Last year in these pages, we predicted a difficult 2015 for the railroads followed by a somewhat easier 2016. While the first half of that prediction came true, we couldn't have been more wrong with regard to our expectations for 2016. Far from posting modest gains, traffic plunged during the first half of the year. Dramatic declines have occurred in the mainstay movements of coal, and crude oil shipped by rail, a previous growth superstar, has seen its luster dim under the pressure of declining oil prices and the tightening of the price differential between imported and domestic crude oil. Most other rail carload commodities have also suffered under the weight of weakness in the U.S. industrial sector, global overcapacity, and the strong dollar. Meanwhile, the railroads' competitive "ace in the hole," intermodal, has also encountered substantial headwinds thus far in 2016.
In short, the railroads are suffering from what might be considered a "perfect storm" of adverse conditions. The key question is, how much of the current difficulty is the result of transitory factors, and how much of the change is permanent? What does the future hold, and what must the industry do to meet those challenges?
Volumes decline across the board
Through the first half of 2016, North American rail carloads were down 11.5 percent year-on-year, a decline of over 1.1 million. Of the 20 rail carload commodity groups, eight recorded year-on-year gains, accounting for an increase of fewer than 100,000 cars. Most impressive of this group was motor vehicles and equipment, which increased 8.6 percent (39,500 carloads) over an already strong 2015 performance. Part of this increase was fueled by higher automotive sales, while a portion was due to consumer sentiment shifting toward larger sport utility vehicles (SUVs) and trucks, which must be carried in bi-level cars with two-thirds the unit capacity of the tri-level cars used for sedans and other conventional passenger vehicles.
The remaining 12 commodity categories fell short of the prior year by 1.2 million carloads. Coal accounted for over 800,000 of that shortfall (down 26.5 percent year-on-year), as low-priced natural gas aided by tightening environmental regulations continued to displace coal-fired electric power generation, and the strong U.S. dollar hindered coal exports. But volume has been improving, with the most recent four-week moving average (at the time of this writing) at 94,000 loads per week versus 68,000 at the trough.
Among other commodities that substantially contributed to the shortfall, metals, metal products, and metal ores stand out. This category saw a decline of 155,000 units as global overcapacity, particularly in China, put pressure on domestic supplies. Petroleum products, which came in 109,000 cars lower this year, reflected the headwinds from reduced crude oil production and the substitution of imported crude versus domestic by East Coast refiners.
Meanwhile, intermodal was also suffering. Through the end of the first half of 2016, intermodal containers and trailers were down 2.3 percent year-on-year. This was much better than the carload side, but since the railroads have become accustomed to a growing intermodal sector, it nevertheless was a jolt. There are multiple causes for the weakness, including the shift of import cargo from the West Coast to the less intermodal-friendly East Coast; lower, more competitive truck rates due to ample capacity; and lower fuel prices.
Fundamental changes underway
In the near term, barring an economic downturn (which could well happen given various international concerns and the turbulent domestic political situation) we do expect things to improve. That portion of the current carload shortfall that stems from cyclical economic factors, primarily weakness in the industrial sector, will eventually self-correct. Coal will stabilize, at least for the time being, although at exactly what level is hard to predict. Intermodal, after a lackluster 2016, will look better next year when truck capacity tightens due to implementation of federal requirements for electronic logging devices (ELDs) and other regulatory developments. But issues like the reduction in shipments of coal, crude oil, and fracking sand will remain. How will the shortfall be addressed?
This is not the first time the rail industry has faced such challenges. During the deregulated era, the railroads have achieved unprecedented financial success through operational excellence, cost cutting, economies of scale, being more selective in the business they handle, and raising rates faster than the rate of inflation. But, with the important exception of intermodal, they have not grown volume.
As compared to the peak carload year of 2006, the major rails originated over 3 million fewer non-intermodal carloads in 2015—and that was before this year's difficulties. (See Figure 1.) About 2 million of those missing cars were coal, but deficits can also be seen in all but four of the 20 Association of American Railroads (AAR) carload commodities, and only petroleum products (that is, crude oil by rail) has showed significant gains. (See Figure 2.) Total rail ton-miles have declined by 0.7 percent per year over the last 10 years, while truck ton-miles have grown by 0.8 percent per year. Rail carload has not been gaining share versus highway transportation; rather, it has been losing share.
The rail industry's challenges will continue as fundamental forces currently underway in the North American economy dramatically remake the freight transportation landscape. Macro forces are moving the economy in a direction where transport providers will be asked to provide more reliable, consistent, and faster service for generally smaller shipments moving shorter lengths of haul. Meanwhile, the rail industry has been moving in exactly the opposite direction, utilizing radio-controlled, distributed locomotive-power techniques to put together larger, less-frequent trains composed of larger, higher-capacity cars. The bigger trains generate more yard dwell time and greater variability in delivery because a missed connection means a longer wait for the next departure than in the past. The larger, heavier cars demand that even single-car shippers commit to multiple truckloads' worth of product moving to a single consignee. And where possible, the industry prefers that the customer tender the freight in vast unit-train quantities. Moreover, average length of haul has been increasing. In short, the rail industry is heading one way and the general economy is heading in another.
But that's only part of the picture, because the competition is not standing still. Although the trucking industry will likely go through a period of very tight capacity in the 2017-2018 time frame due to a shortage of drivers, the shortage will not persist in the long term. Giant strides are being made in autonomous trucks, and once these become commonplace (as they undoubtedly will, and sooner than one might think) trucking capacity will become relatively abundant and truck rates will decline precipitously. So the playing field is going to get much tougher for railroads as we move into the 2020s.
Consistency is everything
Where will the volume come from to replace what has recently been lost? Certainly intermodal is one place, but it can't do it alone. The industry also can't count on the creation of another unit-train market like crude-by-rail. Those things come along once in a generation. For sustainable rail volume, it all comes down to the traditional, single-car network.
The problem is that the single-car network currently delivers a transportation product that is really not truck-competitive. The core issue is lack of consistency. Shippers will accept a slow service provided it is properly priced. But what they won't accept is the tremendous variability in delivery time that is typical of today's carload network. Truck variance is measured in minutes and hours, while rail carload variance is measured in terms of days and weeks.
For shippers to convert from truck to rail, they need to have a clear commitment from the railroad on how long a shipment will take—and assurance that the commitment will be met. It's not how fast the car gets there, it's whether it gets there when it's supposed to. The railroad can't just price around the problem, because for most truckload shippers, a service in which delivery can occur any time within an extended period is unsuitable at any price. With that said, price is also an issue, as the railroads will need to convince customers that they have both a viable service model and a sustainable economic proposition.
What's needed is a "clean sheet" approach. Everything must be on the table, including technology, labor relations, operations, network design, pricing, and accounting. Today, the single-carload system delivers inconsistent service and inadequate asset turns while demanding ever-higher prices, prompting shippers with modal choices to avoid rail and leaving shippers without modal choices in a distinctly uncompetitive position. The railroads need to turn the carload system into a precision network that delivers reliable service and better utilization of expensive railcar assets.
The railroads stand at an important crossroads. Volume growth is the lifeblood of any organization. But for the railroads to grow their top line, they will need to create a single-car freight service that can truly compete with over-the-road truck.