2017 Rail/Intermodal Roundtable: Volume stable, business steady

While the overall economic outlook may be best described as “inconsistent,” the railroad and intermodal market sectors have both witnessed consistent growth for the most part—especially over the last decade. In fact, in terms of volumes, these two vital freight transportation markets are ahead of where they were just a year ago at this time.

On the rail side, it’s clear that it’s no longer the bellwether that it once was, but growth lost on the coal side has been made up for in other areas, such as grain and chemicals. And on the intermodal side, domestic intermodal is not as dominant as it had traditionally been; however, that’s due to the international movements swinging steadily upward. And while rail shippers are still clamoring for regulatory changes in order to provide what they believe would be needed rate relief, the railroads continue to allocate massive amounts of capital spending to maintain and upgrade “the nation’s private rail network” in the name of safety, upgraded track and technological advancements—all with an eye on the future.

To help put the current state of the nation’s rail and intermodal network into better perspective, Logistics Management is joined by three of the nation’s foremost experts in the market. Our panelists include Larry Gross, senior partner at freight transportation analyst firm FTR; Tony Hatch, rail analyst and principal of ABH Consulting; and Bill Rennicke, partner at Oliver Wyman, a management consultancy.

Logistics Management (LM): How would you define the current state of the railroad and intermodal markets?

Larry Gross: Intermodal is in the process of shaking off the doldrums of 2016. According to data from the Association of American Railroads (AAR), volume for the first four months of 2017 was up 2.3% annually. The annual growth in movements of ISO (international) containers exceeded that of import twenty-foot equivalents (TEU) in January and February, a welcome change from last year.

Movements of domestic containers and trailers were also up slightly annually in January and February. Rail carloads are notching strong annual increases so far in 2017, but these are overstating the health of the sector. While volume is surely better than a year ago, most of the recovery occurred in the second and third quarters of 2016. Since that time, total carload volume has generally been declining; and if the current trends continue, volume will once again fall below prior year during the second half of 2017.

Bill Rennicke: To build on Larry’s data, railroad and intermodal markets are currently very challenging for rail carriers. The overall economy is putting an emphasis on smaller shipments; faster, more reliable service; and optimizing the supply chain—especially on the consumer side of things.

Railroads have allowed many intermediaries in the market, and these make a significant impact on the efficiency and pricing of the supply chains in which railroads participate. At the same time, markets are undergoing significant technological changes that are creating disruptions in the logistics business and for much of the traditional customer base of the railroads. For the year, intermodal traffic is up a meager 0.5% and automotive traffic is down 2.5%, suggesting little actual growth in market share in the consumer sector.

Tony Hatch: I’ll add that rail markets are improving overall, as coal markets have stabilized—and compare quite favorably to year-earlier results—and the high-margin sub-sector, export coal, is having one of its periodic “boom-lets.” The so-called “freight recession” is over, for sure.

LM: Carload volumes are showing decent growth on a year-to-date basis, with these early Q1 numbers helped by “easy” comparisons. Overall, are things moving in the right direction for carloads?

Rennicke: It’s tough to argue that the numbers aren’t moving in the right direction against weak comps. However, the intermodal and automotive sectors are not growing faster than GDP like they were two years ago. Declines in diesel fuel costs and incremental gains in trucking fuel efficiency are putting pressure on intermodal traffic. Automotive business, especially for cars, is down as the industry slumps a bit after back-to-back record years for automobile sales.

Sometimes weak demand is actually OK for rail share, as slower transit times just become storage-in-transit for slower moving models. However, this does not speak well of the overall value of rail service. Also, anecdotal evidence suggests more production from Mexico to the Eastern Seaboard is moving via short sea, while trucks are moving greater volumes direct to dealer from transplant assembly plants in the Southeastern U.S. Overall, the industry needs to discover a new growth catalyst to replace energy traffic, and figure a way to reignite intermodal as a growth area.

Gross: Although volume is substantially higher than a year ago, these year-over-year comparisons don’t provide a full, timely view. The current trend for carloads in general is negative. Setting aside the usual seasonal dip around the holidays, total carloads have been trending flat to down since the middle of the fourth quarter of 2016.

For example, carloads of coal for the four weeks ending April 1 averaged 86,400 per week, 14% below the recent peak achieved in November. However, the picture is not all bad. I’m seeing nice sequential growth in construction-related commodities, including stone, sand and gravel and, importantly, lumber and wood products. The latter recently reached the highest level since early 2016, providing a tentative indication of improvement in new housing construction.

LM: Shifting to intermodal, year-to-date volumes are also up, with domestic continuing to lead the pack and international starting to regain its footing. That said, how do you view the current state of intermodal?

