Sorry Warren Buffett: Things Just Went From Bad To Worse For U.S. Railroads

Back in November 2009, knowing he had both the inside track and the final decision on US energy policy under his crony president Obama, Warren Buffett acquired the 77% of the Burlington Northern (aka BNSF) Railroad he did not own for one simple reason: realizing he could pressure the "progressive president" Obama to curb all pipeline progress, confirmed recently with the terminal failure of TransCanada's Keystone XL pipeline, Buffett would be ahead of everyone by controlling one of the key actors among "the New US Petroleum Pipelines." The "pipelines" in question were shown in the following chart from our March 2013 post.

 

And while Buffett's strategy worked great for many years, certainly as long as oil was rising and above $100, over the past year, things went downhill fast. Nowhere, was this more visible than in a one year chart of transports, which have crashed over the past several months entering their first bear market since 2008 in late December.

 

While all transportation components contributed to this plunge, rails were the biggest culprit. To be sure slumping railroad traffic was something we have covered extensively in the past year - together with ocean freight, together with trucks - and most recently covered it on January 3 in "What Rail Traffic Tells Us About The U.S. Economy." The short answer: bad things.

But while we were quite concerned about the implications of plunging railroad traffic, others ignored it, claiming as they always do, that "it is only coal, or only oil, or only [insert commodity related factor]".

However, a Bank of America report issued on January 6 revealed that the decline in rails was much more widespread than just "it's only X." This is what BofA's Ken Hoexter said in a report titled "Carloads flashing a warning signal; lower 4Q estimates again"

Longest and deepest carload decline since 2009

 

We believe rail data may be signaling a warning for the broader economy. Carloads have declined more than 5% in each of the past 11 weeks on a year-over-year basis. While one-off volume declines occur occasionally, they are generally followed by a recovery shortly thereafter. The current period of substantial and sustained weakness, including last week’s -10.1% decline, has not occurred since 2009. In looking at carload data going back nearly 30 years, similar periods of weakness have occurred in only five other instances since 1985: (1) the majority of 1988, (2) the first half of 1991, (3) several weeks in early 1996, (4) late 2000 and early 2001, and (5) late 2008 and the majority of 2009. We exclude the period in 1996 from our analysis, as we consider it anomalous given that it overlapped with harsh winter conditions and was limited to January and early February of that year. Of the remaining instances, all either overlapped with a recession, or preceded a recession by a few quarters. The current period starting in October and continuing through the present has been accompanied by weak ISM results, with the purchasing managers index recently falling to 48.2 in December from 48.6 in November (a reading below 50 suggests contraction), and our proprietary BofAML Truck Shipper Indicator recently falling to its lowest level since 2012.

Here is a rather troubling finding from BofA: the manufacturing recession has spilled over from purely the industrial sector and into "other, more consumer-oriented segments." In other words, the service recession is imminent.

Weakness no longer limited to industrials or coal

 

For much of 2015, it was easy to dismiss weakness in carloads as being concentrated in industrial segments, and reflective of a secular shift away from coal. More recently, the softness has spread to other, more consumer-oriented segments. Intermodal carloads, which were up +1.0% and +3.6% in 1Q15 and 2Q15, respectively, posted a tepid +0.9% gain in 3Q15 and were down -1.7% in 4Q15. This follows the broader trend in 2015 of carloads accelerating to the downside through the year. Until recently, the difficult comparison year of 2014 was another reason to be dismissive of the decline percentages. Despite soft year-over-year results, absolute carloads remained above the 2010-2013 levels through the first 3 quarters of 2015. However, in 4Q15, volume is at its lowest level since 2010. BofAML Multi-Industrials analyst Andrew Obin recently noted that industrial weakness has not always been coupled with severe GDP declines, despite the high correlation between the two (86% correlation coefficient). However, as non-industrial segments post declining carload volumes, we are increasingly concerned with the breadth of the weakness.

 

All of the above is very bad news for the US economy of which railroad traffic is just one of the proxies, but isn't necessarily bad for Warren Buffett's major gamble on the "new pipelines."

This is.

According to a report in the FT, "the amount of oil hauled on US railways has declined steeply in the past year as refineries swallow more foreign supplies in the face of falling domestic crude output."

From a peak in January 2015 to last October, movements of crude by rail declined more than a fifth, the latest data from the US energy department show. Genscape, a research group, said rail deliveries to US Atlantic coast terminals continued to drop to the end of the year and the spot market for crude delivered by rail from North Dakota’s Bakken region “is at a near standstill”.

 

Once seen as a 19th century relic, moving crude oil by train re-emerged as a hot technology five years ago as surging output from long-neglected shale oil regions overwhelmed pipeline capacity. Investors from oil companies to Wall Street banks clamoured for tank cars, while fiery accidents prompted federal regulators to impose more stringent standards on rolling stock.

And Buffett was there to provide the needed cars, for a generous fee of course, while doing everything in his power (it's a lot) to delay implementations of stringent, or even any standards, on "rolling stock." Here are some highlights of the outcome:

And so on. However, the following brief blurb in the FT article reveals that the time to pay the Piper has finally arrived.

Tank cars, once feverishly ordered during the US shale boom, are sitting on sidings. Lessors are obtaining car rents 20-30 per cent below early 2015 — “if you’re lucky enough to keep your car in service”, said James Husband of RailSolutions, a consultancy.

This means that the rail industry is about to be slammed with a dramatic repricing, one which is only the start and the longer oil prices remain at these depressed levels, the lower the rents will drop (think Baltic Dry but on land), until soon most rails will lose money on every trip and will follow the shale companies into a race to the bottom, where "they make up for its with volume." After all, those billions in debt interest payments won't pay themselves, meaning doughnuts for equity holders like folksy uncle Warren.

Then again, we are confident that in the end, the Avuncular Octogenarian of Omaha will find a way to avoid being on the receiving end of yet another bad decision, courtesy of two things: this...

... and this.