs. And some of this was pure pricing gain; Union Pacific’s pricing power is a symptom of strong demand for coal transport.
Better still, Union-Pacific still transports coal under contracts signed years ago at lower freight rates. As these contracts expire, Union Pacific should see strong pricing gains as it signs new deals.
Agriculture—Agriculture accounts for about 16 percent of Union’s revenues and is its most profitable business lines in terms of average revenue per car, generating $2,880 on average per carload.
This segment is roughly 80 percent grain and grain products (like ethanol) shipments. As noted earlier, this business has also seen strong growth in recent years. Total revenues soared 22 percent in 2006 and 8 percent in 2007.
This growth is mainly a function of rising prices. Total agricultural carloads rose 5 percent in 2006 and fell 2 percent in 2007, but average revenue per car rose a very healthy 16 percent in 2006 and 11 percent last year. Again, stronger pricing is a function of high demand for shipments and a limited number of railroads capable of handling all that demand.
The recent floods in the Midwest are expected to have an impact on second quarter 2008 volumes for Union Pacific. However, underlying volume and pricing trends remain positive this year as agricultural prices and export demand have actually accelerated.
Industrial—Industrial products account for around 19 percent of total revenues and offer above-average profitability at $2,347 per carload.
Industrial products include lumber, construction products, steel and paper. The trends in this business aren’t particularly positive; in particular, the housing bust has brought a severe slowdown in demand for construction-related products and commodities such as lumber.
Total carloads declined 4 percent in 2006 and another 8 percent last year. However, despite the drop in volumes, Union Pacific has been able to push its costs higher and enact fuel surcharges. With average revenue per car rising 17 percent in 2006 and 7 percent last year, Union Pacific managed 13 percent overall revenue growth in its industrial segment for 2006 and only a slight drop in 2007.
There’s little sign of improvement to come in this business. This is a traditionally economically sensitive part of the rail business.
Chemicals—The chemicals segment makes up 14 percent of revenues and also offered a high revenue per carload of $2,471 in 2007.
This segment is dominated by petroleum-related products, fertilizers, plastics and soda ash, a commodity in high demand abroad. This is another solid, growing business for Union Pacific. Demand for fertilizers is booming because of rising prices for agricultural commodities. And shipments of petroleum-related chemicals have also remained firm.
Noncyclical demand for many key chemicals Union Pacific ships has meant steady volumes in this segment over the past two years; in 2007, carloads actually rose 4 percent. And Union Pacific has demonstrated pricing power in chemicals. The combination of solid volume growth and rising prices meant that chemicals showed the highest total revenue growth of any segment last year.
Intermodal—Intermodal comprises 17 percent of Union Pacific’s revenues, though it only produces about $850 in revenue per carload.
This business is driven by imports of goods from abroad, primarily Asia. Volume growth in this segment is clearly slowing as a weakening US economy gradually reduces imports. This trend will likely continue this year. Union Pacific has managed to offset slowing volume growth with some price increases.
Overall, this rundown of Union’s business illustrates that the majority of the company’s segments aren’t particularly sensitive to US economic growth; some, such as coal and agricultural shipments, are driven more by overseas demand.
Even more important, even in segments showing flat or falling volume growth, Union Pacific has been able to boost pricing. This is a phenomenon many analysts call the railroad Renaissance.
In short, weak returns and profitability throughout much of the ’80s and ’90s meant that railroad operators didn’t invest much in expanding their networks. Much of the cash they did invest was directed at improving fuel efficiency or taking other steps to cut costs.
But as demand for coal, agricultural products and other forms of transport surged after 2000, network capacity quickly hit a wall. With capacity constrained and demand for shipments rising, railroads for the first time in decades had real power to raise prices.
This pricing power should continue; in order for the rails to invest the capital needed to expand their capacity, they’ll need to earn a decent return on their investment. Most of the big rails have begun to plow some of their free cash flow into expansions.
A final trend is worth noting: The railroads are taking steps to cut their costs and improve the traffic flow across their lines. For example, a few years ago Union Pacific began implementing what it calls its Unified Plan.
Among other things, a big piece of this is implementing what’s known as a scheduled railway. Traditionally, companies would contract with a railroad to ship a few cars’ worth of goods to a certain destination. The railroad would take on the goods and store them in a terminal or depot at a switching yard.
The railroad would then wait until other cars destined for similar locations could be assembled; railway managers would try to assemble full trains before sending shipments along to their destination. The idea was that no train would move until it reached a certain tonnage or full train length.
The idea of this traditional model was that it would be more fuel and labor efficient to fill a train with cars before sending the shipment along the line. But there are some big problems with this methodology. First and foremost, it doesn’t result in particularly good service for customers. Goods routinely waited in depots while trains were assembled, sometimes for days.
But there are other logistical problems involved. For example, teams of locomotives, engineers and other employees tended to stack up at certain switching yards waiting for trains to be assembled. Meanwhile, other yards were empty because trains weren’t moving across the network efficiently.