Hatch: General freight is doing fine, and intermodal is contributing. What’s unusual is just that—intermodal is contributing but not leading. Truck capacity remains loose, though trucking earnings, unlike the robust results in rail, were quite poor. Intermodal is also affected on the international side by the confusion over the alliances—a net neutral short-term effect that can still cause gyrations—and muted consumer spending.

Gross: Domestic intermodal movements were up less than 2% through the first four months of 2017, as domestic container activity grew only sluggishly. However, there has been strong growth in the use of 28-foot pup trailers in intermodal, which I believe reflects e-commerce related activity being handled by parcel and LTL carriers.

We’re expecting to see continued acceleration in domestic intermodal activity as the year progresses, especially as the implementation date for electronic logging devices on trucks approaches. This will cause a tightening of truck capacity, which will work to intermodal’s benefit.

Rennicke: The current state of intermodal is OK, but not great. A small but perceptible amount of international traffic is shifting from the West Coast to the East Coast, where the shorter haul puts it under extreme truck pressure. Possible future border tariffs may further hamper future international intermodal growth.

Domestically the industry is being challenged by improving truck fuel efficiency as well as by supply chains that are getting shorter and more tightly managed. Driver shortages, so far, don’t seem to be a problem for the trucking industry, possibly because fuel efficiency gains have enabled truckers to marginally increase driver pay—and also because demand is stronger in shorter-haul lanes where driver productivity is higher and railroads are less service and cost competitive.

LM: How do you view the current railroad service levels compared to this time a year ago?

Gross: The railroads are running as fast as they choose to thus far in 2017. In an economic response to lower volumes, the railroads are running fewer, longer trains in order to lower costs. This results in longer waits between departures, boosting yard dwell times. These huge trains also tend to be slower, and the resulting average train speeds are substantially down from prior year, but in line with the long-term average.

Similarly, average yard dwell is somewhat higher than it was last year, also standing above the 10-year average. Although the service statistics are negative, I don’t view these as indicative of major service issues. The network is running smoothly by all accounts, just a bit slower than was previously the case, and the situation is much the same for intermodal—speeds are down, but barring weather interruptions and the like, service appears to be running smoothly.

Rennicke: Railroad service levels are up marginally from a year ago, but not enough to matter. A continuing focus on longer trains suggests that overall railroad service is not going to dramatically improve, and the weather woes on the West Coast this winter may actually drag service numbers down for a month or so for the western carriers until service equilibrium is restored.

Ultimately, to really drive strong growth will require new lanes or a fresh focus on service. We will be watching CSX and the Hunter Harrison saga to see if new norms are set for eastern railroads. Interestingly, in Canada, where both carriers are highly service focused, railroads seem to be gaining market share, with stronger gains in both carload and intermodal traffic than we see in the United States.

Hatch: Rail service is stable, while down a bit annually according to the metrics, but has been affected by the winter weather, which was normal to bad, compared to an easy winter a year ago. “Stable” is not good enough, of course. It wasn’t addressed enough by analysts in the first quarter earnings calls. However, I expect it to continue to improve over the course of the year, given the focus and the big capital expenditures of the previous five years.

LM: How are market conditions affecting capacity and rates for rail and intermodal?

Rennicke: Overall capacity is not tight in any of the major commodity areas for railroads or trucks, so rates are likely to be flat. And with technological advances in trucking in accident mitigation and fuel efficiency, truckers will likely be able to keep reasonable pressure on rail rates. Railcar supply is good for most car types and production is keeping up with modest growth rates. There are huge surpluses, though, in tank cars and hopper cars, and still some surpluses in centerbeam cars for forest products.

Hatch: Market conditions are clearly affecting rail pricing overall, especially in select merchandise areas, where trucks are pricing at or close to costs like paper, and, of course, in intermodal, where pricing is lagging overall rail 2% to 3% annually in gains so far this year. Overall, rail intermodal can expect to see the winter/spring as the bottom of the pricing cycle, as their service improves and truck capacity tightens due to some combination of regulations like electronic logging devices (ELDs) and economic conditions.

Gross: When it comes to rail carload pricing, the railroads are somewhat between a rock and a hard place. Normally, one might expect to see more aggressive pricing as a result of challenges in rail volumes. On the other hand, upward pressure on pricing is the result of the industry’s desire to maintain good financial results and low operating ratios.

The industry has limited ability to increase volume through pricing activity because most of the traffic moving in truck is not susceptible to conversion to rail carload no matter how it’s priced, due to service, location, lot size or a host of other considerations. Therefore, more aggressive pricing will only result in market share shifts between carriers, and that is typically a self-defeating exercise over the long run.

Because of that, I expect a steady-as-you-go approach to carload pricing that will be a continuation of the current trends. With regard to intermodal, there may be some room for upward movement, particularly as truckload capacity begins to tighten toward the end of the year due to ELD implementation.

