8th Annual Rail/Intermodal Roundtable: Work in progress

The freight economy is enjoying a decent 2018, and the rail and intermodal sectors are no exception. Both sectors have seen annual volume and pricing gains on a year-to-date basis.

But it’s not all roses on the nation’s rails. The railroads have been dealing with service-side issues for the past several months, as well as carload volume declines in key commodity areas. And, there’s also concern on the regulatory side, with Positive Train Control (PTC) top of mind for service providers.

To help bring the current state of the nation’s rail and intermodal network into clear view, Logistics Management is joined by some of the nation’s foremost experts in the market.

Our panelists include:

Larry Gross, principal of Gross Transportation Consulting;

Tony Hatch, rail analyst and principal of ABH Consulting;

Bill Rennicke, partner at management consultancy Oliver Wyman;

Jason Kuehn, vice president at Oliver Wyman.

Logistics Management (LM): How would you define the current state of the rail carload market?

Larry Gross: Carload activity has been showing good annual gains since the beginning of the second quarter. At this point in time, carload volume, excluding intermodal, was up 4.6% annually for the first eight weeks of the third quarter—and the gains are broad-based.

Of the 20 commodities tracked by the Association of American Railroads, 16 are running ahead of last year. Only coke, coal, primary forest products and non-metallic minerals are lower than they were last year during this period. The five biggest growth contributors were grain, petroleum products, chemicals, motor vehicles and equipment and metals. With growth in this broad array of commodities, it appears that, as of now, the U.S. industrial economy is humming along.

Tony Hatch: The rail market is currently characterized by strong demand and ongoing issues of available capacity due in part to less than ideal levels of service. It’s sort of a chicken and egg thing. There are pockets of rail capacity shortages causing service issues, and there’s poor rail service (lower network velocity and higher terminal dwell) that’s reducing available capacity. It’s not a “crisis” by any means, but it’s an issue.

Bill Rennicke: The current U.S. carload—defined as non-intermodal traffic—market is strong, but not as robust as the economy. Growth in carload volumes for the first 35 weeks (through the end of August) was a modest 1.9% compared to the previous year. This is due to a shifting economy that increasingly favors consumer products over traditional industrial products that use carload rail. One railroad in each region seems to be growing faster than this pace, however, suggesting that it’s gaining market share either from the other railroad in the region or from trucking.

LM: Carload volumes look solid overall. How do things look for volumes over the remainder of 2018 and into 2019?

Hatch: Carload volumes look bright for the intermediate future—barring any worsening of a trade war or a sudden decline in the health of the overall economy. The secular stories in agriculture, energy, plastics and refined products to Mexico all should do well in almost any environment—providing we leave well enough alone.

Jason Kuehn: As was mentioned earlier, carload volumes have grown by 1.9% so far this year, and we think this pace can be maintained as long as the economy remains positive. We’re concerned, however, that the economic recovery since the last recession is growing long in the tooth and has been propped up by recent tax cuts. Larger concerns include continued economic expansion due to high levels of government deficit spending and growing trade tensions resulting from the Federal Government’s change in perspective and policy from globalist to nationalist. Such changes often result in recessionary economies.

Gross: I’ll add that because there’s little share shift that will occur between highway and rail carload, future trends will depend on the performance of the U.S. industrial economy in the coming months and what happens to certain key commodities over the same time frame. While I’m not an economist, as an analyst who has been observing the economy for a couple of generations, I have some real concerns over the longevity of the growth spurt that occurred in the second quarter.

Export growth was a key component, and some of that was undoubtedly volume racing to beat promised trade restrictions. A ballooning Federal deficit, rising interest rates and trade restrictions are all areas of concern. So I’m feeling pretty cautious.

Declining coal activity will continue to be a long-term drag on carloads no matter how many environmental regulations are repealed. Grain activity will depend on the harvest and could certainly take a hit from export restrictions. Crude-by-rail is looking good as is frac sand and export coal. So it’s a mix, but I’m more concerned than optimistic.

LM: Looking at intermodal volumes, both international and domestic are on solid footing in terms of growth. What are the key factors behind this growth?

Rennicke: Intermodal volumes are strong, averaging 6% growth year-to-date through the week ending August 25. This pace exceeds GDP growth and suggests a gain in market share for intermodal traffic. We believe that this is largely due to a shortage of truck drivers. Although the driver shortage has existed for years, it has been exacerbated by the implementation of electronic logging devices (ELDs) this year, which has reduced driver productivity and the distance driven by a truck in a driver day.

At the same time, truck rates have risen at a double-digit pace, capacity utilization is around 98%, and shippers are having difficulty finding trucking capacity. These trends have driven traffic—especially long-distance movements—to rail/intermodal. However, the intermodal market also has been capacity constrained of late, as evidenced by the growth in trailer versus container traffic.

Shippers are particularly constrained in the 400-mile to 800-mile market, where truck movements exceed one driver-day, but are not fully efficient for two driver-days—a market not well served by intermodal.

