Thursday, September 27, 2012

Railroad Financial Desk Book 2013

Written by  Anthony Kruglinski, Contributing Editor

In October of each year, we put on our thinking caps and attempt to divine what is coming at us in the New Year—rail equipment and rail finance, that is.

Some years it’s difficult to see that far into the future. This generally occurs when we are in the depths of a building slump and/or some kind of economic crisis. It’s not always easy in September (when this is being written) to see clarity in a foggy future for the coming year months in advance. When will things turn around? How quickly will the recovery come?

This year: no problem. We are currently in a full-fledged, gangbuster equipment building boom. Led by massive new car building orders from the energy sector, our North American builders are on course to build and deliver what could be as many as 65,000 new cars this year. Even better, there seems to be no shortage of cash to support this building. Well-heeled industrial end-users of the cars are sitting on a ton of cash that’s available for railcar purchases. Where financing is desired there are nearly a dozen big banks vying to provide lease financing on extremely attractive terms that include bargain rents driven by the low interest rate environment which the economy is now enjoying. If you are a railroad and your credit is good, banks and investment banks are lining up to stuff debt on an unsecured basis into your pockets that you can also use to pay for your new equipment purchases.

Trouble with your credit? If you a railroad or industrial end-user with “iffy” credit, there is an equally determined set of rolling stock investors placing orders for new equipment for their operating lease fleets. Some of these operating lessors have “underwriting” rules that require them to have leases in place before they take delivery of new built units. Others are willing to order and take delivery on spec. So strong is their view on the “sense” of building modern, efficient equipment for lease that they don’t seem to mind paying the higher prices that the builders are getting for new construction. (After all, the rents they are charging and getting have seen a parallel increase!)

So, what are we looking for in 2013? The fog is still there, but are we are looking at a wall of fog for 2013 that could mask a brick wall of some kind that we, moving at today’s speeds, could hit at a high rate of speed?

What could happen? Could it be that we might hit an economic crisis of some sort? We are already in an economic crisis of some sort and our rail equipment owners and operators are voting with their wallets for new modern equipment, engineered to become the basis for a renewed fleet that can last another 50 years. Since the rail equipment market is clearly benefiting from the boost that rail has received in this economy over other modes, it’s very difficult to see how an economic dip, even deeper than the one we are in, could have much of an impact.

(RA has predicted for some time that the North American “build” of new railcars needs to average 50,000 just to keep track with retirements in the existing fleet.)

What about the possibility that one of the markets underpinning today’s new building surge slips as a result of factors beyond the control of the folks building cars to service that market? For instance, what if one of the oil or natural gas fracking markets ends up causing some significant environmental damage of some sort and (the specific market) comes to a crashing halt? Call this writer Pollyanish, but I just don’t see any individual issue or family of issues ending what could be the era of American energy independence. No, we will stop building tank cars to haul crude oil when we either have enough of them or the railroads can’t move any more……or someone builds pipelines to replace them. None of that is likely to be hiding in the fog of the early months of 2013.

For all of this writer’s interest in wanting to be the seer who predicts the ultimate sea-change in our marketplace that brings an end to the current boom times we are experiencing. For that I am profoundly thankful. Good luck in 2013!

Tank car travails

(By David Nahass, Senior Vice President, Railroad Financial Corporation)

The proliferation of hydraulic frac drilling and its expansion into the Bakken Shale region of North Dakota has been one of the great growth stories for North American rail in 2011 and 2012. Initially, the demand for frac sand, the treated sand used in the horizontal drilling process, increased new car build demand (and prices). As many readers know, recently there has been some decrease in the demand for hopper cars due to the low prices of natural gas. Up in the Bakken, however, growth continues. Much of that oil is being hauled out of the Bakken region and put into 30,000 non-coiled and non-insulated tank railcars (30 Mg NC/NI in industry lingo). On Aug. 29, The Wall Street Journal reported that 325,000 barrels of oil were being loaded into railcars in the Bakken shale region on a daily basis. Demand for the 30Mg NC/NI tank railcar (and for other tank railcars as well) is through the roof. Tank railcar backlogs are generally into 2014 and there have been several highly publicized reports of multi-thousand orders for cars to service this demand.

This is the second turn for the 30Mg NC/NI tank railcar. This functional and widely used tank railcar hauls as many as 30 different products. Four to five years ago, the ethanol boom drove demand for this car type to similar extremes, only to see the railcar inventory surge to oversupply and prices (for cars and leases) drop to historically low levels. One issue attached to the current iteration of unbridled enthusiasm for the 30Mg NC/NI tank car is a concern that the manufacturers, investors, and their customers are creating a “bubble” in tank railcars that will inevitably burst, not unlike the bubble that burst following the ethanol boom. Who can blame them? Rumors of short term lease rates that are multiple thousands of dollars per car per month might make anyone consider an investment in a tank car.