LM: Is pricing where it needs to be in light of the major capital expenditure outlays made by the carriers?

Hatch: Pricing, of course, needs to continue to grow—along with share—to justify the big capex spent developing the domestic intermodal network—including corridors and gateways—and the high cost of service.

Rennicke: Capital spending for line capacity and for rolling stock was down last year and will be down further this year, although because of positive train control (PTC), overall capital spending remains relatively strong. Railroads have sufficient margins that they’re not cutting back on maintenance spending.

So yes, it seems that railroads are able to support their capital plans with current pricing. However, in the future, railroads can expect pricing gains to moderate as trucks continually improve their efficiency. Also growing market share will have to come at the expense of margins if railroads want to better penetrate shorter haul traffic markets.

Gross: We’re seeing some dialing back on capital expenditures, and this makes sense in a time of stable or declining volume. While it may prove difficult for the railroads to maintain their current, rather lofty margins on lower volumes, their economics should still be sufficient to continue to support the needed investments in the business as required.

LM: While the Trump administration is very much in its early innings, how do you view the current state of rail policy as it relates to things like the STB’s ongoing quest for reciprocal switching, the possibility of railroad re-regulation, and PTC?

Gross: I think the chances for significant re-regulation of the industry have diminished, but not vanished. The STB is a semi-autonomous agency that’s more capable of charting an independent course than the Federal Railroad Administration (FRA), which is a part of the executive branch. FRA efforts such as the two-person crew mandate are dead, but the PTC requirement is already enshrined in legislation and therefore is not subject to potential delay.

Rennicke: It’s difficult to speculate, but regulatory changes are likely to be a mixed bag. PTC implementation is probably too far along to be pulled back. The real funding challenges around PTC are more on the passenger side than on the freight side, and public pressure after some relatively high profile passenger accidents in the Northeastern U.S. will likely keep the pressure on for PTC implementation. We think reciprocal switching (EP-711) is too close to call, but not likely to be resolved this year, as filling vacancies on the STB tends to be a lower priority item for most incoming administrations.

Hatch: I don’t buy into the Trump infrastructure boost. Quite frankly, you have to show me the money. And remember, infrastructure in this case includes schools, hospitals, internet, etc. So, I continue to think that the North American rail network will grow its “infrastructure advantage,” perhaps aided by reduced “red tape” regulations and working with trucks to take share at good returns.

LM: What will the rail and intermodal markets look like five years from now?

Rennicke: The rail industry is at a crossroads due to technological innovation and disruptions in the energy and logistics businesses. Railroads and their suppliers must either begin to step up the pace of change in technology and service levels to evolve and become more aggressive and competitive in the marketplace, or they will begin a slow and inexorable decline.

To thrive, the industry needs to put a strong focus on getting back ahead of the technology curve instead of chasing it. This will take some new capex to pursue things such as integrating various technologies to get a driverless train, LNG as a locomotive fuel, and hybrid technology to improve raw fuel efficiency by capturing regenerative braking energy. Further, railroads seem a long ways away from booking systems, dynamic pricing, and managing data interfaces to boost capacity utilization, eliminate delays and disruptions at interchange points, and maximize margin capture.

Hatch: Intermodal makes so much sense from a shipper and public policy point of view, so I expect the next five years will be pretty good. I continue to think that the North American rail network will grow its “infrastructure advantage,” perhaps aided by reduced “red tape” regulations, and work with trucks to take share at good returns.

As for things that are concerning, there’s rail service improvements on a consistent basis; rail capex, where good returns will ensure positive reinvestment; and Trump and trade, not only the obvious parts related to NAFTA, but to any trade war’s impact on international container shipping, on agriculture, plastics and exports. Longer term? I don’t know if all of the talk on autonomous vehicle trucking means that “winter is coming,” but certainly the race is on for the rails to generate enough heat to stay hot over the long haul.

Gross: I think the industry will look much the same as it does today. The carload side will be under continuing volume pressure, and it would not surprise me if volume is lower five years from now than it is today. Coal still accounts for one in four rail carloads. Coal consumption will continue to decline no matter what the Trump administration does with regard to environmental regulations because the major issue is economics, not regulations.

There will be no change in the relative standing of coal vs. natural gas, which is currently driving conversion. It’s difficult to see where the industry will make up the carload volume that will be lost.

Intermodal will also not look much different, although I expect good growth that will likely exceed that of over-the-road trucking in most years. The big question mark is the timing of the introduction of autonomous or semi-autonomous trucks. When these begin to meaningfully enter the marketplace they will put severe pressure on intermodal because it’s likely they will trigger significant reductions in trucking rates.