Energy Factors Point To A Contrarian Trade In Railroad Stocks

Contrarian trading, taking positions in opposition to prevailing trends and sentiment, can be addicting and, like most addictions, can also be dangerous. One should always respect the power of momentum, but when that momentum stalls and whatever has driven a move looks to be fully priced in it can present traders with golden opportunities. That seems to be the case right now with several railroad stocks. The case for stocks in that sector are both obvious and ubiquitous, but that is what makes it time to oppose that view, and there are two energy-related factors that support that contention.

Let’s start with that bull case.

Railroad stocks in general are driven by general economic growth, or more accurately by expectations for growth. With those expectations running high, stocks in the sector have been posting significant gains this year. Union Pacific (UNP), for example, is up around fifty percent since the lows twelve months ago.

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With the market seeing the trade agreement with Mexico as a sign that other agreements can be reached, the biggest danger to sustaining that growth is seen as receding, so one would logically expect railroad stocks to have surged again over the last week or so, but that hasn’t been the case. That would indicate that good news is priced in, but there is another, energy related factor that suggests that the optimism is in fact overdone.

In North America an important part of growth for railroads in the last few years has been growth in oil production. During the first fracking boom, oil became a major revenue producer for rail freight companies. The pipeline infrastructure was insufficient to carry the load, particularly in the new oil production areas, so despite higher costs and some safety concerns, increasing quantities of crude were transported via rail. The two charts below, however, show that as U.S. oil output has continued to grow, rail shipments of crude have been falling.

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The conclusion is obvious. As pipeline projects that serve the new oilfields are completed and come on line a much smaller percentage of U.S. production is being shipped by rail. With total production as high as it is that isn’t too much of a problem for railroads, but it is a trend that is continuing, and even a slight downturn in output growth could quickly impact railroads’ profits.

The other energy-related factor in the fortunes of railroads is coal. Stocks have understandably received a boost as President Trump has enacted his pro-coal agenda, as coal shipments have historically been primarily by rail. Most economists and industry watchers seem to agree, however, that while the policy changes may give a welcome respite for the embattled U.S. coal industry, they will not affect long-term trends towards cleaner energy sources. In other words, the boost that railroad stocks have received from a more pro-coal regulatory environment will be short-lived.

It seems then that two of the big drivers of the surge in railroad stocks, increasing oil and coal production, may not be what they seem. On that basis, shorting them despite their strong run looks like a risk worth taking at this point. My choice would be to sell the aforementioned UNP. As one of the biggest beneficiaries of the move up in percentage terms it is likely to be the most vulnerable to a correction and a stop loss above the highs, somewhere just over $160 say, would put a manageable cap on potential losses.

Whether you choose that or another way to play it though, betting on a retracement of railroad stocks may defy conventional wisdom, but it looks like a smart move at these levels.