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Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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Railroad Stocks Hit Hard By Oil And Coal Collapse

There has been a lot of focus on the collapse of the energy industry over the last two years and how badly bruised many of the associated company’s stocks have become. What investors often overlook though is the ancillary damage that has been done to firms that do business with the energy industry.

In particular, it has been awful year for nearly all major railroads and railroad suppliers. The combination of collapsing oil prices leading to lower crude by rail growth opportunities and the decline of the coal industry has been a one-two punch that has leveled many major railroads.

Titans of the industry like Norfolk Southern, Union Pacific, Canadian Pacific, and Kansas-City Southern have all shed billions of dollars in market capitalization. Railroad car makers Trinity Industries and Greenbrier have literally seen their share prices cut in half. The damage to the railroad industry is in many ways on par with the damage in direct E&P firms – at least according to investors. Related: $40 Oil Not High Enough To Save A Lot Of Drillers

Yet is this level of price decimation justified? Are railroad profits really as doomed as they seem? The key for railroads predictably is rail car traffic. Monthly rail car traffic has been volatile, but notably, traffic in February 2016 looks considerably better than December 2015, and only slightly worse than February 2015 levels.

(Click to enlarge)

There are essentially two problems for railroads right now balanced against one positive (fairly strong intermodal demand).

First, oil and petroleum product values have come down a lot in the last few months with February being particularly horrendous. At this stage, it’s really not clear if or when crude by rail volumes will come back to reasonable levels. Even if oil prices do rebound enough to make shale production bounce back as well, it’s unclear if this will materially boost rail volumes. Crude by rail is considerably more expensive than shipping by pipeline, so newly cost conscious crude producers may wait for pipelines to be installed before they begin producing large amounts of product again. Related: Does Saudi Arabia’s Play For Market Share Make Sense?

On the other hand, the volatility in crude might make pipeline operators reluctant to invest in new pipelines until shale production is less volatile. Thus the future of crude by rail is uncertain.

One fact that is worth noting though is that petroleum product shipments are a very tiny part of overall carload volumes. Many commentators talk a lot about oil as a driver of rail volumes, but the reality is that oil is at best an after-thought for rail companies.

(Click to enlarge)

The same thing can’t quite be said for coal. Coal does matter to rail operators, and for some companies, it matters a lot. Further, coal volumes are admittedly very weak, and as bad as oil is, there is even less room for hope on coal. Coal mines are very expensive to open and it’s quite hard to imagine anyone committing enough capital to open even one new mine given the uncertain regulatory and economic situation around anthracite. Related: Oil Rally Unwinds Ahead Of Inventory Data

In other words, coal’s decline may be structural. There will always be a need for some coal – for instance for use in steel, and coal from the Powder River Basin is probably in better shape than Appalachia coal, but like it or not, the coal industry’s best days may be past.

(Click to enlarge)

All things considered then it’s not surprising that railroads are having a rough year. Yet it does look as though the stock market is overreacting.

Take Union Pacific Railroad as an example. The company is among the best rail operators in the country, and its stock peaked at a little over $120 a share early last year. Today the company trades at $80 a share giving it a P/E ratio of less than 15X. Even in the present environmental, UNP’s earnings are likely to be flat this year. The stock is in a stable business with few direct competitors and its business is virtually guaranteed to grow at the same rate as the overall economy (EPS will grow faster thanks to periodic share buybacks). Investors looking for stability and an investment that is likely to be a strong long-term performance should look at UNP and its peers.

By Michael McDonald of Oilprice.com

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  • Jason Williamson on March 31 2016 said:
    Nice reading railroads are being hit hard, which makes me happy. Warren Buffet was the cause of the pipeline not going thru. He doesn't realize there is enough oil in America that we need both railroads and a pipeline to transport it all.

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