Friday, December 14, 2012

2013 Freight Rail Outlook: The challenge of change

Written by  William C. Vantuono, Editor-in-Chief
William C. Vantuo William C. Vantuo
Resilience and resourcefulness are two terms that have become closely associated with North American railroads in recent years. The industry has emerged from the worst economic recession since the Great Depression in relatively solid shape, and enters 2013 positioned for growth.
More important, it has demonstrated that it is capable of dealing with changes in its traffic base that not so many years ago would have dealt a crippling blow.

The big change has been the precipitous drop in coal, once the railroads’ single-largest revenue source. Cheap and abundant natural gas combined with tightened environmental regulations on coal have taken some of the gleam off the black diamonds that the industry has relied upon for generations. But in a not-so-strange twist, the abundance of natural gas has actually worked in the industry’s favor, because a highly efficient, rapidly growing means of extracting it from the ground—fracking—is now big business for railroads, the single-most efficient and productive form of surface transportation.

This same efficiency and productivity have been the catalysts for growth in intermodal, which has consistently seen increases in traffic.

All this, combined with continued strong pricing power, underpins an industry that in 2013 is expected to surpass $20 billion in capital investment.

“Significant long-term potential exists in the intermodal market,” CSX chief executive Michael Ward told Railway Age. “We continue to seek opportunities to expand new markets and lanes and convert highway shipments to rail. In the long term, we see the total addressable opportunity to convert highway freight to rail in the eastern U.S. at more than nine million loads per year. Our strong service product will be important to converting those loads.

“Developing energy markets also offer opportunities as new domestic reserves of natural gas and crude oil are tapped. This growing market has driven increased demand for specialized sands moved by CSX to wells from which natural gas is extracted. In addition, CSX has been working closely with customers to develop rail direct or rail-to-terminal options to move crude oil from the West to the eastern refinery base.

“We continue to see weakness in domestic coal markets that face significant headwinds from the low price of natural gas, above-normal utility inventory levels, and environmental regulation. Export shipments, however, are strong. In general, we expect the U.S. to continue to be a strong supplier of world coal in the long term.”

Kansas City Southern, according to chief executive Dave Starling, “would like to see a stable domestic U.S. energy policy that includes our nation’s most abundant energy source, coal. We hope to see sensible regulatory relief toward the rail and energy markets or at least stability in the regulatory environment. Policy should focus on improvements to existing remedies for rate complaints at the STB, which would be less disruptive to the national economy than wholesale changes to the long-standing public policy regarding rail service, rates, and access.”

“2013 could look similar to 2012 in terms of traffic, although we see some exciting growth opportunities developing in both the United States and Mexico in 2013,” Starling said. “In 2012, KCS had its share of challenges related to coal and agriculture. We were hit with the one-two punch of a very warm winter and low natural gas prices. Heading into 2013, we will keep a close eye on our coal franchise as some of our utilities still struggle to compete with low natural gas prices. We will also watch our grain franchise closely next year as the nation recovers from one of the worst droughts in recent history. Despite those challenges, in the U.S., we believe our auto business will continue to produce strong results as consumers continue to replace an aging fleet of automobiles. Continued strength in our crude oil and frac sand shipments should benefit our energy segment. In addition, two new grain origins on our system should give a boost to our agriculture business in the second half of 2013. In Mexico, we expect to see continued growth from our automotive and intermodal businesses.”

“Looking ahead, we expect weaker overall fundamentals in most of our markets through the rest of the year, and into the first half of 2013,” Norfolk Southern chief executive Wick Moorman said at the company’s third-quarter earnings presentation. “Continued competition from natural gas and reduced demand for electricity will continue to impact our utility coal volumes. And dramatic changes in the export coal market due to weaker demand for metallurgical and steam coal into Europe and Asia will continue to present a challenging environment for export volume at export pricing. The outlook for domestic intermodal remains positive with a favorable environment for highway conversions. In particular, the launch of new Crescent Corridor lanes starting in January will support higher volumes ahead. We also expect continued expansion in our international and premium market segments. The outlook for our merchandise sector is mixed as project growth in crude oil, along with continued growth in the automotive industry, should create favorable conditions throughout the rest of the year for chemicals and automotive.”

In terms of change, no railroad is facing more than Canadian Pacific, now in the midst of a near-total overhaul under recently installed chief executive Hunter Harrison. At a Dec. 4 investor conference, Harrison outlined his plan for taking the railroad out of last place among North American Class I’s in terms of operating ratio, productivity, cost structure, business growth, and other performance measurements.

“Momentum is building at Canadian Pacific, and the organization is driving to a culture of intense focus on operations,” said Harrison. “Service will be what drives this organization, by providing a premium, reliable product offering through a lower-cost operation. We have initiated a rapid-change agenda and have made tremendous progress in my first 160 days, and we are only getting started.”

Harrison outlined the next steps CP will take through 2016 to continue “to improve service reliability, increase the railway’s efficiency, and grow the business.” He is targeting a full-year operating ratio in the mid-60s by that year. Among CP’s key initiatives: annual capital spending in the range of $1.0-$1.1 billion; reducing roughly 4,500 employee and/or contractor positions by 2016 through job reductions, natural attrition, and fewer contractors; construction of new, longer sidings to improve asset utilization and increase train length and velocity, allowing CP to move the same or increased volumes with fewer trains, and potentially reduce crew starts by 14,500, or 4%; reviewing options for the Delaware & Hudson in the U.S. Northeast; and turning over operations of the 660-mile portion of the former Dakota, Minnesota & Eastern west of Tracy, Minn., to a short line

With these programs in place, CP expects in 2016 to see compound annual revenue growth of 4% to 7% off the 2012 base, cash flow before dividends of $900 million to $1.4 billion in 2016, and a full-year operating ratio in the mid-60s.

CP is scrapping plans to build a new line into the Powder River Basin coal fields and anticipates taking a fourth-quarter 2012 estimated pre-tax non-cash charge of approximately $180 million ($107 million after tax) on its option, inherited from the DM&E acquisition, to build into the PRB.

“We now have a leadership team that understands the urgency of making change and improving the culture of this organization,” Harrison said. “CP has many talented railroaders who want to win. Together we are squarely focused on improved service and becoming the low-cost carrier. This will allow us to continue to grow with our customers.”

“CP’s energy portfolio has seen double-digit revenue growth for five consecutive quarters,” Harrison told Railway Age. “Early in 2013, we expect to hit an annualized carload total of 70,000. Going forward, we plan to roll out our crude-by-rail program to wider implementation in Saskatchewan and Alberta. Expect the current shipments of light, sweet crude to expand to include heavier grades. We expect continued growth in this area as marketers and producers continue to diversify their supply chains by investing in the crude-by-rail model.

“Elsewhere in our business mix, we’ve tightened Vancouver-Chicago and Vancouver-Toronto intermodal schedules, taking a day out of transit times. And there’s more of these improved service offerings being developed. While the majority of our coal franchise is metallurgical coal for export, should the softness for thermal coal in the North American market continue, we expect thermal coal to continue to grow through West Coast export. Asian buyers of potash have been cutting back this year. We’re confident they’ll come back, but we don’t know when.”