Freight Railroads Take a Hit From the EPA

Old “King Coal” is anything but a �merry old soul� these days thanks to the EPA�s first-ever carbon-pollution standard for new electric plants. The rule, which effectively would ban construction of all new coal-fired power plants, could have an unintended victim: freight railroads, which haul the lion�s share of the nation’s coal.

The EPA�s proposed rule is a big deal because coal accounts for 40% of the volume of freight railroads such as Union Pacific (NYSE:UNP), CSX (NYSE:CSX), Norfolk Southern (NYSE:NSC), Kansas City Southern (NYSE:KSU) and Berkshire Hathaway�s (NYSE:BRK.A) Burlington Northern Santa Fe.

Coal�s flagging fortunes were the elephant in the room when CSX and UNP reported first-quarter earnings this week. Higher rates and strong intermodal growth drove CSX earnings up 14%; its $449 million (43 cents a share) beat the Street�s 38-cent estimate and eclipsed last year�s 35 cents. The railroad�s nearly $3 billion revenue also was higher than expected.

But CSX� coal volumes were down 14% in the quarter; the railroad had to increase coal rates 10% to make up for the lower volume.

It was a similar story at Union Pacific, which reported first-quarter earnings growth of 35% on Thursday. UNP beat analysts� estimates on both the top and bottom lines, with a profit of $863 million ($1.79 a share) on revenue of $5.1 billion. Wall Street expected earnings of $1.63 a share on revenue of $4.9 billion. UNP�s 25% growth in automotive and industrial-product shipments offset declines in coal loads.

Softening coal demand has played out in UNP�s weekly coal-car loadings, said Eric Butler, executive vice president of marketing and sales, at UNP�s conference call with analysts. �The volume shortfall [was] growing as the quarter progressed, coming down 19% in March,� he said.

Despite the stellar earnings, investors punished rail stocks on Thursday. Union Pacific shares fell 4.1% on higher-than-average trading volume. CSX and KSU fell nearly 3%, and Norfolk Southern slipped 1.5%.

Because natural-gas prices are so low, coal volumes have declined as power plants switch from coal to natural gas. In its most recent weekly rail-traffic report, the Association of American Railroads said total carloads were down 6.4% compared with the same week last year. Coal slipped more than 18%, second only to non-grain farm products, which fell 28%.

The proposed carbon-pollution standard calls for radical reductions in CO2 emissions at all new energy plants — a standard that natural-gas plants have attained, but even the most advanced “clean-coal” plants can�t meet.

Coal companies do see a light at the end of the tunnel — and it�s not an oncoming train. Coal use is still growing in emerging markets, particularly in China. Growth in coal exports could help railroads, since the easiest way to move coal to coastal terminals for export overseas is by rail.

The bottom line: Eventually, King Coal will be forced to yield his throne to more environmentally friendly energy sources, at least in the U.S. While an increase in coal exports will help railroads in the short term, future success will lie in reducing their reliance on coal and replacing lost volumes with petroleum products or intermodal traffic.

Ironically, railroads� biggest new opportunity might well be the usurper that�s killing coal: natural gas. So-called �frac sand� is essential to the process of extracting natural gas from shale deposits through hydraulic fracturing.

Frac sand is mined in quarries — mostly in the Midwest — and shipped by rail. But if the rail industry wants to maximize the frac-sand opportunity, it may need to extend its lines nearer to quarries. BNSF and Canadian Pacific (NYSE:CP) already are growing this business at the Baaken Shale play in Montana.

I expect rail stocks to experience short-term challenges from the loss of coal volume, but they’re adjusting their business models accordingly. There�s good news, too: Intermodal traffic continues to rise, non-coal volumes are up as manufacturing strengthens and railroads� economics are better than those of the trucking industry.

Also, the EPA�s proposed rule doesn’t affect �shovel-ready� coal plants that can break ground within the next year — potentially providing the impetus for coal plants to fast-track new construction.

I like UNP and CSX, particularly since current dividend yields are above 2%. And Thursday�s sell-off might set the stage for bargain hunters.

As of this writing, Susan J. Aluise did not hold a position in any of the stocks named here.