Gross: In the meantime, robust customer spending leading to strong retail sales has buoyed international intermodal growth. Import and export figures have been strong, but there’s a concern that at least some of the recent volume has been cargo that’s moving earlier than normal to beat possible tariff actions, or to allow for possible delays due to congestion and capacity concerns or some combination of all the above. To the extent that this is true, then some of the current strength will prove to have been borrowed from later months, resulting in a more subdued peak season.

Domestic growth is also extremely strong, as Bill mentioned. However, domestic growth is currently being limited by the capacity of the domestic container fleet, as demand is exceeding the fleet’s capacity to deliver. Evidence can be found in the very strong growth being seen in 53’ trailer-on-flat-car trailer movements, which don’t face the same capacity constraints, and which are acting as a safety valve for those seeking the intermodal option.

Hatch: International intermodal reflects strong consumer spending and perhaps the near-term win of the tax cut effect over the tariff impact. However, I’m not sure that’s sustainable at this pace. But it’s worth noting that big-box retailers—once the leaders of the pack, and now considered dinosaurs—did quite well this summer.

Domestic volumes were up almost 8% in the first six months based on IANA data—and for that you can thank the combined impacts of the strong, tax-cut fueled economy, the driver shortage, the positive impact of e-commerce and the ongoing secular trend favoring intermodal. That said, the 6% half-year growth rate of domestic containers is on-trend. And given the state of the truckload industry, it should have been well above trend, but the aforementioned service and capacity issues hampered that growth.

LM: The digital economy continues to introduce the need for smaller, faster shipments and more reliable service levels. That said, how does that make an impact on rail and intermodal operations?

Gross: With the possible exception of intermodal, there is not much interaction between rail freight and the digital economy. The rail industry continues to pursue economies of scale with increases in railcar capacity and the operation of fewer, longer trains. The focus is on cost reduction as a means of enhancing the operating ratio (OR), which remains the key metric by which railroad managements are being judged by Wall Street.

Hatch: It’s not clear yet, obviously, and those words—smaller, faster, more reliable—sound scary to anyone with three decades following rail. However, Amazon has a direct relationship with most if not all of the railroads. And the fastest growing unit within intermodal is the left-for-dead 28-foot pup trailer, which grew 23% annually in the second quarter.

Kuehn: In the near term, there appears to be plenty of traffic for all, and structural shifts in the economy are not adversely impacting intermodal traffic growth. UPS, FedEx Ground and Amazon Prime are all users of intermodal services, which suggests, at least for strong service lanes, that intermodal is being integrated into these newer supply chains. We remain concerned, however, that a significant recession could make a bigger impact on rail than on trucking, as trucking is still clearly the preferred modal choice of shippers for many movements.

LM: How do you view the current railroad service levels on a year-to-date basis?

Rennicke: Railroad service levels are generally marginally better than a year ago, but fairly stagnant overall. One carrier in each service region is generally experiencing service challenges. We don’t see this changing dramatically over the next year. Most railroads are cautious about investing in additional assets, due to a tight focus on shareholder returns and wariness about the future economic outlook. But short-term preoccupations with operating ratio may, in the long run, structurally harm service levels.

Gross: I’ll add that there’s a dearth of meaningful, publicly available statistics for measurement of rail service. The two available stats—average train speed and yard dwell—don’t really tell the customers what they need to know. They are equivalent to an airline telling passengers what the cruising speed of the airplanes are and how much time they are typically spending taxiing to and from the runway.

Interesting information, but not particularly useful when what I want to know is how long will it take me to get to a destination and how likely it is that the flight will be canceled or delayed. Having said that, to the limited extent that the available statistics convey information, the news is not good. Average merchandise train speeds have lately been running slightly below prior year—and almost 12% below the average for this season over the past five years.

LM: What is the outlook for rail carload pricing compared to the beginning of the year? Have things changed, or are they within—or meeting—expectations?

Kuehn: Railroad pricing for both carload and intermodal traffic is strong right now, and we expect in the near term to see continued strength due to tight capacity in both rail and trucking. Railroad revenues have generally grown at twice the rate of volumes this year. This strong pricing environment will likely continue until the next recession.

Hatch: Despite sub-par service, remember this is no “crisis.” Rails will get their so-called “rail-inflation plus” pricing, on the upper end of the +3% to 4% annual rate range.

Gross: Given a lack of long-term volume growth, there are two levers available to railroad management to lower the operating ratio: increased efficiency/cost reduction and price increases. Rail rates have generally been rising faster than the rate of inflation, and I don’t see any reason to expect this trend to change.

LM: Given the ongoing tight capacity and driver shortage issues that the truckload market is up against, have railroad carriers and IMCs been able to successfully take advantage of the situation? If not, why?

Hatch: Rail service does seem to be improving—maybe it’s too early to call a general inflection, but it seems to be so at CSX, CN, even NS. If so, there’s still some time before the inevitable slowdown. This isn’t just about making hay now; it’s about reputation with shippers, regulators and politicians that can help with secular share change.

