RAILWAY AGE, JUNE 2020 ISSUE: Welcome to the 2020 Railway Age Guide to Equipment Leasing. It would not be an exaggeration to say that heading into mid-year 2020, the railroad industry and railcar owners and operators are dealing with times and circumstances heretofore never seen in the rail industry and to the lives of those working in it.
The relentless, exhaustive and ever increasing shadow of the COVID-19 pandemic has impacted domestic and global business in ways that were unimaginable four months ago. This is acutely felt throughout the North American rail business. The statistics are generally awful right now. YOY railcar loadings are down 11.8%, while intermodal loadings are down 10.9% (through April 30, 2020 vs. 2019). Loadings levels have dropped below the level seen during the Great Recession in 2009. Perhaps worse still, freight was already feeling downward pressure heading into 2020. For rail freight, the pandemic is more than from the frying pan into fire. It is the frying pan into a lava pit.
The projections for the remainder of 2020 are dire. New railcar deliveries are projected to be close to or even below 20,000 units (from a February 2020 projection of 35,000 units). This is impacting the value of existing cars. Together, the lack of demand for new and used cars is having the same impact on the lease market for cars. In other words, pretty much everything is in a down cycle. It is widely expected for 400,000 stored cars to increase by at least 25%.
Chemicals and farm products (except grain) have been the most resilient loadings-wise to date, while autos and auto parts have been an expected and notable underperformer. An outsized decrease in coal loadings has surprised to the downside. Coal’s battering from all sides continues. The volatile cocktail of cheap oil and natural gas, pandemic-related decreases in power consumption and power prices, decreasing costs for renewables and their increasing market share continue to provide downward stress on even the most pessimistic projections for coal demand. The Wall St. Journal reported on May 1 that coal-fired generation is expected to decline another 20% in 2020 (hazily sourced from the Energy Information Administration), while additionally reporting that, by some measures, renewably sourced power out-generated coal in 1Q2020 The net result is that coal loadings are down 22.6% YTD. Big ouch.
There is not one area of the rail transportation supply chain free from the impact of the pandemic. Railroads, railcar owners, railcar operators, railcar manufacturers, shippers across all market segments, intermodal import levels—nothing is immune to the impacts. Its ubiquitousness causes the greatest level of concern. What life looks like on the other side of the pandemic remains the great unknown. Broad scoping questions exist, such as the nationwide commencement of the recovery from the pandemic and the length of the recovery to return back to already-depressed 2020 pre-pandemic levels, never mind getting to a period of economic and rail marketplace expansion (remember the first 75 days of 2020 were a period of freight loadings contraction). Perhaps the most important question of all: How will an economy struggling to put people to work and to return everyday life affect the pace of the recovery in freight markets?
While it may feel like years since the world began sheltering in place, at this writing, the U.S. is two (plus) months into sheltering in place and extensive social distancing. As a result, the full impact of the pandemic is really unmeasured at this time. Certain financial market impacts were felt quickly. Liquidity in certain areas of the equipment finance market dried up early, and some railcar investors have moved to the sidelines to see what the future holds. New car prices have dropped, and in certain market segments, secondary market pricing is also dropping. There have been some rumors of railcar sales, but nothing confirmed of a material nature. Scrap prices bottomed out below $200/ton (Chicago Heavy Melt #1) before moving up in May. Some lessors have been able to keep some cars on lease at expiration, but it is generally expected that many cars across all segments will be coming home from their existing leases at expiration. Inevitably, lease rentals will be impacted. The locomotive market is reeling as well.
Around the Market
Lease rates are, to be kind, scuffling a bit in the current market. Here is a summary of current rates. Fair warning: This is written in May 2020; these are the rates from the current moment.
Coal: Standard and Poor’s notes the following, “As of April 17, generators had 9,038 MW worth of capacity slated for retirement in 2020 and another 23,010 MW of coal capacity set to retire between 2021 and the end of 2025.” Need one say more? Coal was under stress and still found room to be worse than before. Net rates are low- to sub-$100 per car per month for net leases, and not much higher for full-service deals. Term notwithstanding. Rapids are a little less prevalent, but not enough for it to really matter price-wise. Car owners should prepare for more suffering ahead.
Small-Cube Covered Hoppers: Forget negative WTI. At $30/barrel, long-term frac drilling is unsustainable. Already under pressure from shorter-haul local brown sand, technology and severe overbuilding, this fleet is likely 40,000 cars long. Lease rates are sub-$100 (net) and likely to stay there for the foreseeable future.
Tanks for Crude and Ethanol: Here, WTI pricing is an impactful factor in bringing CBR to its knees. Equally impactful is the further whipsaw of fewer cars on the road, fewer planes in the air and fewer ships in the water. All these factors combined have body slammed refined fuel consumption. While there will be recovery here, some projections have WTI staying below $50 barrel until 2024. Some tank railcars are being used as storage on private tracks, but it’s not enough to hold up prices or demand. Storing crude is highly regulated and almost impossible on the tracks of a Class I railroad. Lease rates for 117R cars are sub-$500 (full-service) while some 117J cars have being quoted below $700 (in some cases with new cars). DOT 111s are commanding less.
