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Rail Stocks: Don’t Fall For The Wrong Energy Story

Here’s the train story going around that investors love to repeat: oil and gas drillers, desperate to move suddenly abundant product from places with insufficient pipelines, are making the railroads rich. In fact, railroad shareholders, including the two investment gods Warren Buffett and Bill Ackman, are already making a lot of money from rail’s growing numbers of oil tankers.

It’s a great happy tale, especially since this new business is expected to grow for several years to come. But it’s hardly the only story to consider when evaluating a railroad investment. While there are some other happy tales, others help explain why not everyone is fanatically bullish on the sector now.

To be sure, fracking has been a boon to railroads. Railroads are carrying record amount of petroleum and petroleum products; up in North America 32% so far this year from the same period a year ago, according to the Association of American Railroads. The subset of crude oil shipments, which were traditionally shipped by pipeline until those filled, were up 166% in the first quarter from a year earlier.

Shareholders have generally done well in railroads in recent years. Kansas City Southern (KSU) and Canadian Pacific Railway (CP) have more than doubled investor money in five years, while Union Pacific (UNP) and Canadian National Railway (CNI). CSX (CSX) has lagged well behind but is the biggest gainer of that list so far this year.

CSX Chart

CSX data by YCharts

Modest but steady increases in intermodal business, which involves containers that can be moved from trains to trucks, also has helped. Trains have been getting more of this business largely because of relatively high gasoline prices and lots of road traffic that makes trucking more expensive and less reliable. The rising passion for buying stuff over the Internet helps too.

The railroads see growth in both areas for years ahead. They’re investing heavily for both, by building out lines to be convenient for drillers and upgrading others to carry more intermodal containers.

CSX Capital Expenditures Quarterly Chart

CSX Capital Expenditures Quarterly data by YCharts

Now for the darker tales. First, drillers still prefer to transport product via pipelines because it’s considerably less expensive. They’ve entrusted trains by necessity, but the pipe companies are building lines to their fields just as fast as they can. Building a pipeline is a long and tortuous process involving property rights and environmental issues – consider all the controversy on the Alberta-to-Texas Keystone XL pipeline, for example -- so the pipeline companies could take years to catch up with today’s capacity demands. Once they do, however, the more expensive trains will compete with the pipelines, which will not be good for profit margins. On a related note, the oil-carrying train that flattened a Quebec town in a wreck earlier this year didn’t help the railroad’s side in a debate over the environmentally best way to transport crude.

Also, coal shipments continue to fall sharply, and this is a far more important product for railroads today than petroleum products. North American coal shipments by rail are down about 3.9% so far this year; a key reason overall shipments are up just 1.9% despite the nice business from the oil fields. With cheap natural gas from those fracking fields, the coal business is not expected to stage a great comeback. One can see the pessimism surrounding the coal industry in share prices of several major coal miners, like Peabody Energy (BTU), Arch Coal (ACI) and Alliance Natural Resources (ANR). Coal still fills about 18% of North American train cars, according to the railroads association. Petroleum products fill about 9%.

BTU Chart

BTU data by YCharts

Valuations, measured by forward PE ratio, are high right now for a couple of railroads but not especially so for others.

CSX Forward PE Ratio Chart

CSX Forward PE Ratio data by YCharts

The oil windfall for the railroads is wonderful investment story, and one that could very well pay out nicely. But right now, investment analysts stand with a whole lot of hold recommendations on the major railroads, generally seeing today’s share prices as too optimistic. For a happy ending in investing, it’s always best to check out the less cheerful tales too.

Dee Gill, a senior contributing editor at YCharts, is a former foreign correspondent for AP-Dow Jones News in London, where she covered the U.K. equities market and economic indicators. She has written for The New York Times, The Wall Street Journal, The Economist and Time magazine. She can be reached at editor@ycharts.com. Read the RIABiz profile of YCharts. You can also request a demonstration of YCharts Platinum.

Read more articles about: Investing Ideas  railroad stocks   energy stocks   

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