The freight railroad industry, like other industries, faces certain external and internal challenges. In addition to being an extremely mature industry, railroads are capital intensive, requiring operators to always have access to capital markets. Further, the cyclical nature of business makes it susceptible to macroeconomic changes and hurts growth during economic downturns.

Below, we discuss a few key factors which investors should take into consideration when investing in the railroads stocks:

Oil Price Decline: High oil prices in recent years have been a big contributor to the rail industry’s cost advantage relative to other transportation modes like trucking. This advantage remains at risk of getting eroded if oil prices remain low for an extended period.

Oil prices have an impact on the industry’s prospects more directly as well -- railroads have been a source of crude oil transportation from the new shale basins of the U.S. and Canada, limiting the need for pipeline capacity from these regions. The drop in oil prices likely wouldn’t have any negative impact on transportation volumes at this stage.

But if prices remain low for an extended period, it will have a bearing production from these shale basins, which will result in lower rail-based crude oil shipments.

Capital Intensive Nature: The railroad industry is highly capital intensive that requires continued infrastructural improvements and acquisition of capital assets. Moreover, industry players access the credit markets for funds from time to time. Adverse conditions in credit markets could increase overhead costs associated with issuing debt, and may limit the companies’ ability to sell debt securities on favorable terms.

Positive Train Control Mandate: The Rail Safety Improvement Act 2008 (RSIA) has mandated the installation of PTC (Positive Train Control) by Dec 31, 2015 on main lines that carry certain hazardous materials and on lines that involve passenger operations. The Federal Railroad Administration (FRA) issued its final rule in Jan 2010, on the design, operational requirements and implementation of the new technology. The final rule is expected to impose significant new costs for the rail industry at large.

Price Regulations: The pricing practices of U.S. freight railroads comprise the major reason of friction with captive shippers, who move their products through rail and do not have effective alternatives. According to the latest studies by the STB, approximately 35% of the annual freight rail is captive to a single railroad, allowing it monopoly pricing practices.

The unfair pricing power exhibited by the U.S. railroads has prompted intervention by Congress. The latter intends to implement stringent federal regulations on railroads. So far, the Congress has discussed railroad price regulation but has not passed any new rule yet.

U.S. Environmental Protection Agency: Railroad companies remain concerned about the proposed regulation by the U.S. Environmental Protection Agency (EPA) for power plants across 27 states. The proposed guideline –– Carbon Pollution Standard for New Power Plants –– aims at restricting emission of carbon dioxide by new power plants under Section 111 of the Clean Air Act. The standard proposes new power plants to limit their carbon-dioxide emission to 1,000 pounds per megawatt-hour.

Power plants fueled by natural gas have already met these standards but the majority of the units using conventional resources like coal are exceeding the set limit, as they emit an average of 1,800 pounds of carbon dioxide per megawatt-hour. Railroads, which transport nearly two-thirds of the coal shipment, are most likely to be affected by implementation of the new regulation that could pose a significant threat to utility coal tonnage.

Coal

Reduced electricity generation from coal turned into a major concern for rail freight carriers. Class I railroads originated 6.2 million coal carloads in 2012, the lowest annual total output since 1993. Coal carloads fell below 6 million in 2013, approximately 4.4% down from 2012 levels according to Association of American Railroads (AAR) reports. The decline in coal carloads offset the positive impact of gains from crude oil for the U.S. railroads.

Fraught with issues raised by the regulatory environmental agency, decreasing demand from power plants for electricity generation and the shutdown of coal-fired power plants, there are slim chances for railroads to benefit from this commodity segment, which continues to contribute a large part of railroad tonnage.
 

Bottom Line

As is evident from the above discussions, the railroad industry faces a number of headwinds. While companies like CSX Corp. (CSX - Analyst Report), Kansas City Southern (KSU - Analyst Report), Canadian National Railway Co. (CNI - Analyst Report) and Norfolk Southern Corp. (NSC - Analyst Report) have shown earnings growth over the first nine months of 2014, our stance on them remains cautious given these factors. Hence, we have a Zacks Rank #3 (Hold) rating on these stocks.

>> Continue to Part 2: Is It The Right Time To Add Railroad Stocks To Your Portfolio?