Many oil producers ship the crude from the Bakken Shale region in unit trains of tank railcars. A unit train is a set of railcars (usually between 80 and 120) hauling one commodity to one location. Large quantities of unit trains of tank cars hauling commodities like crude oil and ethanol have increased scrutiny on the design of these cars. The result is that the AAR’s tank car committee has made certain design change recommendations that are likely to be implemented for DOT Class 111 (which includes the 30Mg NC/NI) tank railcars. The goals of the design changes are to make these tank railcars able to withstand 100 minutes in pool fire, to prevent rapid discharge of the commodity from a loaded car in a derailment, and to prevent the puncturing of the tank. (A pool fire is, “A buoyant diffusion flame in which the fuel is configured horizontally.”)

Without going into specific detail on the design changes, generally they involve thicker material (steel) for the car shell, rollover protection (to protect the loading and unloading devices), a head shield (to prevent puncture), and a new pressure release valve.

Tank railcars that were not manufactured to the new DOT Class 111 design specification can be retrofitted to meet the new requirements. Many cars can have the head shield and the rollover protection added, and the pressure relief value can be switched out. Many other cars will not be able to be retrofitted to withstand the pool fire requirement. Tanks that do not match up can still move crude, ethanol, gasoline, and denatured alcohol in 263,000 pound gross rail load (GRL) service. Cars may be able to move certain less hazardous commodities at the maximum 286,000 pound GRL capacity. No car will be required to be modified to remain in service.

Here’s the point: If you follow the changes in railcar design over the past 20 years, there are two very significant design changes that have impacted railcars, their manufacture, and their financing. One is the increase in gross rail load to 286,000 pounds. The second is the shift to a specifically designed railcar truck to haul that increase in capacity, the AAR S-286 truck design. The S-286 design was officially implemented in 2005. Any tank railcar built with a railcar truck that does not meet the S-286 spec will not be able to meet the criteria for hauling all commodities at 286,000 pounds capacity whether or not it meets the other design criteria. Approval of the recommendations from the tank car committee will mean that the inventory of cars able to haul all commodities at 286,000 pounds GRL will decrease significantly.

One potential result may be a marginalization of (a) tank railcars built with the S-259 truck design (S-259 was the truck design prior to S-286) and (b) tank railcars built using an S-286 truck that cannot be retrofitted to meet the design criteria for DOT Class 111 cars. Demand will still proliferate, but there will be a distinct difference in the tank railcar marketplace. Suddenly the number of 286,000 pound GRL capacity tank railcars for hauling crude, ethanol, gasoline, and denatured alcohol may not look as bubbly as some people once thought.

Low interest rates keep many railcar leasing rents down

A perfect storm of interest rate, tax, and market factors is driving down the medium term rents for many of today’s railcar users to historic lows. At this time, there seems no indication that this situation won’t continue into 2013.

Low interest rates are contributing to medium term lease costs of 3% or less per year depending on the credit quality of the borrower. With the economy in the doldrums and a Presidential election in the offing, the monetary policy that’s keeping rents down is likely to continue.

A variety of factors are pushing the 2012-2013 North American railcar build rate to near historic highs.

Today’s tsunami of railcar building and leasing has a diverse and incredibly strong economic underpinning. It used to be that spiked car building usually meant one thing ... operating lessors speculating on a hot rental market. All kinds of long term bets were placed on short term requirements and everyone shared in the roasting that the market served up for them when it turned. In this market, the new car building is being driven by a variety of economic factors, some super-heated, to be sure:

• Small cube covered hoppers and general purpose 30,000 gallon tank cars are being built to serve the fracking industry that is pulling hydrocarbons from shale deposits both in the American West and in central and eastern regions.

• Industrials have decided that this is a good time to reequip and have placed and are placing orders in line with this strategy.

• Virtually all market sectors (with the specific exception of railcars for the hauling of coal and center beam flatcars) are participating in this aggressive building of new cars.

Not only is it a great time to be a railcar builder; it turns out that it is a great time to finance these cars on medium term leases with the nation’s banks.

What’s going on?

Tax leasing—the purchase by a taxpayer of capital equipment for lease to others—is one of the few ways left for a bank to manage its tax bill. The bank buys the equipment and uses the depreciation it receives as the equipment owner to subsidize lower rental rates. If you were able find manufacturing capacity, U.S. 50% bonus depreciation made 2012 a particularly good year to do this. It won’t be available in 2013, but this will have only a modest impact on tax leasing.