Covered Hoppers for Grain: The supply of covered hoppers for grain remains in excess of demand. The decrease in grain loadings (down 6.1% through April) will be further exacerbated by increases in railcar velocity due to impacts of PSR and the overall drop off in total railcar loadings. Low scrap disincentivizes car owners to take older cars to scrap. This will hold these prices down. 4,750cf cars are leasing for around $200 full-service; 5,200cf cars are leasing for around $300 full-service. DDG hoppers (an ethanol byproduct) have become excess as ethanol demand has dropped. Those cars are down into the low $300s, full-service.
Covered Hoppers for Plastics: Project delays, some market saturation and consumption-related decreases in product demand have tilted the scales to being more unfavorable for car owners. This is another market that will rebound, but for the time being, lease rates on newer cars are sub-$500 full-service (sub-$450 net). Smaller cars with some age are going to scuffle as demand for those cars will show more weakness. Those cars are leasing at $300 and might never recover to higher ground.
Pressure Tanks: This market is slightly more resilient, but under pressure right now. Lease rates (which were tracking above $750 full-service for used and close to $1,000 for new (pre-pandemic)) have come down, and the opportunity to build cars in the short term is keeping prices checked. Lease rates for newer cars are in the $700 range.
Mill Gondola Cars: The steel market remains weak as auto and other industrial production and construction levels drop significantly. As noted earlier, scrap continues to wallow around $200 per ton. Car demand remains weak and values follow with it. Older mill gons (263K GRL) are in the low- to mid-$200s per car per month, full-service, while newer cars (286K GRL) are in the mid-$300s.
No Freight to Pull
With loadings down, it is no surprise that the locomotive market has drifted downward in tandem. The lease market to railroads is virtually non-existent right now, and the few bright spots (rebuilding existing locos) that were hopeful areas heading into 2020 have been marginalized indefinitely. As a result of contracting freight demand and PSR, heading into 2020, only CN and BNSF were not storing locomotives. Now, CN and Canadian Pacific have the fewest number of locomotives stored, while the U.S. Class I’s have larger numbers stored but have been more reticent to release those numbers. As Union Pacific COO Jim Vena noted in the 1Q2020 earnings call, “We’ve got so many locomotives parked. I’m just about embarrassed to say how many.” Rumors suggest both BNSF and UP could have half or more of their loco fleets stored. (Oftentimes, locomotives are stored serviceable in order to begin operations as soon as there is demand. UP has suggested many units are stored in this condition.) Many railroads are selling more-modern owned units such as SD60s and SD70s. With the order book for new builds decimated and rebuilds sidelined, it is not a good time for this market overall. What needs to happen? One word: Loadings. More loadings.
Q&A With Four Lessors
To get a gauge on the impact of the pandemic on the railcar market, its longevity and lasting impacts, Financial Edge invited the senior officers of four railcar operating lessors to answer the same five questions on the current state and future of the railcar lease market. The participants are Paul Deasy President, Chicago Freight Car Leasing, a Sasser Family Company; Jeff Edelman, President, Infinity Transportation; Jeff Lytle, President, Rail, CIT; and Greg Schmid, Managing Director, Rail, RESIDCO.
1. How deep is the current downturn in the operating lease market?
Deasy: The impacts of lower industrial production and segment specific challenges, e.g., lower northern white frac sand and coal demand, were being felt prior to the manifestation of COVID-19. Over the last month, we have experienced aggregate carload volume decline near 30% (higher than the low experienced during the “Great Recession”). This, clearly, impacts the demand for railcars. Shipper response to this is mixed. Some are returning railcars to lessors to manage their particular situation. Others are holding onto to railcars in order to be positioned to supply product as demand improves.
Edelman: It’s extremely hard to project the duration or measure the depth of this downturn. Obviously, there is a direct correlation between a broad reopening of the economy and the speed and strength of a recovery. Aside from a second wave of COVID-19 forcing a major shut down, we think the market will recover steadily throughout the balance of the year and into early 2021. The market was in a bit of flux prior to COVID-19 and this situation has led to further challenges. We are concerned about the inconsistency and varied approach to reopening adopted by individual States as well as the current low-level volume of international trade. This issue will create continued uncertainty in the market, which is not good for anyone, and may lead to choke points in the supply chain, whether products are slated for domestic or international destinations.
Lytle: We’re seeing different levels of resilience and pressure across the markets we play in. Our food-related and petrochemical markets are relatively sturdy compared to some others. In times like these, our balanced expiration profile and strong and diverse customer base will serve us well.
Schmid: I don’t know if it feels the same as 2009 where the whole world stopped, but the downturn is as bad or worse for current demand as back then. Redeployment of assets that have been returned is a rarity, but renewals for certain car types at lower rents are still occurring. This is about as dramatic a falloff in demand that there can be, but once there is a little more clarity demand will pick up more quickly than the last crash.
2. Will there be fundamental changes in the lease market related to the mix of softening demand, PSR and modal change that will have a permanent impact on railcar demand?
