“It’s no exaggeration to characterize railroads as the circulatory system of our economy,” Warren Buffett told investors in his annual Berkshire Hathaway (NYSE:BRK.A, BRK.B) shareholders letter last February. “Your railroad is the largest artery.”
The Oracle of Omaha is still bullish on rail freight, and with good reason. That $26 billion investment he made in Burlington Northern Santa Fe back in 2010 has been a winning move for Berkshire — the railroad made the company about one-fourth of its total profits for the first nine months of 2012.
Railroad stocks posted solid performance this year, with shares of Union Pacific (NYSE:UNP), Kansas City Southern (NYSE:KSU), Canadian Pacific (NYSE:CP) and Canadian National Railway (NYSE:CNI) all trading within 4% of their 52-week highs now.
Prospects are good for the freight rail recovery to stay on track next year. But there are some rough patches of track ahead, particularly declining coal shipments and the dreaded fiscal cliff. Here are six factors — three positive, three negative — that could affect railroad stock performance in 2013:
Rising petroleum product volume: Petroleum product shipments have been a bonanza for railroads in 2012, with volumes up a whopping 45.2% year to date. Credit the fracking-fueled shale oil boom, which the Energy Information Agency (EIA) says will drive explosive growth in domestic oil.
Freight rail is playing a larger role in transporting petroleum, particularly from the resource-rich Bakken shale formation in North Dakota. Growth should continue in 2013 because of limited pipeline infrastructure; new delays on the Keystone XL pipeline should boost the fortunes of railroads.
Intermodal growth: Intermodal freight — shipped in containers or trailers that can be handled by rail, ship or truck — is rising. Railroads’ intermodal container volume rose 5.4% through Dec. 1, offsetting lower shipments of commodities like coal and grain.
Railroads are gaining ground in intermodal at the expense of trucking companies, a trend that likely will continue into 2013, in part due to tight trucking capacity. The Great Recession took some 1,800 trucking companies off the road.
Rising auto shipments: With automakers driving back to pre-recession sales volume in 2012, they’re on track to ship some 15 million vehicles this year. And a growing share of those cars and light trucks is moving by rail.
Fuel efficiency is one reason, since a train can move a ton of freight more than 480 miles on a single gallon of diesel. Freight railroads’ motor vehicle and auto parts volumes are up 16.7% year-to-date.
‘King Coal’s’ tarnished crown: Coal is the single most important commodity for freight railroads, accounting for a whopping 43.3% of rail tonnage and nearly one-fourth of railroads’ gross revenue in 2011, according to the Association of American Railroads. So far this year, coal volumes are down 10.5% as King Coal loses ground to cheap natural gas.
Railroads could suffer more if the EPA’s first-ever carbon-pollution standard — which basically bans new coal-fired power plants — is adopted as expected in 2013. Railroads would need to boost other cargo to take up the slack.
Cuts to government grants: Even if lawmakers avoid the fiscal cliff, count on federal government infrastructure grants to be on the list of spending cuts. States, which also contribute to rail infrastructure improvements, will be forced to further tighten their belts too.
Back in June, railroads won a big share of the Transportation Department’s $500 million in Transportation Investment Generating Economic Recovery (TIGER) program infrastructure grants. Given more urgent spending priorities, don’t expect to see this TIGER burning bright in 2013.
Short lines could get short shrift: While most large Class I railroads should weather the industry’s headwinds next year, short-line railroad operators like Genesee & Wyoming (NYSE:GWR) and Providence and Worcester (NASDAQ:PWX) could feel the pinch if a key tax benefit is not included in whatever tax extensions lawmakers finally agree on.
The Section 45G tax benefit gives smaller railroads a credit of 50 cents for every dollar they spend beefing up their tracks and other infrastructure, capped by mileage. The tax credit expired last year, but the Senate Finance Committee voted to extend it retroactively to Jan. 1, 2012. Final action on 45G, however, awaits the same fate as broader tax break extensions.
Warren Buffett thinks of “forever” when deciding how long to hold a stock. When it comes to having and holding economic bellwethers like freight railroads, you could wind up poorer rather than richer if the economy goes south in a big way.
That said, the railroad sector boasts attractive valuations now and most stocks pay at least a nominal dividend (NSC and CSX are at the top of the class with current yields of 3.2% and 2.8%, respectively). If you’re contemplating a new position in these stocks, watch the economy and coal shipments — those are the big drivers for 2013 … and the foreseeable future.
As of this writing, Susan J. Aluise did not hold a position in any of the aforementioned stocks.