Friday, September 30, 2011

2012 Railroad Financial Desk Book: Stability

Written by  Tony Kruglinski, Financial Editor
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Welcome to this year’s edition of the Railroad Financial Desk Book. Each year we try our best to take a look back and a look forward to see if we can discern what the tea leaves have in store for the rail equipment and leasing industries.

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In years past, life was easier. If you were in a business upswing, predicting more of the same was not that difficult (up to a point!). If we were in a business depression, which we endure periodically in this industry, you could look forward to a lessening of that situation and eventually the business upswing that would follow.

If you take a look back over what has happened over the past 24 months or so, most observers would come to the conclusion that we were in a business upswing. With the exception of centerbeam flatcars, virtually all of the rolling stock parked serviceable is now out working, cars and locomotives to boot. Rental rates have picked up materially from two to three years ago, although, arguably, they are still short of where they were before the downturn. All of this is a function of an increase in traffic that has resulted in an increase in the need for railcars. Even the weather has “cooperated” in putting equipment to work insofar as flooding and other natural disasters have disrupted rail operations to the point that more cars and locomotives are required to do the same work.

Since cycles in our industry usually last five or six years, we should be able to predict more of the same good news for 2012. But that is difficult in these economic times.

As the rest of the world is waiting to see if the United States will have to endure a double-dip recession, the rail equipment industry is wondering if the good news will continue into 2012, or peter out as the economy it supports sputters.

Railway Age has spent the past few weeks interviewing industry insiders on their views on 2012. Generally, there has been a consensus of sorts that the American economy would have to get very, very bad before the bloom comes off our rolling stock rose. Having said that, another consensus was unwilling to rule that out completely. Most interestingly, some of the reasons underpinning today’s robust marketplace have in them the seeds for future “issues.” We’ll discuss all of that.

New car orders go up—and up

Predictions for new railcar production in North America can be had from a variety of sources. For purposes of this discussion, we can report that those predictions for our 2011 build range from the high 30,000s to the mid 40,000s. Predictions for 2012 seem to be gravitating to the mid 50,000 range. (Veteran readers of The Railroad Financial Desk Book will recall that in the past, we have predicted the need for production in the 50,000 range just to cover regular and timely replacement of the existing fleet.)

Generally, industry insiders tell us that this increase in new car orders is due to a variety of factors:

Investment in new cars by lessors. Historically (for the last decade plus at least) the biggest increase in new railcar building has come in the form of orders from the nation’s railcar lessors—CIT, GATX, First Union Rail, Union Tank Car, etc. The reasons for this investment are varied, but the increase at this point in time is primarily due to the confidence that these lessors have today that they can profitably deploy the newly constructed equipment in their lease fleets. There are a variety of reasons why they have this view at this point in time and these reasons have to do with the various markets that these car types serve. (More on this later.)

Investment by shippers. We are also seeing increasing commitments to new equipment by manufacturers who ship their products by rail. Some of this investment is due to pending changes in accounting rules that will put leased equipment on the manufacturers’ balance sheets for the first time. Some of this investment is due to the fact that many manufacturers are able today to make use of the depreciation deductions that come with railcar investment. But the important point to take away from this discussion is the fact that the abysmal economy confronting all of us is not dissuading these rail equipment end-users from making thesInvestment by railroads. Railroads (including railroad-owned TTX) are also stepping up to order new cars. For some of them this is not a usual occurrence. Why are they buying new cars? Again, there are several reasons. First, many of them are awash in cash from their profitable operations in recent years. They are buying this new rolling stock because they can! Another reason is that even though railroads would generally prefer to have someone else’s capital invested in new rolling stock (the leasing companies), they (the railroads) do have certain core business needs that will always require certain numbers of certain car types. (And not owning these cars leaves the railroads subject to the vagaries of market dynamics with respect to rental rates.) Another reason for this need to invest appears to be in the fact that the more efficient operations that are generating these profits are wearing out these railroad-owned fleets faster than in the past. Recent improvements in railcar design and related efficiencies are tipping the balance of railroad investment decisions toward new equipment rather than the traditional routes of rebuilding and renewing rolling stock. Finally, railroads are corporations and taxpayers just like the manufacturers they serve and have the same balance sheet and tax issues as their customers.

What about the future? Interestingly, you would expect that a lousy economy would act as a brake on the kinds of investment described above. And perhaps it is. Perhaps there would be another 10,000 or 20,000 railcars built this year or next if concerns about the economy that the equipment will be serving were not there. Still, current production rates are being constrained by component suppliers. Castings are in particularly short supply. (We know of one lessor that is taking trucks from existing centerbeam flatcars that are parked as a result of the continued depression in home building and “recycling” them under new railcars that would not have been able to be completed due to a shortage of castings!)

We should also comment on the fact that several of the large railcar lessors are building cars on spec insofar as they do not have lessees lined up before the lessors commit to build the cars. In the past this has been an indicator of risk-taking on the part of a segment of the lessor market seeking to increase market share in an expanding marketplace for leased equipment. At this point in time these bets on the marketplace seem to be good ones as the new equipment is being leased prior to delivery and there are no new car inventories that we could find at lessors. We will know that we have reached the top of the new business curve when new cars start to be parked upon delivery in significant numbers. Several lessors with whom we spoke worried out loud about this possibility as a potential function of an economy that is continuing to worsen.