Low interest rates also push down the rental costs of bank-provided operating leases. But there’s more! Financial debacles in the mortgage industry coupled with international efforts to bolster bank capital have combined to make long term leases (15-20+years) unattractive to banks. Instead, the banks which have had a positive “experience” with railcar residual values on longer leases, have taken the view that medium term operating leases of 7 to 12 years are just their cup of tea.

The result?

Railcar buyers, particularly those with decent credit, are finding that they have very affordable financing alternatives to the 1-year to 5-year operating leases traditionally offered by North America’s operating lessors. If railcar buyers can stretch their commitments to meet the banks’ sought-after 7-to-8 year minimums, they can do a sale/leaseback and save 20% to 25% on the rents that the operating leasing companies need to make their deals make sense. Even better, the bank deals come with purchase options. (Existing car owners are getting in on the action with their own sale/leasebacks.)

Make no mistake about it. Operating lessors are open and eager for business and are writing new leases at rates that finally make financial sense for them. But these deals are primarily in the operating lessors’ “sweet spot” of 1 to 5 years and don’t come with purchase options. If the operating lessors’ borrowing costs are also at near-all-time lows, why aren’t they passing along the costs to lower short term rents of operating lessees? Well, they are … in a sense. If interest rates were not this low, operating lessors would need to charge significantly more than they do today for many of their rents. (Clearly, when something in short supply like tank cars are concerned, the shortages are driving up the rents being charged.) Or the cars that are needed for our industry that the operating lessors are buying to add to their fleets would not be purchased in the numbers that are currently being ordered.

Low interest rates help everyone.

A question of balance

Many general news media reports, linking the boom in U.S. natural gas production and the falloff in coal use, suggest U.S. freight rail activity (and equipment use) will automatically decline—presuming coal uses railcars; nat gas production does not.

Not so fast, Tony Kruglinski has already warned Financial Edge Readers (RA, Aug. 2012, p. 44): “Limited pipeline resources exist to carry hydrocarbons from where they are currently being extracted to where they need to go, and a good slug of new tank car building is being driven by the needs of the oil and gas industries. There is also the lift that new sand car building for fracking is giving to the new car industry.”

Emerging issues for 2013

Beyond predicting the difficult-to-ignore signs of continued good times for our industry in 2013, what is likely to be going on next year that will need the attention of professionals following the rail equipment and rail leasing markets?

Each year Railroad Financial Corporation sponsors our Rail Equipment Finance Conference in March in Palm Springs. (See our ad on page DB2.) As part of the agenda process for that meeting in the fourth calendar quarter of each year, we focus on industry hot spots or trends that appear to be emerging in the next 12 to 18 months. We thought that for this year’s Railroad Financial Desk Book we would share some of the topics that we are considering for our March agenda:

• Tank Cars and Sand Cars: We expect Rail Equipment Finance 2013 to provide increased focus on the rail industry’s involvement with the oil and gas industry. Moving crude oil and gas by rail as well as the movement of fracking sand to drilling sites are sure to be areas of focus. What’s going on? How long will the boom last? What impact will the boom have long term on North American railcar fleets and their values? As we have already reported in this issue of the Desk Book, we expect these trends to continue, but the market shift, if and when it comes, could be swift and we will be keeping an eye on it.

• PTC: On the locomotive side, we will be tackling the advent of Positive Train Control apparatus in the cabs of road locos both from a manufacturing point of view as well as after markets. We’ll explain what PTC is, what it costs and who is being asked to pay for it. We have already heard some rumblings that railroads leasing locomotives for short to medium terms may ask lessors to pay for some of the costs of adding PTC to their units.

• Railcar Building: So far the North American railcar building industry (OEM’s and component suppliers) have done a superb job of managing the ramp-up to produce the cars that they have chosen to produce. 2013 may be more of the same or a different story. We will be watching it carefully.

• Finance: In addition to our usual overview of 2012 “deals” we expect to explore the recent advent of medium term bank single investor leases. What questions will we be asking? What banks are still “in” this market? What kinds of equipment are they buying to lease back to end-users? And, most important, when does it look like their appetite will be satiated?

• Pending Accounting Changes: While it’s not at all clear what the final rules will look like, there are important questions being asked about how pending accounting changes will impact accounting in our industry and how these changes may have on equipment leasing decisions. We’ll do our best to discuss these questions, the possible answers to them and try and predict the future impacts.

• Locomotives: One of the big stories in 2012 has been the remanufacturing of older EMD power with newer 710 Series prime movers. Will this trend continue? We will also visit the industry’s movement toward implementing the latest level of EPA emissions requirements and the overall cost and performance of these new units being built by both EMD and GE.

Finally, we’ll make an offer to any of our readers who would like to suggest topics either for our 2013 Railway Age “Financial Edge” columns or our REF2013 agenda to contact this writer at tkruglinski@railfin.com with any ideas or questions on what might be coming at us in the New Year.