The solution to this problem is to analyze what sort of shipments move across a railroad at a given time of year. Usually, computer systems are able to manage projected traffic flow and predict what sort of shipments and routes will be most in demand. Then the railroad schedules trains to leave from a certain start point to a particular destination at an exact time—so-called scheduled service. The railroad moves trains according to schedule even if they’re not full.
At any rate, Union Pacific has implemented a scheduled railway, adopted a sophisticated computer system and locomotives designed to reduce fuel consumption, and added to capacity on parts of its network where there are visible bottlenecks. The result: Union Pacific’s costs have been falling, and network reliability improving. These steps have also added to profitability.
Back to In This Issue
How to Play It
In the table below, I’ve summarized some key metrics, financial ratios and data for a broad selection of North American railroads.A few key metrics of railroad efficiency are worth watching. First up, velocity is a measure of how quickly a railroad’s trains move across its network. The faster the velocity, the more capacity a railroad can handle and the higher potential profits. Another way to look at this is that, by making operational improvements, a train operator can move more goods without hiring more employees or buying new locomotives.
Second, the operating ratio is one of the most commonly quoted measures of railroad financial performance. It’s a measure of operating expenses as a percentage of total revenues. The lower the operating ratio, the more efficient the railroad.
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Railroads
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Company (Exchange: Symbol)
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May 2008 Operating Ratio (%)
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First Quarter Revenue Growth (%)
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Velocity (mph)
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2008 Price to Earnings
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Percent of Revenue from Energy
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Percent of Revenue from Agriculture
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| Burlington Northern Santa Fe (NYSE: BNI) | 78.9 | 17.0 | 23.2 | 16.4 | 20.8 | 17.2 |
| Canadian National (NYSE: CNI) | 72.9 | 1.0 | 24.9 | 13.8 | 4.9 | 16.6 |
| Canadian Pacific (NYSE: CP) | 79.6 | 6.0 | 24.5 | 15.0 | 12.2 | 19.9 |
| CSX Corp (NYSE: CSX) | 77.0 | 12.0 | 20.2 | 17.0 | 24.8 | 7.8 |
| Genesee & Wyoming (NYSE: GWR) | 84.9 | 12.5 | n/a | 19.9 | 11.7 | 7.1 |
| Kansas City Southern (NYSE: KSU) | 81.5 | 10.0 | 25.1 | 21.5 | 11.1 | 23.2 |
| Norfolk Southern (NYSE: NSC) | 76.9 | 11.0 | 21.3 | 15.1 | 24.5 | n/a |
| Union Pacific (NYSE: UNP) | 81.5 | 11.0 | 22.2 | 18.1 | 19.3 | 15.9 |
All of these railroads are in the How They Rate Table, and I’m adding Norfolk Southern to the Wildcatters Portfolio this issue. Here’s a quick rundown of several of the stocks in the table and my current take on each:
Union Pacific—I highlighted Union’s business at some length in my general commentary above. The railroad benefits from a huge network concentrated in western states near key, fast-growing coal producing regions.
One point to note is that Union Pacific’s operating ratio is higher than most of the other rails in the above table. This means its costs are high relative to revenues. The railroad has seen a gradual improvement in this ratio over the past few years, thanks in large part to the cost-saving initiatives that are part of its Unified Plan. As recently as 2005, Union Pacific’s operating ratio was closer to 87.
Union has plenty of additional room to cut costs, and management has proven it’s capable of improving the operating ratio over time. I expect that Union Pacific will gradually close the cost gap with its competitors. In fact, in May, the rail announced a target of reducing its operating ratio by 700 basis points (7 percent) over the next five years. This cost structure improvement should power earnings growth in the mid-teens for the foreseeable future.
Union Pacific also benefits from the fact that nearly a quarter of its freight contracts are scheduled to be repriced over the next five years. As these contracts are repriced, Union will be able to push big fare increases. I’m adding Union Pacific to the How They Rate Table as a buy. Also note that this rail is a major holding inside Gushers Portfolio holding iShares Dow Transport Average (NYSE: IYT).
Burlington Northern Santa Fe—The nation’s second-largest railroad also has an enviable track network in the West, particularly in the prolific Powder River Basin. The railroad is well placed to handle the west-to-east coal trade. And Burlington also has a large weighting in the agricultural freight business.
The one point that bothers me about Burlington is its above-average exposure to intermodal and consumer-oriented revenues. In 2007, some 36 percent of revenues came from consumer-related businesses, much of this representing goods shipped from Asia into the US. This could be a drag on growth potential if the US consumer and US dollar remain weak. I’m rating Burlington Northern Santa Fe a hold within the How They Rate Table.
CSX Corp—Unlike Union and Burlington, CSX covers the eastern half of the US with its 22,000-mile network. CSX has the highest weighting in coal of any stock in the above table. It also stands to benefit handsomely from the coal export story.
The US historically directs its exports to Europe; until recently, Asia wasn’t a major importer from the Americas. Therefore, many of the key coal export ports for both thermal and metallurgical coal are located along the eastern half of the US.
In addition, while overall coal production is declining, it’s still an important production center, particularly for high-grade met coals. In fact, Appalachian met coal is among the highest quality found anywhere in the world and fetches high prices on the export market. CSX is well positioned to connect Appalachian mines with East Coast export fac
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