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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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Railroads A Safe Bet Even As Oil And Coal Shipments Down

Train

Everyone knows it has been a rough few years to be an oil investor, and an even tougher few years to be an investor in anything related to coal. While the outlook for each of these sectors varies dramatically based on who you talk to, many investors fail to realize the risks and opportunities being created in the industries that work hand in hand with the commodities space. One of these industries is railroads.

As bad as it has been to be an oil investor, it’s been almost equally awful to be a railroad investor. Railcar makers like Trinity (TRN) and Greenbriar (GBX) have seen their stocks cut in half. But those firms were always smaller and highly cyclical. What differentiates the investment environment of today is that blue chip railroad names from Union Pacific to Norfolk Southern and CSX are also off by more than a third. These are companies with market caps ranging from $25 to $70 billion even today after their price drops. Against this backdrop, investors should consider if companies like UNP, CSX, NSC, KSU, and others present a possible opportunity.

The fundamental problem for railroads from the market’s standpoint has been the declining rail traffic in the last few years. Coal in particular is a major source of traffic for many of the largest railroads, and as coal-fired power plants have been increasingly phased out and replaced by natural gas plants, coal volumes have dropped. The volumes of coal shipped are probably in secular decline. Coal is not going to go away tomorrow, but it’s probably never going to be a larger share of electricity production in this country than it is today (and it’s already down substantially from where it was). With that said, coal volume declines are probably steeper today than their equilibrium level thanks to a temporary glut of coal. It is likely that coal carload volume will bounce back over time. Related: Can The Natural Gas Rally Continue?

A second source of anxiety for investors in railroad stocks is oil. Crude by rail has been a major new demand source for the railroads and railroad car makers. There have been some train derailments that have caused considerable consternation over the crude by rails transit method, but the reality is that oil is going to continue to be produced all across the country for years and it has to get shipped somehow. The scrutiny over new pipelines like Keystone XL only makes crude by more crucial to oil production as well.

As production levels across the U.S. and the world have dropped, crude oil carloads have also dropped. That’s not a sustainable path though. Indeed, to the extent that oil markets are more volatile and oil companies are less confident in future prices, it probably helps bolster the case for crude. Why build a pipeline to a new area if you can use an existing railroad track?

The woes of railroads stocks are directly tied to the price of commodities and to the extent that commodities prices should recover over time, rail stocks probably will as well. Yet investors considering rail stocks should not overlook another important benefit the firms provide compared to pure play commodity companies; the railroads by and large remain profitable today.

While oil companies and miners are mostly unprofitable at current commodities prices, railroads have a diversified enough business model and a low enough overhead that they are profitable even with lower levels of coal and oil production. As a result, the firms provide the potential for commodity upside while having better security and safety if Brexit and other global events lead to renewed commodities weakness.

By Michael McDonald of Oilprice.com

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