White flag of surrender

Posted by Bill Stephens
on Tuesday, November 5, 2019

From a volume standpoint, the third quarter was a doozy. Railroad traffic slumped for a variety of reasons, not the least of which was increased competition from trucks.

A Union Pacific merchandise train struggles upgrade at Tehachapi Loop in Southern California in September 2019. Bill Stephens photo

If there was a theme on the Class I railroad earnings calls last month it was that volume is not going to get better until trucking capacity tightens sometime in the middle of 2020. It’s a point driven home by the ratings agency Moody’s, which now projects rail traffic will fall by as much as 3% next year.

But here’s the thing. Whenever I hear an executive say that their railroad will be able to resume volume growth once trucking capacity tightens, the translator in my brain spits out this: Railroads really can’t compete with truck.

Part of this has to do with trucking’s superior service. And part of this has to do with the Class I railroads’ desire for ever higher profits, which cuts out traffic that’s perfectly profitable but doesn’t meet the margin standard du jour. In other words, railroads don’t want to compete. Oh sure, you’ll hear railroads talk about wanting to grow. But for the most part they keep falling further and further behind trucks.

All of this ultimately leads back to the Cult of the Operating Ratio, as the analyst Anthony B. Hatch calls the obsession with the efficiency metric. The 50-something O.R. Club is getting more crowded. For the first time, four of the seven Class I railroads reported operating ratios below 60% in the third quarter.

A better operating ratio is not a bad thing. It leaves more dollars for maintaining and expanding the network in this most capital-intensive of industries. And in theory it leaves railroads some wiggle room on pricing. Union Pacific CEO Lance Fritz, sitting at the helm of a railroad with a 59.5% operating ratio, told investors and analysts that his railroad’s new lower cost structure should open up business opportunities it would not have considered before. But there is no indication that’s translating into volume gains on UP, which had the industry’s deepest traffic decline for the quarter.

What’s telling is that trucking tonnage increased 4.5% in the third quarter, according to the American Trucking Associations. Meanwhile, at the Big Four U.S. Class I systems volume was down an average of nearly 6%. Rail and truck compete in the same transportation marketplace. Yet they are heading in opposite directions.

Yes, trucking tonnage versus rail carloads is somewhat of an apples to oranges comparison. No matter. The inescapable conclusion is that railroads continue to bleed volume to the highway. That should not be a surprising outcome when railroads jack up rates regardless of the competitive landscape. Railroads are prioritizing profitability over volume, with the result being that they are making more and more on less and less. It’s a game you cannot play forever.

There are a few encouraging signs of growth here and there. CSX Transportation is now supposedly out beating the bushes for merchandise traffic, according to their shortline connections. Shortlines also are enthused that Canadian Pacific, the only big system to gain volume in the third quarter, is showing renewed interest in partnering with connecting shortlines. And why not? Excluding frac sand and crude oil, CP merchandise carloads have grown by more than 10% over the past three years, with two-thirds of the growth in the past year attributed to cars that touch shortlines and regionals. Finally, Canadian National and CSX are going after short-haul international intermodal traffic linking ports in New York, New Jersey, and Philadelphia with consumers in Toronto and Montreal.

Railroads face a number of economic headwinds, including a slowing industrial economy, the decline of coal, the impact of tariffs, and ongoing uncertainty over global trade. The industry can’t control any of that. What railroads can control is the extent to which they compete with trucks. Right now their white flag of surrender is waving in a volume headwind of their own making.

You can reach Bill Stephens at bybillstephens@gmail.com and follow him on Twitter @bybillstephens 

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