Deasy: We, as always, should expect continued investment in technology to improve scheduled railroading and potentially some modal shifts. In the near term, I would expect shippers to utilize their historic modes of transportation to service their customers. Broadly, we need to see growth in both domestic and export rail demand to support railcar demand.
Edelman: Despite lower treasury rates, softening demand, PSR and modal changes, we believe yield requirements will rise for the majority of investors. Certain investors have viewed rail as a safe haven and were willing to accept lower yields to play in the space. There has been a little taste of reality for certain commodity sectors and the inherent risks in railcar leasing is front and center again. Depending on portfolio mix, specifically with energy related car types, the disruption could remain for some time.
Lytle: The railroads have had the benefit of a low-demand environment to implement their operational changes and I’m hopeful that this will allow them to add capacity and grow their market share over time. In terms of modal change, I don’t favor “de-marketing” certain lines of business because if you do, it’s hard to bring that business back to rail.
Schmid: The market appears to be in a demand pause, rather than demand destruction like 2009. There will be some long term softening due to the mothballing of inefficient plants and the like. PSR however is going to have a longer-term impact on the leasing business. Until the railroads are forced to look at revenue growth, PSR will continue to reduce demand for assets. Old and sub-optimal assets are at risk of long-term storage before redeployment.
3. For how long can we expect the market disruption to occur?
Deasy: I think it will be up to two years before we see more significant industrial production improvement and corresponding railcar demand.
Edelman: Despite lower treasury rates, softening demand, PSR and modal changes, we believe yield requirements will rise for the majority of investors Certain investors have viewed rail as a safe haven and were willing to accept lower yields to play in the space. There has been a little taste of reality for certain commodity sectors and the inherent risks in railcar leasing is front and center again. Depending on portfolio mix, specifically with energy related car types, the disruption could remain for some time.
Lytle: That’s a very difficult question to answer. I’ll leave forecasting to the economists out there. What I can say is that in CIT’s Rail business we’re focused on what we can control. Our leadership team has been through markets like this before and we’ve never felt more prepared as we lean in to this one.
Schmid: Outside of PSR I am seeing signs of a hockey stick return sometime in Q4 this year and Q1 next year. Reduced regulations, liquidity being pumped into the economy, and inventories that need to be re-stocked should all help in recovery.
4. What, if anything, scares you about the future of railcar leasing?
Deasy: We have a vast and productive rail network in North America. I believe we need to see a resurgence/ commitment to leverage this network as a growth mode of transportation.
Edelman: Without a doubt what scares us about the railcar leasing market is that many recent investors seem to forget they are investing in 40- to 50-year assets. The last couple of years we have seen yields, especially on the new car side, that suggests the inherent risk of railcar leasing isn’t priced into the transaction. These aren’t long-term bonds that we’re buying, they are depreciating assets that have real utilization and renewal rate risk. These fundamentals are seemingly lost with certain transactions and the effect shows itself in the pricing in the marketplace. We’re hopeful that we’ve all just received a bit of a reminder of the inherit risks in the leasing market.
Lytle: I’ve been around too long to be scared. Instead, we focus our energy on keeping our employees safe and productive, working with customers to develop and deliver railcar leasing solutions and partnering with our suppliers to drive the lowest total cost of ownership. We are well positioned among market leaders in this environment with a young, diverse fleet and strong customer service.
Schmid: The railroads have had the breathing room to perfect their own versions of PSR. Their shippers are being squeezed to keep private railcar fleets to the bare minimum needed. They are effectively being discouraged from incremental business opportunities. This, combined with railroads purchasing their own core fleets, and lack of interest in marginal business opportunities, may mean a long-term contraction of demand for the certain railcar types.
5. Railcar leasing has always been a relationship-centric business. Do you see any changes in the way companies address their future railcar needs?
Deasy: The complexity of the leasing business (railcar supply, repair & maintenance/ regulatory requirements) leads to the need for strong communication and collaboration between lessor and lessee. This will not change significantly. Clearly, virtual/ technology supported processes are and will change to do more things that were done face to face in supporting the relationship.
Edelman: We remain a firm believer that relationships matter and we don’t see that changing regardless of the economic environment. We aren’t suggesting price doesn’t matter because of course it does, but without strong relationships we believe it’s difficult to stay in this business long-term. Major downturns happen as they did in 2008 but at the end of the day, we are strong believers in relationships with our customers and working in partnership with them.
Lytle: There are a lot of efforts to market rail-related services, including leasing – online, and the internet will remain a distribution channel in the leasing space. But relationships still matter, and they are often tested in difficult operating environments. We highly value our strong customer relationships and work hard, at all levels of our organization, to build on them during these challenging times.
Schmid: There has been some commoditization of relationships, especially in industries where the bubble has burst. The net lease banking type lease business shall always be more at risk in this regard. The operating lease business will always involve intangibles like relationships, customer service and quality that will help a company differentiate themselves. Bank Lessors have regulatory constraints keeping them from being as customer friendly as they would like. The operating lessor that can maximize flexibility to their customer still has an advantage. Funds and non-traditional equity investors are also becoming bigger players in this market, and some are taking more direct control of the management of those assets.
Deasy, Lytle and Schmid participated in a Rail Group on Air podcast I hosted. Click HERE to listen.