Railroads Prepare for the Threat of Natural Gas

Daniel is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

North American's freight railroads have delivered impressive performances since deregulation in the 1980s, growing into one of the largest and most efficient freight transportation systems in the world. Significant revenue drivers for railroads over the past few years have been large coal shipments to power plants, as well as a competitive advantage over trucking due to better fuel efficiency.

Over the next decade, a secular trend in favor of cheap, clean natural gas will undermine these strengths. Railroads are anticipating the challenge and are taking steps to protect their businesses, but some lines will be far more exposed than others. 

American power plants have been hungry for coal, and the railroads have delivered it, transporting over 70% of the nation's coal. Coal typically accounts for around a quarter of rail volumes and just under a third of revenue for North America's Class I railroads. Like most commodities, coal volumes took a hit in 2009, which in turn dragged heavily on railroad's bottom lines. More distressingly, coal has been slow to recover with the rest of the economy, as a natural gas boom made possible by hydrofracking makes coal a less attractive fossil fuel. Worse for coal, the EPA has come out with new emissions guidelines that are likely to prevent another new coal plant from ever opening in the country. Last quarter, the volume of coal shipped by railroads slipped by 15–20%. But the railroads aren't sitting still.

For one, while natural gas may be on the rise in the US, China is still hungry for coal and American exporters haven't even begun to meet this need. As domestic demand cools, coal miners and railroads alike are hoping that China can pick up the slack. Vast reserves in Wyoming's Powder River Basin are conveniently located for Pacific export, but current infrastructure on the West Coast is insufficient to handle large volumes. Plans are in the works to construct six new coal terminals in Washington and Oregon, and that would tremendously benefit rail lines with access to both the Powder River Basin and the planned terminals, including Union Pacific (NYSE: UNP) and BNSF, owned by Berkshire Hathaway (NYSE: BRK-B). Rail lines exposed primarily to Appalachian coal, without access to Pacific terminals, like CSX (NYSE: CSX) and Norfolk Southern (NYSE: NSC), will find it much more difficult to compensate for lagging domestic demand through export growth, as the European export market is already quite developed.

These companies will simply have to diversify their shipment mix away from coal. Canadian National (NYSE: CNI) is the leader here, with coal accounting for only 7% of revenue, less than a quarter of its peers. Recently railroads have profited from an increase in the volume of automobiles and intermodal traffic, typically containerized cargo. Ironically the natural gas boom could help railroads, because cheap natural gas is used by American chemical companies as a feedstock for other products. Increased chemical production should translate to increased volumes of chemical shipments on the rails.

Ultimately, the bigger threat from natural gas could be the advantage it gives to rail's chief competitor, freight trucking. The trucking industry is in the early stages of converting to natural gas engines, which will drastically reduce truckers' fuel costs. The better fuel efficiency of rail is what makes it competitive, because trucking benefits from public infrastructure support that rail doesn't have. Trucks do pay the Federal Highway Use Tax, but this doesn't cover the full cost of highway construction and maintenance, and truckers only have to pay the tax to the extent that they actually use roads, allowing them to better control expenses when volumes are low.

Rail companies typically own their own tracks, and are fully responsible for maintenance and expansion. When volumes suffer, and fewer trains use the tracks, the railroads must still maintain them at full cost, putting them at a disadvantage. Most Class I railroads pay around 20% of total revenue on capital expenditure. If they lose their advantage in fuel efficiency to natural gas engine trucks, they could be forced to accept lower pricing to remain competitive. In an industry that has typically struggled to earn returns above and beyond their cost of capital, this prospect could negatively impact shareholders for many years to come.

Daniel Ferry owns shares of Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway. Motley Fool newsletter services recommend Berkshire Hathaway and Canadian National Railway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.

blog comments powered by Disqus