Wednesday, December 04, 2013

2014 TRAFFIC AND SPENDING OUTLOOK: A capital year for suppliers

Written by  William C. Vantuono, Editor-in-Chief
An economy that is still sputtering has not put the brakes on railroad growth and profitability. An economy that is still sputtering has not put the brakes on railroad growth and profitability. Norfolk Southern
2013 has been a record year for the railroads, “a very robust and challenging year for growth and re-investment,” in the words of BNSF chief executive Matt Rose. The indications are that 2014 could be even better—from a shareholder’s standpoint, “a profile of continued steady earnings growth, stock repurchases, and increasing dividends,” in the words of Jason Seidl, Railway Age’s Wall Street contributing editor.

All this translates into opportunities for suppliers, particularly those on the engineering side, where roughly 80% of capital dollars are spent.

Matt Rose’s outlook for 2014 pretty much defines the cautious optimism expressed by those railroads that responded to Railway Age’s inquiries about the year to come. “Our traffic volumes have been growing faster than the economy overall at the same time we were investing a single-year record $4.3 billion in capital on our network,” he says. “And we expect 2014 to present similar opportunities for growth and investment.”

“BNSF is on course to potentially surpass in 2014 the record volumes carried on our railroad in 2006, which means it will have taken eight years from peak to peak to have regained the volumes lost to the Great Recession,” Rose says. “Yet the traffic mix leading us back to that point is very different from the record traffic year of 2006, further reinforcement of the value of a diverse traffic base that touches so many different parts of the broader economy.”

In 2006, volume growth on BNSF was led by international intermodal, coal, and agricultural products. Now the growth is being led by domestic intermodal, crude by rail (CBR), “which was not even on our radar screen in 2006,” several other industrial products segments, and automotive. BNSF expects those trends to continue in 2014. In addition, strong harvests for corn, wheat and soybeans in late 2013 should enable those volumes to continue to improve into 2014.

BNSF experienced a stabilization of its domestic coal volumes in 2013. “However, the long-term trend for coal is down,” says Rose, “due to low-priced natural gas and increasingly stringent emissions regulation.”

CBR “is the biggest game-changer for railroads and energy since the development of the Powder River Basin,” notes Rose. “BNSF didn’t deliver its first unit train of crude oil out of North Dakota until January 2010, yet we will finish 2013 moving 700,000 barrels per day. In the prior rail volume record year of 2006, no one envisioned the possibility of North American energy independence let alone the vital role rail would play in enabling that to happen. But as we’ve seen following the tragic incident in Quebec, there will be a move toward more regulatory oversight of operational practices and equipment.”

BNSF will also continue to invest in capacity expansion, including parts of the network “that have not experienced this kind of traffic growth before,” says Rose. “That was particularly the case on our Northern Corridor. We intend to invest record levels of capital again in 2014 to support the growth opportunities we see ahead of us. Those investments will benefit all of the traffic growth and service improvements on our network and are also a critical part of our efforts to continue to improve the safety of our railroad for our customers, our employees and the communities we serve.”

CSX continues to adapt to a changing traffic base “by managing the things we control the most—relentlessly focusing on safety, service to our customers, and efficiency,” says chief executive Michael Ward. “This foundation for long-term profitable growth gives us the ability to capitalize on modest growth in the economy and overcome significant headwinds as the energy markets evolve. To accomplish that, we are leveraging opportunities in our growing merchandise and intermodal businesses, which now make up more than 80% of the company’s volume. We anticipate that those businesses will continue to grow at a rate above the general economy, with agriculture and chemicals among the markets that currently are favorable, along with intermodal, which now represents 40% of overall volume. We expect intermodal to increase further, reflecting the attractive economic value of converting freight from highway to rail. Well-documented headwinds in domestic coal consumption are likely to persist, the result of increased availability of natural gas, regulations, and high stockpiles at many of the U.S. utilities that we serve. On the flip side, we are capturing opportunities created by the expanding domestic oil and gas industries, which also are supporting the potential for more manufacturing in this country.

“This historic transition in traditional rail markets leverages the new diversity and vibrancy of our product portfolio, especially when paired with an underlying business that is strong, highly focused, and able to capitalize on opportunities in the near- and long-term. This is especially true in light of the positive long-term outlook for rail transportation as population and consumption increase and global trade requires the movement of products across this country in ways that are good for the economy and the environment.”