Finally, what about 2012? Nothing in the industry conversations we had in preparation for the Desk Book gave us any indication that the mid-50,000 2012 delivery target that seems to be predicted will be materially affected by the economy. No matter what the economy does, building railcars is a long term affair with orders for cars and components placed significantly in advance of deliveries. Based on what we are hearing, carbuilding is unlikely to be impacted by the doings of the economy. What might happen, we are told, is changes in types of cars included in orders by lessors due to developments in specific market segments.


How about some specifics as to what types of railcars are being built and why?

Tank cars and sand cars. We should start off this part of The Desk Book by commenting on the almost unbelievable strength of the energy market. For the past few years, the rail-shipped energy market was spelled E-T-H-A-N-O-L. Thousands of tank cars were built to ship the end product and thousands of covered hoppers were built to move the distillers dried grain (DDG) after-product of the ethanol process. Then the retrenchment occurred and thousands of these cars were parked in the weeds.

Today’s energy market is dominated to a large degree by the need to move frac sand that is a major component of the new market in oil and gas created by hydraulic fracturing. This new market took up some of the slack in the ethanol market by causing the redeployment of tank cars and DDG covered hoppers (for the frac sand). The DDG cars, however, are not ideal for frac sand and, as a result, the industry is currently building new 3,250-cubic-foot covered hoppers to move this new commodity.

The dramatic increase in the amount of crude oil moved by tank car was illustrated recently by AAR stats that show approximately 46,000 carloads of crude oil traveled by rail in 2010, which was approximately 57% more than in the prior year. The need for cars for this service is expected to continue to grow dramatically over the next few years as new oil fields come on line that are not served by pipelines. Rental rates of as much as $1,000 per month have been reported in this very, very tight market.

Grain cars. The North American grain car fleet is an old one and as it ages the owners and end-users of the traditional 4,750-cubic-foot covered hopper cars are moving to new higher cube cars with 286 GRL capacity. At the same time as this is happening, the fertilizer marketplace is developing a requirement for its own, smaller covered hopper car at 4,300 cubic feet. Initially the idea of one shipper, we are told that this car is catching on in the market and could become an industry standard. One way or another, older 4,750s that were built before the date rules allow them to be renewed for service after their 40th birthday are on the way out. New building is or will be providing replacement cars.

Coal cars. Pressure from Washington has put a damper on coal car building, which should have come roaring back from the business downturn like the other car types. Having said this, there has been significant railroad purchasing of this car type beyond what has occurred in the past. The need to replace existing equipment that is wearing out due to significant use (which we mentioned above) is the principle reason for this activity.

Autoracks. Railroads are ordering new trilevel autoracks in significant numbers for the first time in some years. These new builds are due primarily to the need to replace existing bilevel and trilevel cars that have to either be extensively (and expensively) renewed in order to be recertified for continued service to the auto industry.

Plastic pellet cars. We have also received reports that—again despite a poor economy—more than one plastic producer has placed significant orders for new plastic pellet cars. This comes after several years of very light production for this car type.

The tank car dilemma

We have already reported that the energy industry is helping to prop up the market for new car construction and leasing. General purpose 30,000 gallon cars equipped to handle hazardous commodities are the mainstay of this market. The problem that the market has in ordering new cars of this type is that the FRA is in conversations with the industry regarding enhanced safety enhancements for new cars.

We understand that the FRA is also currently considering enforcing mandatory modifications to existing 30,000 gallon tank cars. Many of these cars were built during the ethanol boom and then subsequently parked when it busted. The recent shale deployments, which have been and continue to be exploited for natural gas and oil, have been a savior for the lessors.

Today's 30,000 gallon car is a non-coiled and non-insulated general purpose car. Due to recent derailments with ethanol and crude that involved fires and a lot of damage, here are some of the onerous modifications being considered:

Requiring top rollover protection.

Requiring head shields.

Potentially requiring thermal jackets (mineral wool or ceramic fiber) that (we are told) would subsequently mean another outer shell ($15,000 to $20,000 per car).

We have heard mixed things about changing valve requirements, but due to bottom discontinuity and the low profile valves with skid protection, there could be some changes there as well

Obviously, mandating all this will mean huge capital inputs for many lessors. We are told that doing all of the above may add $30,000 to the price of a new car. Older assets, like “long 30s” (grouped as over 60 feet in length and that cannot be put in unit trains) may be the first to be scrapped instead.

(Railroad Financial Corporation’s Will Geiger assisted in preparing this information.)

When will it end?

Earlier, we mentioned that a number of industry insiders were waiting for the perennial shoe to drop in the form of the ordering of new construction by one or more large lessors in numbers that would be beyond what could be leased out on delivery. We also reported that it was our view that the industry needed to build an average of 50,000 new cars a year just to keep up with the retirements that the North American fleet should be making over the next decade. And no matter how you figure it, we are only in the second or third year of a business cycle that traditionally lasts six or seven years.

Based on the above, there is no way that 2012 or (more likely, 2013) could see any marked downturn in new car construction.

Or is that so?

Here are some of this writer’s musings as to what could prompt a deflation in our current situation—and some drama for operating lessors plowing big money into new cars:

A financial meltdown that makes it harder to raise money for new car acquisitions or that results in bank losses that reduce capacity for tax-affected financing.

A major derailment (God forbid!) involving a unit oil train. A public relations disaster of some sort involving horizontal fracturing as a method of extracting oil and gas that causes that industry to retrench.

Were one or more of these things to happen—well, you get the picture. No matter how rosy the situation may seem today, stuff happens.

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