Gross: I’ll add that intermodal has certainly benefited from these trucking issues. Pricing has been moving up rapidly in response to increases in trucking rates. Volume has grown, but the gains have been limited by the capacity of the domestic container fleet. When things began to tighten up late last year, there was little if any excess capacity in the fleet.

Subsequently, equipment has been flowing into the fleet over the course of this year, but some of this capacity has been lost due to lower equipment velocity stemming from various service and capacity issues including slower and late trains, terminal congestion and chassis/drayage shortages. The problem has been most acute with the rail-owned container fleet that has been further burdened by interchange frictions and the termination of steel-wheel interchange arrangements.

Rennicke: We believe that the industry will increasingly focus its equipment and service in higher-volume lanes to drive up equipment utilization and reduce costs. This will allow unit growth on the current base of equipment—which is not necessarily a bad thing. We would like to see intermodal become the primary or base mode of transport in these key lanes before the beginning of the next recession.

We also believe that there’s one potential pocket of capacity that has yet to be fully exploited: empty 40-foot and 45-foot international containers that could be used to move domestic freight. This would require railroads to offer differential pricing to make rates more comparable to 53-foot domestic boxes on a cubic capacity basis. This is an option that merits more examination as equipment capacity tightens.

Our expectation is that the rate of growth in intermodal will fall back next year against a stronger baseline for comparison, perhaps back down to the 3% to 4% range, barring a recession.

LM: How do you view the current state of rail policy as it relates to things like the NITL’s ongoing quest for reciprocal switching, the possibility of railroad re-regulation and PTC?

Gross: One of the hallmarks of the Trump Administration has been its aggressive rollback of a broad spectrum of Federal regulations. This will make for tough sledding for any re-regulatory efforts. Further, Congress is in an unprecedented state of dysfunction, even as the institution faces a raft of very significant issues including confirmation of a new Supreme Court justice, mid-term elections, the Russia collusion investigation and so on.

This will leave little oxygen available for dealing with “secondary” issues such as railroad regulation. The STB is a semi-independent agency and therefore it could act on its own with regard to the issues before it, but I see little sign of imminent action. The PTC situation is settled law and it will literally take an act of Congress to change the deadlines, which in my view is highly unlikely.

Kuehn: Currently the regulatory environment for the railroad industry appears to be stable, and we expect this to continue through the current presidency. This is probably the most favorable regulatory environment in the past 20 years. Most freight railroads are in reasonable shape in terms of PTC implementation and will qualify for extensions if they are unable to fully implement PTC by the end of this year.

Hatch: It’s important to point out that the undermanned STB isn’t questing for anything; but it is reviewing suggestions from the NITL and other trade associations looking to lever their position in an ongoing and historic economic battle. The STB doesn’t have opinions on this—or they shouldn’t, anyway. PTC is moving, perhaps a bit slowly, from the “unfunded mandate” to becoming the “backbone of the future digital railroad,” as NS stated at the RailTrends event last winter.

LM: What is on your wish list for gains and advancements in the railroad and intermodal sectors in the next few years?

Rennicke: Our first wish would be to see the railroads better understand that growth and service are not in opposition to operating ratio improvements. Cost cutting is wonderful if it’s focused on asset utilization and cycle time, but operating margins improve the most when revenue is increasing.

The industry still struggles with a focus on crew starts, which creates service issues. And because rail transportation is more complicated than trucking, especially on the intermodal side, there needs to be more listening, collaboration and data transparency among railroads, IMCs and shippers to improve asset utilization. To accomplish this, management of the day-to-day customer relationship should be pushed further down in the railroad organization, to where decisions on service are made.

Our second wish is for the industry to focus much more strongly on technology innovation and automation. If trucking can be automated, it should be even easier to do on railroads, which have fixed guide ways. The industry needs to at least keep on par with other modes in this area. Ideally, railroads would be leading the transportation sector, as they control and manage their own rights of way, unlike other modes.

Hatch: The rails need to fix the current service issue, but what they really need to do, and they seem to acknowledge this, is up their game in technology from a visibility and ease of doing business perspective. Autonomous trucks aren’t showing up anytime soon. However, with all of the Silicon Valley money out there, we need to be sounding the alarm—winter is coming.

Gross: I would like to see a more outward-looking focus on the part of the industry with increased emphasis on growing the business and arresting the long-term decline in rail carload market share. In 2006, the industry handled 21.7 million carloads, excluding intermodal. In 2017 the number was 18.4 million, a decline of more than 15%.

Over the same time period, dry van and reefer truckloads have increased by over 6%. Even allowing for higher capacity railcars, the industry has lost ground. Stabilizing market share will require fresh thinking with regard to the single car rail network as the task cannot be accomplished by unit trains alone.

On the intermodal side, substantial opportunities exist to gain intermodal volume in mid-range lengths of haul of between 1,000 miles to 2,000 miles. Penetrating this large potential market will require better interchange arrangements between carriers than currently exists.