CSX anticipates that its 2014 capital investment program will represent 16%-17% of revenues over the next few years. “Our planned 2013 investment of $2.3 billion is part of $14 billion invested since 2005 in our network and equipment,” says Ward. “These investments are designed to ensure that CSX continues to deliver safe, reliable, and efficient transportation to the customers and communities that rely on us by, among other things, expanding track and terminal capacity, purchasing new locomotives, and leasing or purchasing railcars. As always, current levels of capital investment hinge on a balanced regulatory environment. New and unnecessary regulations would reduce capital investments, job creation, and contributions to much-needed economic development and environmental benefits.

CSX’s capital program will continue to be focused on infrastructure including projects to support growth such as the intermodal market. “The high service levels and available capacity that our customers have come to expect is a result of the efforts of our 32,000 employees combined with targeted capital investment,” Ward says. “The addressable intermodal market in the East has the potential for 9 million loads that move more than 550 miles that could be converted from the highway to rail. That is driving a significant portion of our capital investment. We are evaluating the potential expansion of our Northwest Ohio Intermodal Terminal as a result of increasing demand in that region. In addition, we completed expansions of the intermodal terminals in Worcester, Mass.; Columbus, Ohio; Atlanta; and Louisville, Ky., earlier in 2013. New terminal construction is in progress at Winter Haven, Fla., and Salaberry-de-Valleyfield, Quebec, to create additional capacity to meet current and new demand.”

Investment will continue in the National Gateway, the CSX-led $850 million public-private partnership designed to enhance the flow of freight between Mid-Atlantic ports and Midwestern consumption hubs. CSX and its state and federal funding partners have completed the clearances necessary to operate doublestack trains between Northwest Ohio and Chambersburg, Pa., the project’s first phase. Part of the second phase of the National Gateway involves upgrading the Virginia Avenue Tunnel in Washington, D.C., a single-track, single-stack historic tunnel. In conjunction with the other Phase II clearances, expanding the tunnel will allow for CSX’s doublestack service to run unimpeded to Northwest Ohio from Mid-Atlantic ports after the Panama Canal expansion in 2015. CSX also recently announced plans to build a $50 million intermodal terminal in McKee’s Rock, Pa., near Pittsburgh, as part of the National Gateway.

Other key capital investments include capacity expansion on the River Line between Selkirk, N.Y., and northern New Jersey to support overall traffic growth and to facilitate deliveries of crude oil to eastern refineries. In addition, CSX is prepared to make investments in partner Louisville & Indiana Railroad Company’s corridor between Indianapolis and Louisville. If the alliance is approved by the Surface Transportation Board, that investment will improve track for higher speeds, and increased capacity and flexibility of freight movement to Louisville, Cincinnati, and Sidney, Ohio, via Indianapolis.

CSX currently expects to spend $1.7 billion on the research, development, and implementation of Positive Train Control. It has spent more than $700 million on PTC, including technology development, signal replacements, and locomotive upgrades to meet this mandate. Along with other railroads, “we are seeking a much-needed extension to implement PTC safely and without jeopardizing the hard-won gains in service reliability and efficiency,” says Ward.

Norfolk Southern “sees ongoing opportunity in the intermodal and merchandise markets, while coal continues to face challenges from natural gas substitution and global oversupply,” according to chief executive Wick Moorman. “Our outlook for intermodal remains bright as we complete new facilities and launch new services such as the South Carolina inland port project at Greer, S.C., which will convert highway shipments from the Port of Charleston to Greer for BMW and other customers. We will open a new intermodal terminal in Charlotte, N.C., which will be the last major Crescent Corridor terminal. Highway conversion and international growth both represent continued opportunity ahead for our intermodal network.”

“We continue to see growth in crude by rail as well as natural gas liquids and plastics,” says Moorman. “Frac sand shipments should increase as hydraulic fracturing technology requires higher volumes of sand. In our metals markets, domestic steel production is projected to expand modestly, while automotive production continues at a steady pace.

“We expect capital spending in 2014 to be roughly comparable to spending in 2013. The majority of our 2014 capital budget will go toward core investments in track and infrastructure. We will continue a program to replace aging coal cars and other essential equipment. As in 2013, we will spend more than $200 million on Positive Train Control.”

CN, according to chief executive Claude Mongeau, “is anticipating strength in a number of markets. CN has the largest forest products franchise in the industry and we expect lumber and panel shipments to benefit from the continued recovery in the U.S. housing market. An improving U.S. housing market will also support growth in intermodal as well as various other commodities including steel, aluminum, plastics, cement, roofing, and other construction materials.

