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A year of transition
For the North American freight rail system, 2019 has, thus far, been a year of mixed signals. Railroads are recording record profitability, and operating ratios (operating expenses as a percent of net revenue) were lower than ever in Q2. Yet during the second quarter, carload volume was down 1.6% year-over-year even as U.S. gross domestic product (GDP) grew by 2.1%. Why did this significant shortfall in rail carloads occur, and what does this mean for the industry's future?
One reason for the seeming discrepancy is that the industry is in the midst of change, and the effects are being felt across the system. Of the seven U.S./Canadian large Class I railroads, all but one (BNSF) have initiated or completed the transition to a new operating philosophy known as "Precision Scheduled Railroading" or PSR. What exactly is PSR? There is no precise definition, but in general PSR, as pioneered by the late Hunter Harrison, includes a streamlining of railroad operations while at the same time working to increase their consistency and reliability. These operational changes may include efforts to reduce the sorting of railcars, create longer trains, make cost and headcount reductions, and increase asset utilization.
[Figure1] Single-car volume for selected commodities Enlarge this image
One of the core concepts of PSR is a relentless focus on identifying those markets that play to the railroads' strengths. Freight that introduces too much complexity and requires too many "touches" on the journey from origin to destination is viewed as undesirable. As this undesirable volume is shed, the operation will become simpler, and speed and consistency theoretically will improve.
The adoption of PSR has incontrovertibly led to improved financial performance for the rail industry. But, in the near term, it has also led to lower volumes in spite of a growing economy. PSR advocates maintain that this traffic loss is a necessary prerequisite for tuning up the rail network and that the process is setting the stage for future growth as the quality of rail service improves. Detractors claim that PSR is actually just a short-term cost-cutting exercise being driven by and for the railroads' investors at the expense of long-term volume and growth. Who's right? We won't know for quite some time.
The transition to PSR has not always gone smoothly. Some railroads opted for a "big bang" approach that attempted to compress the changes into a short period of time. Service disruptions led to shipper dissatisfaction, which in turn got the attention of the U.S. Congress and the Surface Transportation Board. More recently, railroads making the transition to PSR have adopted a more measured pace which has reduced, but not eliminated, such issues. While the situation has improved somewhat this year, there is still a long way to go to fulfill the promise of "precision railroading."
But in fairness, looking only at the broad system averages for service obscures signs of real progress on the part of some PSR adopters. The system average speed for "merchandise" trains (those trains carrying general classified freight that pass through yards) stands at roughly 20.4 mph at the time of this writing (mid-year). This speed is more than 3% better than the prior year, although 3.4% lower than the average performance over the previous five years. Perhaps a better measure of progress is "yard dwell"—the average time that railcars spend in a yard waiting to be placed on the next outbound train toward their destination. In 2019, yard dwell is running about 10% below the prior year and the long-term average. This metric indicates that service has improved, as railcars are spending less time sitting in yards and more time on the move.
Larger economic issues at play
Before concluding that PSR is the leading cause of the reduction in volume, however, it is important to consider other factors that could be affecting rail volume. A good deal of railroad carload volume is made up of key commodities. Whether the volume of these commodities is rising or falling often depends on macroeconomic factors well outside the control of the railroads. To determine the true effect of PSR on rail performance, the effect of these commodities must also be taken into account.
For example, coal has continued to decline due to broad competition from natural gas and renewables, despite the Trump Administration's attempts to prop up the industry. Conversely, movements of crude oil by rail (CBR) have recently been growing strongly as world oil prices have shifted (at least for now) in favor of U.S. sources. However, despite increasing U.S. oil production, shipments of frac sand (a growth star in recent years) have recently declined, as drillers have shifted more toward the use of locally sourced, inexpensive "brown sand" versus the gold standard "white sand" that needs to be railed long distances from mines in the upper Midwest to drilling sites such as the Permian Basin of Texas. Shipments of grain are also down due to both weather and trade tensions.
Taking these volatile commodities out of the equation gives us a better idea of railroad performance in the single-car freight network that is a major focus of PSR. (See Figure 1.) Volume for the remaining commodities through the first half of 2019 was down 1.2% year-over-year. Performance in Q2 was similar but slightly weaker at -1.5% year-over-year. At the same time, Q2 GDP growth has been estimated at 2.1% according to the initial estimate. So even after eliminating the special commodities, rail carload growth continues to lag that of the economy as a whole.
But there are other items to consider as well. While GDP is growing, 70% of U.S. GDP lies in the service sector. The goods sector, which provides all the volume to the nation's freight haulers, has probably not been growing as strongly as the GDP numbers would indicate. Yet, truck volume has continued to show gains, while rail has not. There are good indications then that rail has been losing share to highway and not due to an overall economic slowdown.
Rail's primary point of competition with highway is the intermodal sector. This sector has also been the recipient of the PSR philosophy. Most railroads have simplified their intermodal networks and eliminated many city-pairs. For example, "steel-wheel" interchange services between connecting railroads have been eliminated in key junction points such as Chicago. Users have instead had to switch to what is known as "rubber-tire" interchanges, where the inbound intermodal load is grounded on one side of town and driven across the city to the connecting railroad's terminal to resume the intermodal journey. Trailer-on-flat-car (TOFC) services have also been reduced as the industry strives to standardize operations on international and domestic containers.
The intermodal business is composed of two equal-size sectors: international and domestic. The International sector involves the movement of ISO containers to and from ports. This segment has been subjected to dramatic push-pull effects as the ongoing international trade tensions and tariffs have altered the normal timing of when import freight hits our shores. While this has not yet affected overall volume, it has distorted the year-over-year comparisons and caused a great deal of congestion and added costs.
The domestic sector consists of 53-foot containers and trailers moving primarily domestic freight along with some transloaded import cargo. This sector is the cutting edge of the competition between rail and highway. Through June of 2019, year-to-date domestic intermodal volume was down a full 6.0% versus 2018. This decline is comprised of a drop of more than 10% in TOFC volume and, more importantly, an unusual 5.2% decline in domestic container activity. The decline in TOFC loads is not surprising because 2018 was an especially strong year for this segment, as the shortage of truck drivers and tight capacity pushed some shippers to shift part of their volume to rail. The TOFC segment is also a rather small piece of the intermodal pie these days. The decline in domestic containers, however, is more significant in that all indications are that truck traffic has continued to rise thus far this year. Hence domestic intermodal appears to be losing share.
At least some of the volume decline is the calculated result of railroad companies "de-marketing" services and lanes that are now regarded as too complex and high cost to achieve the desired level of profitability. Again, PSR advocates argue that shedding less desirable volume will allow the railroads to focus on improving service speed and reliability across the remaining core system. These service improvements will theoretically lead to greater market penetration in desirable freight categories that will, in time, meet or exceed the current volume lost to these actions.
A focus on profitability
Inherent in the PSR revolution is a relentless focus on the railroad operating ratio as one of the most significant measures of efficiency and profitability. The railroad operating ratio is a function of both costs and revenue. While the PSR revolution is focusing on operations and costs in the near term, another facet of current railroad financial performance is what the industry terms "focused pricing discipline." In practice this has meant that the rates that the railroads have received for their services have generally exceeded the rate of inflation in rail cost inputs. Even as economic growth slows, railroads are displaying a strong desire to maintain and even drive pricing, especially in the domestic intermodal arena.
It seems clear that the railroad industry's focus in the near term will be on profitability and not volume. History says that such swings of the pendulum are often followed by a return to more "normal" volume-driven behavior, including more pricing flexibility. Whether that will happen this time around is a question that we will be able to be answer with greater clarity in another year or two.
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