As we approach the final stretch of 2024, the rail industry is at a critical juncture, facing a convergence of long-standing challenges and emerging opportunities.
In recent years, the rail industry's story has been one of persistent headwinds: financial pressures, labor shortages, and heightened safety concerns following the East Palestine, Ohio, derailment, to name just a few. The shadows cast by these difficulties continue to loom large. These challenges, however, are symptoms of deeper, structural issues that have plagued the industry for over a decade.
Since the late 2000s, aggregate rail volumes have remained stubbornly stagnant. The initial gains from Precision Scheduled Railroading (PSR), once hailed as a revolutionary approach to operational efficiency, have largely been exhausted. The industry now grapples with this model's limitations, searching for new avenues to drive growth and profitability.
This pivotal moment demands a nuanced understanding of the sector's current state and potential trajectories.
The weight of history
In many ways, the root of today’s rail industry dilemma lies with coal. Coal was first used to generate electricity in the United States in 1882, and coal production, power plants, and railroads all grew together. In the 1970s, the development of the vast coal deposits of the Powder River Basin in Montana and Wyoming and their proximity to major rail lines fueled a massive nationwide railroad infrastructure investment cycle that lasted a decade. It was truly a bonanza.
In the early 2000s, however, advancements in hydraulic fracking and horizontal drilling led to a surge in natural gas production. As its prices fell, natural gas grew to be a titan competitor of coal for electricity generation. The impact of inexpensive and abundant natural gas has led to huge declines in coal production and coal’s share of electricity generation. According to the Energy Information Administration (EIA), coal’s share of U.S. electricity generation averaged 52% in the 1990s and fell to 16% in 2023. The natural gas share rose from 16% to 43% during that same time.
The impact on coal production, transportation, and consumption has been massive. In 2023, U.S. coal production was 577.5 million tons, representing a 51% decrease from 2008 volumes of 1.13 billion tons. During that same time, originated carloads of coal by U.S. Class I railroads peaked at 7.71 million in 2008 and plummeted to 3.43 million in 2023.
The short-term outlook is just as gloomy. According to the Association of American Railroads (AAR), coal carloads were down 17.1% from last year, the lowest January to June volume since the AAR began keeping records in 1988. Natural gas prices remain extremely low, and the cost of generating electricity from wind and solar farms has plunged. Coal’s share of U.S. electricity generation is expected to continue to decline in 2025. As a result, a significant amount of historical rail traffic will not return.
All factors considered, in the first half of 2024, U.S. railroads originated 4.17 million carloads, excluding coal and intermodal. That volume hasn’t changed much over the last 10 years, meaning that U.S. Class I’s have been unable to replace the diminished coal traffic with other carload traffic.
Filling the carload breach
Currently there are three AAR commodity segments that ship in enough volume to potentially offset the contracted coal volumes—grain, chemicals, and petroleum products. Of the three, do any provide a platform for volume growth?
Grain does offer some of the unit train economics of coal and represents about 12% of the first half of 2024 volume for U.S. railroads. However, for railroads, the grain market is divided into two very distinct sectors—domestic and international. Domestic grain demand has been relatively flat for the last 10 years, offering little opportunity for significant volume growth. The international market is quite different. While the United States is the world's largest grain exporter, volumes can swing wildly from year to year. The unpredictability of grain exports makes the entire segment risky as a growth strategy for Class I railroads.
The chemicals industry consists of thousands of producers throughout the United States, representing a material growth opportunity for Class I’s. The American Chemistry Council (ACC) reported that in 2022, 1.02 billion tons of chemicals were shipped in the United States at a cost of $79.0 billion. As a commodity segment, chemicals are the largest carload revenue source for U.S. Class I railroads. According to the ACC, rail represents 18% of total chemical tonnage while trucks led with 58%.
Like the chemicals segment, petroleum products represent a wide range of categories, including crude oil and refined products, including liquefied petroleum gases (LPGs), fuel oil, lubricating oils, aviation fuels, and other fuels. Together, they represent approximately 5% of U.S. rail-originating carload shipments.
A noteworthy structural opportunity that Class I’s can continue to nurture for growth in both the chemicals and petroleum products is south of the border. Today, Mexico’s ability to both produce and refine enough energy to meet its domestic needs is quite constrained, and that is reflected in the growth in imports from the United States. This export market represents a unique opportunity for Class I railroads.
Three things have driven this structural event. First, the Permian Basin in Texas and New Mexico creates a low-cost feedstock source for the world’s most sophisticated refining complex located in the U.S. Gulf Coast. Second, Mexico is a nearby market for both the feedstock and refining capacity. Finally, Mexico is facing a structural challenge in that its refining capacity has been operating below 50% for the last several years, and PEMEX, the Mexican state-owned petroleum company, is carrying massive debt. Railroads could serve as a vital link transporting feedstock.
The intermodal conundrum
Intermodal transport has long been considered the industry's golden ticket to growth, but in 2024, it presents a more complex picture. The segment saw a downturn in 2023, hitting its lowest volumes in three years. In June of this year, Class I railroads did report about an 8.7% volume growth in intermodal for the month over 2023. But even those numbers don't get them back to pre-pandemic levels.
However, we remain cautiously optimistic about intermodal’s long-term outlook. One way that Class I railroads could capture market share would be to target a significant volume of single-line traffic that travels between 700 and 1,500 miles and traverses only one railroad. That is a fairly sizable market for trucks right now, and if successfully converted to rail, it will add a significant amount of additional intermodal volume to the railroad’s portfolios.
To successfully compete, railroads will need to offer a compelling value proposition that can respond effectively to trucking’s current capacity surplus and low post-pandemic rates. This requires a delicate balance of pricing strategy, service reliability, and operational efficiency.
Path forward
Railroads have long faced criticism for their perceived inflexibility and reluctance to adapt to shipper needs. However, today's competitive landscape and changing customer expectations are driving rapid transformation in the industry. Class I railroads are actively working to enhance the customer experience, but they face significant challenges. To compete effectively with trucking, they must overcome deeply entrenched negative perceptions about rail shipping. This requires demonstrating unwavering commitment to their shippers and the markets they serve, as well as presenting comprehensive, forward-thinking strategies that showcase their long-term dedication to the industry.
For their part, shippers should reexamine the supply chain solutions they implemented to solve pandemic and post-pandemic challenges. They should take advantage of the current transportation market volatility to scrutinize the rates they currently pay and understand the trade-offs they can make in the marketplace to decrease overall transportation costs. Now's the time to start evaluating modal shifts. Railroads may be hungrier for traffic they didn't want to haul during the pandemic and post-pandemic years, and shippers can take advantage of a contracting truck market to inform their rail negotiations. In some cases, shippers may find that railroads have more appetite to commit to long-term contracts with fixed indices.
As we look to the future, railroads may never recover the bygone coal volumes, and their earnings profiles may be forever changed. Still, the industry's trajectory will be determined by its ability to address these interconnected challenges and opportunities brought about by the turbulence of being an integral part of the global economy. Success will require a multifaceted approach, and what worked for Class I’s in the past likely won’t help them be successful soon. All that said, it is a given that railroads will remain an integral part of North America’s industrial economy for a very long time.