“Commodities tied to North American oil and gas development will also be strong. In particular, we see strength in oil and gas consumables, including frac sand and drilling pipe as well as crude oil. Intermodal will continue to be a key growth driver as we continue to benefit from the recovering economy, truck-to-rail conversions, and market share gains. Automotive traffic will grow with rising vehicle sales in Canada and the U.S., and as a result of shifts in market share. Grain is expected to be strong in both Canada and the U.S., with the Canadian crop expected to be near an all-time record. Coal markets, however, are expected to continue to be soft in both thermal and metallurgical segments.”

CN continues to expect capital expenditures to be in the range of 18%-20% of revenues. “For 2013, we’ve targeted C$2 billion,” says Mongeau. “Our capital spending is directed at supporting the company’s strategic agenda. CN spends capital to deliver traffic safely and sustainably, to drive Operational and Service Excellence, to grow the business faster than the economy, and to do so at low incremental cost.”

Kansas City Southern “sees exciting growth opportunities for our business next year,” says chief executive Dave Starling. “In Mexico, we are looking forward to serving the new auto plants that will come on line over the next several months. Also in Mexico, the outlook for our intermodal business is positive as we continue to execute on our strategy to convert cross-border truck traffic to rail. In the U.S., the changing energy market offers both opportunity and risk. Strength in crude oil and frac sand should offset the downside risk that we have in coal, as a couple of plants in our service region still struggle to compete against low natural gas prices. Finally, as the Midwest recovers from one of the worst droughts in U.S. history, our export grain shipments should be stronger in the first half of next year.”

In 2014, KCS expects capex to come down from 2013 levels, “but remain above industry the average in order to capitalize on growth opportunities that we see on our network,” notes Starling. “Additionally, in 2014 we will continue to evaluate opportunities to convert some of our leased equipment to ownership. We will continue to invest in our growth through the acquisition of locomotives and rolling stock, strategic upgrades to intermodal facilities, and capacity enhancements in high-volume areas of our network. A key project for next year is intermodal expansion at Wylie, Tex., to help consolidate Dallas-area operations into one location, improving efficiencies. We will exit 2013 with 35 new high-horsepower line-of road-locomotives, which will position us well to handle the carload growth. We have also earmarked dollars in 2014 for additional new locomotives as well as the option to perform repowers, as the business dictates. For rolling stock, we have targeted funds to acquire new equipment in support of key growth lanes. This aligns with our strategy to increase the ownership vs. lease ratio more in line with the industry.”

“Nobody knows what the economy is going to do next year,” says Canadian Pacific chief executive Hunter Harrison. “Our job is to respond to the needs of our customers based on how much demand there is for their products. But at CP, we’re looking to the following areas:

“Since summer 2012, we’ve been working to rethink our intermodal network in an effort to capture domestic business that’s currently moving on rubber tires. That’s included notably shortened transit times in the Vancouver-Chicago, Vancover-Toronto, and Toronto-Calgary corridors. In the fourth quarter of 2013, we shaved time off another route, a total of 10.5 hours in the Vancouver-Calgary corridor. These improvements are already leading to improved domestic intermodal volumes, and we anticipate that will continue.

“We had a record grain harvest in Canada in 2013. We expect to continue hauling that grain through the winter, giving us a good start for 2014. That should include strong Western Canada-St. Lawrence Seaway volumes, as well as strong Canada-U.S. movements.Our industrial products segment has seen strong growth for several years. We expect that will continue.

“We’re targeting 4%-7% revenue growth over a multi-year window. Meanwhile, we will continue to exercise cost control in planning our operations. We’re demonstrated that controlling costs and improving service to customers are not mutually exclusive. We’ve moved this railroad from the back of the pack to the middle, and we’ve got our eyes firmly set on being the industry leader. We’ve shown conclusively that we have a solid team. They’re embracing change, and they’re becoming better railroaders.

“We expect our capital spend to stay consistent with 2013, in the $1 billion to 1.2 billion range. Our focus on asset utilization has generated over 450 surplus locomotives, so we definitely will not be purchasing locomotives in 2014. The majority of our capital in any given year goes into the replacement of our core infrastructure: track, roadway, etc. Beyond that, our capital will be focused on network enhancements that improve the productivity, efficiency, and safety of our railway.”

