The use of trains to transport crude oil has been a terrific source of revenue growth for North American railways. But with oil prices down and the energy sector reeling, are railway stocks still a good bet?
If investor sentiment shifts away and the economy holds up, the answer is yes.
After a remarkable rally over the past three years, Canadian Pacific Railway Ltd. has essentially stalled. Since September, the shares have retreated about 11 per cent, making it a poor performer among the major railways.
The reason: CP is closely associated with crude oil, including oil produced in the Bakken shale region of North Dakota.
This exposure to the energy sector was a bullish factor when oil traded for more than $100 (U.S.) a barrel in the summer, observers hailed the move toward U.S. energy independence, and pipelines were able to handle just a fraction of oil shipments.
But with oil trading for less than half that price today amid concerns that oil producers will have to slash production, the oil-by-rail argument for investing in railways is looking weak.
Indeed, analysts are now focusing on railways with the lowest exposure to the energy sector.
Thomas Wadewitz, an analyst at UBS, reiterated a "buy" recommendation on Union Pacific Corp. and raised his 12-month target price on the stock to $135 from $128.
One of the biggest reasons for his enthusiasm? Union Pacific has many sources of revenue beyond hauling oil and delivering sand to frackers, estimated at just 6 per cent of the company's revenues in 2014.
"In our view, Union Pacific has the most diverse franchise and customer mix of the major railroads," he said in a note, pointing to the railroad's extensive auto, construction and intermodal segments.
Now, contrast that with any discussion about Canadian Pacific. While analysts remain generally upbeat about CP over the longer term, they tend to tiptoe around the issue of its exposure to energy because the news isn't upbeat.
In its quarterly report this week, CP estimated it would haul 140,000 carloads of crude oil in 2015, down considerably from earlier guidance of 200,000 carloads. Oil accounted about 10 per cent of CP's revenues in 2014 and, perhaps more importantly, sales had been growing at an impressive clip.
Analysts at Goldman Sachs and Credit Suisse trimmed their target prices on the stock by 12 per cent and 15 per cent, respectively.
Where does this leave investors?
For one, it shows just how fast a hot investing trend can turn cold. When oil prices were rising, trains were seen as a kind of flexible pipeline that could tap into a growing industry, and offered one more reason to buy railway stocks. This reason is now dying.
For another, it demonstrates yet again that there is no sure thing when it comes to investing – especially when the sure thing rests on commodity prices.
But there's an upside here: With crude oil no longer attracting fickle trend-following investors, railways are looking stodgy again.
This is good. No one is launching new railways any more, which ensures that existing players will continue to thrive over the long-term.
Railways also remain ideal ways to gain exposure to an improving economy, given that economic growth goes hand-in-hand with shipping activity. Lower oil prices could even provide a nice boost to activity if, as most economists expect, consumers start spending the money they are saving at the gas pumps.
To be sure, railways have enjoyed a nice run with the economic recovery in North America. Canadian Pacific shares have surged 340 per cent over the past five years, Union Pacific shares have risen 300 per cent and Canadian National Railway Co. shares have gained more than 215 per cent.
Clearly, these stocks look their most attractive when times are tough and the economy is in ruins – but perhaps the collapse in oil prices will provide a good entry point for latecomers.