Tuesday, May 8, 2012

US Railroads and the Coal Slump

The US railroad industry has always been the heart of the nation's industrial economy. If the country's major railroads – Union Pacific (NYSE: UNP), Norfolk Southern (NYSE: NSC), CSX (NYSE: CSX) and BNSF, owned by Berkshire Hathaway (NYSE: BRK.B) – were in robust health, it meant good things for the economy.

But does that still hold true today? It may not, thanks to the impact that increased government environmental regulations and decade-low natural gas prices are having on the domestic coal industry.

The US railroad industry traditionally has gotten roughly 20 percent of its volumes from transporting coal, mainly to power utilities, across the country. Overall coal traffic on the rails in the first quarter of 2012 dropped by 14 percent from the year ago period, with revenues derived from coal traffic falling by 5 percent to $832 million. The only thing keeping things from getting worse was a 19 percent rise in coal exports from the first quarter a year ago.

This is significant because of the impact it will have on earnings at the rail companies. Barclays Capital says that for every 1 percent change in the amount of coal they ship, earnings per share will swing 0.2 percent at Union Pacific and 0.5 percent at both Norfolk Southern and CSX. Partially offsetting the effect of coal though will be improvement in other segments.

Rail companies' revenues from transporting shipping containers and the like rose 19 percent to $389 million on a 9 percent gain in traffic. Other key segments including agricultural, automotive and construction rose 10 percent in the first quarter to $1.68 billion on a 3 percent traffic gain. This segment was actually enhanced by the sharply increasing movement of fracking sand, which is used in shale gas and oil drilling, across the country.

The drop in coal shipments by the rail industry to power utilities nationwide may be the beginning of a trend which looks set to continue as long as natural gas remains so cheap. If so, this could mean a rather permanent falloff in railroads' revenues.

The rail companies are well aware of that possibility. Senior executives at CSX were discussing this after revealing that the company's coal shipments in the first quarter to electric power stations were down 28 percent from a year ago. They stated that US railroad companies would have to sit down with power companies across the United States to discuss revising their contractual agreements for delivering coal.

There may be a secular change occurring in the electric industry, where coal is only used for power during peak demand and natural gas is used for the majority of power needs. If so, the railroads do not want to have pay the entire expense of maintaining excess capacity, to deliver coal, which is used only occasionally. The companies want the utilities to share the maintenance costs and thus the need for “discussions” between the two industries.

For investors in these two industries, the results of these upcoming discussions may very well affect the future profitability of both industries and in turn shareholder returns.

This article was originally written for the Motley Fool Blog Network. Be sure to check out my daily articles for the Motley Fool at http://blogs.fool.com/tdalmoe/.

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