Union Pacific’s Board of Directors in late November approved an early renewal of its share repurchase program, authorizing repurchase of up to 60 million common shares by Dec. 31, 2017. “Union Pacific’s continued long-term commitment to increasing shareholder value, while maintaining our strong, investment grade credit ratings,” said Chief Financial Officer Rob Knight. “Since the inception of our current authorization program in April 2011, the growing profitability of the franchise has allowed us to increase our declared dividend more than two-fold and return more than $4 billion to shareholders through our repurchase program. We have confidence in our continued ability to earn re-investible returns on our diverse franchise opportunities. We expect to generate strong cash from operations to support our strategic growth capital investments, maintain a strong balance sheet, and reward shareholders with increasing returns.”

Growth in grain traffic has proved particularly lucrative for UP, and is expected to carry over into 2014. UP shipped an all-time-high number of grain trains to the Pacific Northwest in October, and is poised to help its customers take advantage of a record grain harvest.

Following the 2012 drought, which significantly reduced crop production during 2012-2013, this year’s corn crop has set a new national record. In the most recent crop supply and demand report, the U.S. Department of Agriculture said it expects production of 13.99 billion bushels of corn, up from its September forecast of 13.8 billion bushels. The previous record was 13.1 billion in 2009. This larger production, combined with robust grain export markets, “will create much stronger demand for transportation during the 2013-2014 crop year, compared to the previous crop year,” UP said. “Customer commitments for our trains have increased accordingly.”

UP credits its ability to move all this grain to “superior network performance supported by the best average train speed among the four largest U.S. railroads,” according to data compiled by the Association of American Railroads.

UP also is offering a six-month shuttle commitment program. Such programs allow qualifying customers to exclusively use railcars for a pre-determined amount of time, providing them with guaranteed capacity. Traditionally, shuttle commitment programs have required customers to commit annually. UP says its six-month option offers customers the opportunity to use the cars for a shorter time, allowing for greater flexibility during peak periods.

A better year than 2013?

By Jason Seidl, Contributing Editor

2014 promises to be another good year for the railroads, possibly even better than its predecessor.

Coal and agricultural products woes continued throughout 2013 in the railroad industry, as the two commodity groups fell 3.4% and 5.8%, respectively, through the first nine months. However, someone forgot to tell the railroads. Through the third quarter, publicly traded railroads posted a 24% gain in earnings, with a similar gain mirrored by the stocks over the same period. The rails have managed to put up the good earnings results through a combination of pricing gains, productivity enhancements, and modest volume gains.

Heading into 4Q 2013 and the beginning of 2014, we foresee rails doing well despite coal still being a modest (but diminishing) drag. The industry has clearly shown that intermodal is not only growing in size (carriers continued to expand intermodal hubs and ramps in 2013) but growing in profitability, as much of the traffic coming on board is largely being added to existing trainsets, thus enabling carriers to post strong incremental margins. This has been done in an era when intermodal pricing has been subdued by softness in the truckload space. If the economy picks up, truckload carriers should be in a good position to raise rates given that capacity is not expected to expand in that market. This should enable intermodal rates to rise, particularly in areas that are more truck-competitive.

Crude by rail is also expected to grow, but the pace of growth is likely to be partially tied to crude spreads. That said, traffic headed to the West and East Coasts should continue to grow, as there is limited competition for the industry as well as more terminals being constructed. We remain somewhat cautious about pending regulations to the tank car industry (in both scope and tank car repair shop capacity). If onerous regulations are forced upon manufacturers, we could see a shortage of tank cars in 2014.

After being a drag in 2013, agricultural carloadings are looking up for the last quarter of 2013 and the full year of 2014. A better (but late) harvest and easy year-over-year comps are expected to rule the proverbial day. The outlook for coal is neither bullish nor bearish in our view. In fact, coal could be somewhat of a wildcard in the coming year. While year-over-year comparisons should ease greatly in 4Q 2013 (the industry saw traffic drop nearly 15% in 4Q 2012), there are signs that we may be nearing a bottom in the domestic thermal market. Like the agricultural market, Mother Nature may have a hand in determining the outcome, and so will natural gas prices. What has become clear in recent months is that there is a basin shift occurring. More volume is being sourced from the Illinois Basin, which is currently displacing Central Appalachian output. According to Cowen & Company coal analyst Dan Scott, Illinois Basin coal could stunt the spread of Powder River Basin coal into the Southeast. On the export side, cheaper Australian product will continue to hamper volumes for the eastern carriers even given their willingness to be more flexible on pricing with producers.

