Is It Time To Cut Back On The Railroads?

|
Includes: CNI, CSX, IYT, NSC, UNP, XTN
by: Kevin Quon

Summary

OPEC's decision to hold oil production declares a price war against North American oil producers.

Much of the railroad boom in recent years has been due to rapid rise in shipment demand related to North American oil.

The strong market reaction to the oil news has put some of the railroad growth at risk going forward.

Over the past few years, railroad companies have significantly benefited from the new oil boom taking place within the United States and Canada. One of the greatest influences for this correlation is the lack of pipeline infrastructure within the North American geographic center. This placed a significantly large weight upon the railroad industry to deliver the new wealth as oil began to flow out from the continental center to the coast lines when just a few years before it had flowed in the opposite direction.

However, a major event should now place a critical eye over how sustainable this trend will be over the near term. The shock of OPEC's decision to not cut oil production continues to echo throughout global oil markets. The decision jolted oil-related equities this last Friday, largely extending an already lengthy decline experienced by the industry over the past few months.

Yet the crucial point established by this past OPEC meeting was that this might just be the beginning. A large part of the reason is that the Gulf producing states and Saudi Arabia in particular have made it openly clear that it is looking to defend its market share in the global oil markets. As a result, investors should potentially be ready to settle in for an extended period of time of low oil prices.

The Middle East appears poised for a price war on oil. In early November, the Saudi Arabian Oil Co. lowered the cost of its crude to the U.S. whereby it also increased the cost to Asia and Europe. Combined with the OPEC decision to not cut production, we see that the target of these latest events is the rapidly expanding oil supply found in the United States through the tapping of unconventional basins. Here, shale and tight oil producers found deep inside the United States had been rapidly expanding their supply despite the high cost of production required.

As the price of oil continues to fall below the sustainable cost of production expansion here in the United States, investors should consider the following thoughts on the shale industry.

  1. High Debt Loads. Due to the rapid depletion rate of a completed well, shale oil producers often plan for and commence drilling on sequential wells in advance of production out of the first well. Financing these projects requires large amounts of capital which are often funded with a significant amount of debt. These high debt loads may ultimately backfire and place some of these oil producers out of business.
  2. Tightening Ability To Raise Capital. The fall in oil prices has already hurt many producers in their ability to raise additional capital. The equities of many unconventional oil producers have already been impacted on the market making it more difficult to raise capital. The worsening economic environment for the industry has also made it more risky for financial institutions to lend to such companies. This also adds risk and questions the health of these oil producers should oil prices continue to stagnate.
  3. Reduced Drilling. The first likely stage of an industry wind down would be for a reduction in the amount of new wells to be drilled. This reduces the need for deliveries of inputs such as sand, pipe, chemicals, and proppants which are often transported by railcars.
  4. Reduced Crude Oil Output. Should the price war begin to take a toll on the shale industry as a whole, investors should expect for a reduction in total oil output. This will also reduce the amount of crude oil deliveries from within the United States to the nation's shores.

As a result of these conditions, there remains a growing possibility of reduced demand for the railroad transportation sector should an extended period of low oil prices exist. Much of the sector's growth had been derived from the boom in railroad shipments needed. For example, Union Pacific Corp. (UNP) is responsible for nearly half of the railroad industry's frack sand hauling business. Shipments for sand had been growing about 30% annually since 2010. This was epitomized when the growth went hyperbolic as sand shipments spiked nearly 40% in a single quarter in late 2013.

Reacting to the news of OPEC's decision, stocks of railroad companies also fell on Friday. Union Pacific Corp. fell 4.92% to $116.77. CSX Corp. (CSX) fell 3.75% to $36.49. Norfolk Southern Corp. (NSC) fell 4.74% to $111.64. Canadian National Railway Company (CNI) also fell 4.64% to $71.05. A look at all of these companies have shown strong double digit increases over the past year to date. Yet the clear simultaneous reaction to the latest OPEC news reflects the wary investor sentiment over its potential impact to the railroad industry.

Given the anxiety now residing over the nascent North American oil industry, investors in railroad companies should keep their ears to the ground over the health of shale oil producers. Should OPEC's price war begin to inflict a toll here at home, railroad companies will also be amongst the first indirect casualties of the global pricing conflict found in the form of reduced shipment demand.

However, given the strong reaction felt on Friday it is also reasonable that investors should continue to be cautious regardless. While the largest impact would be derived from a significant operational blow to unconventional oil producers, the mere anticipation of their troubles could also derail the growth which railroad equities have appreciated for much of the past few years.

Traders looking to reduce their risk in the near term might find it ideal to now reduce (or at least hedge) their exposure to railroad companies. While the fundamental long-term outlook remains strong for the railroad sector, long-term investors should anticipate the introduction of new volatility in light of what is now going on with global oil prices.

One potential alternative to safely maintain exposure to this particular transportation sector while still offsetting the possibilities of railroad stock declines might be to invest in a broad transportation ETF such as the iShares Transportation Average (IYT) or the SPDR S&P Transportation ETF (XTN). These ETFs maintain a limited exposure to several of the largest railroad companies including those mentioned above. Yet they are also diversified through other transportation segments including airlines, trucking companies, and etc. As long as low oil prices continue to indirectly harass the railroad companies, the same commodity prices are also likely to benefit the other transportation sectors that prosper when fuel costs stay low.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.