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A rising tide
Things are looking up on the rails. After about a year of stability (that is, limited growth), carload volume began to move up in the second quarter of 2018. According to data from the Association of American Railroads (AAR), North American carloads (excluding intermodal) were up 2.2 percent in the first half of 2018, but this figure masks an acceleration. In the first quarter of 2018, carloads were up only 0.3 percent year over year, but in Q2, they rose a solid 4.2 percent. Volume increased sequentially from Q1 to Q2 by 5.4 percent. The gains were broad-based, with only three of the 20 commodity groups included in the AAR data showing year-over-year losses in Q2.
The timing of the surge tells us something about what is and isn't happening. First, what isn't: Most likely the improvement is not coming from highway freight converting to rail carload. Truck capacity began to tighten up in Q4 2017, as the federal mandate that most trucks must be equipped with an electronic logging device (ELD) approached, and then got extremely tight after the mandate took effect in December. This situation remained through the first quarter of this year and persists today. Yet the tightening truck capacity did not affect carload activity, which remained very quiet in the first quarter. These days, there is little freight that can easily move between truck and rail. Rather, each mode has developed its own distinct market, and structural barriers inhibit easy shifts between modes.
[Figure 1] Four-week avg. merchandise train speeds: Total network Enlarge this image
It's more likely that the improved rail carload picture in the second quarter represents an acceleration in the industrial economy. Gross domestic product (GDP) growth in Q1 was only 2 percent, roughly in line with prior performance over the course of the recovery. But all indications are that growth has moved up in Q2, and accelerating rail carload activity is one of the strands of evidence.
This growth in carload volume has been impressive given the continued decline in the use of coal for power generation despite the Trump administration's efforts to the contrary. (Coal has historically been the "bread and butter" of rail traffic.) The economic power of low-priced natural gas is simply too strong for coal generation to overcome. Coal carload activity in the first half of 2018 was unchanged from the prior year, mainly as a result of stronger coal exports offsetting for the moment the decline in utility coal.
The competition over operating ratio
The railroads continue to compete with each other to achieve the lowest operating ratio (OR), which is defined as expenses divided by revenue. A key method for driving down cost (and therefore improving OR) has been to lengthen trains, thereby increasing the number of cars and amount of freight handled by one crew. A critical tool in this effort has been the use of distributed power, in which unmanned locomotives located within or at the rear of the train are controlled remotely by the crew at the front of the train. Dispersing the locomotives reduces the forces generated within the train and also speeds up brake application, enabling the safe operation of much longer trains of 12,000 feet or more.
Another major recent influence on operating ratios has been the application of the concept of "precision scheduled railroading" (PSR) as promoted by the late E. Hunter Harrison, who was in the midst of implementing this operating philosophy on the CSX system at the time of his death after earlier stints at Canadian National and Canadian Pacific. While the PSR transformation involves lengthening trains, it also entails a wholesale revision of railroad operating plans, with reductions in yards, assets, and workforce in order to wring the maximum amount of efficiency out of the railroad infrastructure.
Cost reduction is only half of the operating ratio equation, however. The other means of reducing the operating ratio is raising revenue. In the absence of volume growth, this has meant continuing to raise rates at a pace exceeding that of the industry's cost inflation, a trend that has been in place for many years.
This transformation of operating practices, is not, however, evolving in a completely smooth manner. Train service has suffered. Figure 1 represents the four-week moving average of the composite merchandise train speeds of all the Class I railroads (except Canadian Pacific) as drawn from the weekly EP-274 reports the railroads make to the U.S. Surface Transportation Board. Merchandise trains are the mixed freight trains that carry the broad span of commodities handled by the railroads. The category excludes the unit trains of coal, oil, or grain, which are tracked separately, and excludes intermodal trains as well.
While average train speeds are a highly imperfect means of measuring service quality, they are useful indicators when the numbers move dramatically. Such is the case right now. Average merchandise train speeds have deteriorated substantially thus far this year, standing most recently at just 19.6 miles per hour (mph), down more than 5 percent from the same time last year and 8.7 percent lower than the average performance of the past five years. Much of the deterioration occurred during the first quarter in the absence of traffic growth, so while more volume may be contributing to the problem now, it certainly isn't the sole reason for the decline.
Intermodal: opportunities and challenges
There is a sector where rail and truck compete fiercely for market share, and that's domestic intermodal. Intermodal consists of two distinct market segments, each roughly equal in size. The international segment involves the inland movement of ISO (or international) containers from overseas. This segment mainly responds to international trade trends and port routing decisions by ocean carriers and shippers. The domestic segment covers the movements of domestic containers and trailers, and it responds to the competitive posture of intermodal vs. truck. The aforementioned shortage of truck capacity has provided intermodal with a golden opportunity to take freight off the highway. Indeed, domestic intermodal is growing briskly, with volume up 8.6 percent year over year for the first two months of Q2 2018. But earlier during the shortage, growth was restrained by a shortage of domestic containers. Intermodal carriers are now working to right-size their fleets to meet the current demand.
Meanwhile, the old stalwart "trailer on flat car" (TOFC) is helping to fill the gap. Intermodal movements of trailers were up over 17 percent year to date through May and over 21 percent quarter to date. TOFC strength is coming from three sources:
1) Movement of smaller trailers (primarily 28-foot "pups") filled with e-commerce-related cargo by parcel and less-than-truckload (LTL) carriers,
2) "Safety valve" movements by shippers who can't find a domestic container, and
3) Trailer moves by over-the-road truckers who don't own domestic containers but are using intermodal to handle load volume for which they otherwise can't find enough drivers.
There are, however, sources of concern regarding the sector's ability to handle the demand. Intermodal trains have not been immune from the rail network's general slowdown. The delays have caused trains to bunch up, which greatly impedes terminal productivity and slows equipment velocity. Drayage, the short-haul highway movement of intermodal equipment, has also been a major disruptor. Long-haul drayage carriers are subject to the new electronic logging device (ELD) requirement if their hauls exceed 115 miles from the intermodal ramp, but short-haul carriers are not. This has caused many carriers to migrate towards shorter hauls. The result has been a shortage in "long-haul" dray capacity for moves of around 200 miles from the intermodal ramps, and rates have been skyrocketing.
While Q2 typically marks the seasonal peak for truckload carriers, intermodal traffic usually peaks closer to the holidays with October typically being the busiest month. In a normal year, October domestic intermodal volume is typically about 7 percent higher than in May. With the system already showing signs of strain, there is real concern over its ability to handle the increased volumes to come.
For the balance of 2018, carload growth will likely be determined by the path of the economy. Will the presumably strong performance of the second quarter endure? Or will increasing interest rates, federal deficits, and possible trade disruption prove to be a drag that brings growth back down to previous levels? Meanwhile, the railroads will find it difficult to recruit the manpower they need to meet increasing demand with unemployment at very low levels, so service recovery may prove difficult. Meanwhile, intermodal will have all it can handle through the balance of this year as tight truck capacity will lead to robust demand. Intermodal's growth will only be limited by its ability to accept it.
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