Speaking of pricing, we expect the railroad industry to continue to price above rail cost inflation in 2014. More specifically, our most recent Cowen & Company Quarterly Railroad shipper survey noted that industry pricing is expected to be up 3.6% over the next 6-to-12 months, up modestly from the prior quarter’s results. We should note that our survey does not include much impact from the coal markets as well as RCAF pricing, both of which are likely to act as a visual drag on yields in the coming quarters. It is our view that the rail industry continues to be a good investment for fund managers in 2014. While the year may not be as much “risk on” as 2013 was, a profile of continued steady earnings growth, stock repurchases, and increasing dividends should make the industry an attractive option for many.

2014 Outlook: A crowded agenda

By Tom Simpson, President, Railway Supply Institute

What will 2014 bring for the railway supply industry and its railroad customers? A look ahead shows an increased focus on tank car safety and a range of legislative issues to watch.

The July 6, 2013 accident at Lac-Mégantic, Quebec, focused federal safety officials on the role the DOT111 tank car plays in the movement of hazardous materials by rail. As an integral part of today’s North American tank car fleet, the DOT111 has been operated safely for more than 40 years. Of the roughly 334,869 tank cars operating in North America, 272,102 are DOT111s; of those, 172,147 operate in hazardous materials service.

Since the 1970s, The RSI/AAR Tank Car Safety Research Project has analyzed incidents and identified improvements to tank cars that have been incorporated into design enhancements. In 2011, working with RSI and shipper organizations, the AAR Tank Car Committee (AARTCC) came up with a proposed new standard for DOT111 tank cars that included enhanced end-of-tank protection, thicker steel or jackets, and top fittings protection. The industry has been using this design standard for new cars ordered after Oct. 1, 2011. In a petition filed with the Pipeline and Hazardous Materials Safety Administration (PHMSA), RSI joined the AAR and others in asking that the new standard be adopted as a federal requirement for cars carrying crude oil and ethanol.

Even before Lac-Mégantic, the RSI Committee on Tank Cars (RSICTC) had been looking at steps that could be taken to continue to remove risk from the DOT111 tank car. In its reply to a PHMSA advanced notice of proposed rulemaking on tank cars and the movement of hazardous materials by rail, RSICTC asked that the agency adopt the standards contained in the AAR petition for new cars. In addition, the RSICTC suggested several modifications to the existing fleet, including addition of half-height head shields, improved pressure relief valves, better top fittings protection, and removal of bottom outlet handles. Such modifications must be implemented in a manner that reflects the complexity of the modification, the capacity of the repair network, and the technical and economic feasibility of such modifications.

In addition to following the ongoing regulatory developments with tank cars, RSI is actively pursuing its legislative priorities on Capitol Hill. Rail issues will be an important part of the Congressional agenda in 2014.

Congress will once again confront the need to reauthorize or extend surface transportation legislation, since Moving Ahead for Progress in the 21st Century (MAP 21) expires in 2014. The fundamental question of how to pay for transportation infrastructure has yet to be answered. The Passenger Rail Investment and Improvement Act of 2008 (PRIIA) and the Rail Safety Improvement Act of 2008 (RSIA) both expired on Sept. 30, 2013 and are also up for reauthorization. Expect Congress to debate intercity and high speed passenger rail, the Railroad Rehabilitation and Improvement Financing (RRIF) program, rail safety, and the impending deadline for Positive Train Control.

RSI is following all of these issues for its members, but two specific issues are of primary concern: intercity passenger rail, and truck size and weight.

PRIIA required states to share costs with Amtrak under a consistent formula for all routes of less than 750 miles, excluding the Northeast Corridor. House Republicans may use that funding template and apply it to Amtrak’s long distance trains—a plan that proved to be unworkable in the 1980s. We will see if states and localities served by these trains can accept this type of proposal to fund the service. There is a business case as well as a public necessity case to continue to operate these trains—points that RSI will make in its Capitol Hill visits.

RSI is also continuing to work closely with the Coalition Against Bigger Trucks and industry partners on combating attempts to increase the weight and length of trucks. With the pending expiration of MAP-21, the battle over truck size and weight has already begun.

MAP-21 required USDOT to conduct a two-year study of truck sizes and weights; RSI has been advocating that Members of Congress refrain from cosponsoring any legislation that would increase truck size and weight until the study has been completed.

What lies ahead? Given the political atmosphere in Washington, D.C. and the fact that 2014 is an election year, it seems a daunting task for Congress to pass major transportation legislation.

However, the railway supply industry and its customers need to be vigilant. RSI will use every tool available to us to be heard on these and other issues.