Q4 2012 review: Signs that 2013 will be one terrific bridge year for the rails- analysis by Tony Hatch

In the rail realm, 2013 will be a bridge year — the wait for the completion of the energy transformation, the farm belt recovery and capital investments by both rails and shippers to pay off in volumes in the auto, steel, petroleum (crude by rail, or CBR), chemicals and especially intermodal. So, coming out of fourth-quarter 2012, expectations were somewhat modest.

The rails hit or slightly exceeded rather modest expectations for Q4 2012, averaging a 7 percent year-over-year gain — up 13 percent if you exclude the two eastern rails, which are the most negatively impacted by the reduction in utility coal while being the least compensated by the explosion in crude by rail (CBR). That’s not bad, considering we apparently had a contraction in the economy during the quarter — overall, rail freight was up about 3 percent. Over time, the rails will increase that compensation (in addition to gaining momentum in the eastern shale plays) while reaping the harvest of domestic intermodal business gained in part by their massive capital programs to create the "Corridors" (Norfolk Southern/NSC) and "National Gateway" (CSX).

The industry also will increasingly benefit over the next several years from near-sourcing capacity being built in Mexico, and the revival of the chemical industry (and other reindustrialization efforts) and overall economy. Both Kansas City Southern (KSU) and Union Pacific (UNP) had excellent quarters, with the former garnering Most Valuable Railroad (MVR) honors (see chart).

Management conference calls reveal slightly more confidence than anticipated, except in coal. Economic signs seem to say that surprises this year, if any, would be of the upside variety (autos, steel, housing-related, chemicals). We had thought that 2013 might only be remembered as "the bridge" and by the absence of the two major negatives that drove 2013 — coal and grain. Coal will stabilize as the utility industry works through the secular changes driven by regulation and the natural gas revolution (gas providers even are writing longer-term contracts), although it looks like sometime in Q2. At its November 2012 investor conference, UNP officials said the railroads' coal volumes might be up in 2013, but they have backtracked, at least in terms of when; Powder River Basin coal is well positioned to gain share even in a reduced overall volume environment. Meanwhile, exports look to be down 20 percent to 30 percent. Coal demand estimates are all over the place (The U.S. Energy Information Administration: Coal electrical demand up 6 percent?), as are exports (The Wall Street Journal stated that exports are "surging to Europe," all evidence to the contrary), but the rails look for exports to be flat-to-down.

Grain demand will be there, and although yields won't recover, it is hard to believe we'll see another (lack of) supply year as we did in 2012. In fact, export grain has a few promising glimmers (Russians buying wheat?) and really just needs supply. The rest looks OK, with CBR looking outstanding, cyclicals outperforming the business headlines and intermodal beating economic growth on both sides of the ball, domestic and intermodal. Chemical shipments outside of CBR will follow GDP (and outperform chemical company results) as one of the bigger rail "bridges," along with Mexican auto, which will begin to show evidence of real growth in 2014 (18 percent).
 
MARS allows a glimpse into BNSF. The excellent winter meeting of the Midwest Association of Rail Shippers (MARS), held Jan. 23-24 in Oak Park, Ill., gave us an interesting glimpse into what's going on at BNSF, a (sadly) rare opportunity. BNSF officials feel good about the future — to the tune of a $4.1 billion capex program targeted to the Bakken (rails putting capex dollars where their mouths are) and intermodal. CEO Matt Rose told MARS attendees that rails are quite flexible, citing the changes in volumes at his own railroad from 2006 to the present: international intermodal, from 30 percent of the total volume to 23 percent; domestic intermodal, 20 percent to 24 percent; coal, 24 percent to 22 percent; forest products, 10 percent to 5 percent; petroleum, 1 percent to 4 percent. To put it in perspective, BNSF is by far the largest CBR play. Interestingly, Rose said that the benefits of hindsight would only have changed his investments in the coal sector — not international intermodal, giving that segment's longer-term prospects a vote of confidence.

So far, traffic doesn't yield a lot of clues. In January, rail traffic was almost 2 percent down year over year (YOY), with five of nine subcategories up (intermodal up 3 percent and chemicals, including CBR, up 12 percent) and coal and grain still down (13 percent and 6 percent, respectively). The other two commodities to show declines were the related autos (down 15 percent) and metals (down 8 percent), which should prove to be an anomaly. Canadian carriers, unburdened by the U.S. coal issue, are running up a bit. Even with the just-passed storm, this winter still has been mild, but not the record-breaker last year was.

Operations at best-ever levels, and reveal control of short-term variable costs and terrific safety levels. All the rails set velocity records, although how much of that is the 12 percent drop in slow-moving coal? Clearly, some — but we applaud CSX's chart, which shows that velocity grew across the commodity spectrum. Even so, this is the best condition for the rail industry in modern history. And the rails are maintaining the network, refusing to fall into historic bad patterns of tactical, short-term thinking.
 
Capex programs will be the highest ever, as well ... although excluding the massive $4.1 billion BNSF program (a $450 million hike from 2012's program), the railroad total would come in about even to slightly below last year's levels ($13 billion for the industry). PTC spending is slightly up and that's just a tiny bit worrisome (and will be explored in a future write-up. Some of the YOY comparisons reflect the good weather all of last year, the hottest on record; it brought some projects forward and reduced locomotive spending (not just at Canadian Pacific), which reflects big programs over the last few years and great asset utilization.

Tony Hatch is an independent transportation analyst and consultant, and a program consultant for Progressive Railroading's RailTrends® conference. Email him at abh18@mindspring.com.