For years coal has been the most transported commodity by railroads, accounting for more than 40% of total carloads originated in the U.S. in the third quarter of this year.  While coal production and consumption demand is likely to grow over the next few years driving traffic volume for freight carriers such as CSX Corporation (NYSE:CSX) and Union Pacific (NYSE:UNP), there may be a long-term shift away from this longstanding reliance. With stricter environmental regulations in the U.S. and signs of a slowdown in economic growth and infrastructural developments in China, we expect that coal’s importance to freight carriers will gradually decline.
Our price estimate for CSX is $34, which is about 60% above the current market price.
China may not support demand for coal as growth decelerates
Analysts have predicted a deceleration in emerging markets like Brazil, Russia, India and China (BRIC), with average economic growth estimates by the International Monetary Fund for these four nations reduced to 6.1% in 2012 compared to 9.7% in 2007. 
China has recently announced plans to cut its railway construction expenditures by 42% in 2012.  This video and story from SBS Dateline offers an overview of concerns surrounding construction and the development of alleged “ghost cities” in China. These factors point to a slowdown in infrastructural activity in the country and raises questions about whether China will sustain its demand for coal, which has been the greatest stimulus to coal producers in the U.S. Additionally the demand for coal in Europe will probably contract as its economy struggles with debt issues.
Coal producers in the U.S. may also face competition from Australian coal producers. We think that railroads that have been planning to march ahead with an expected long-term increase in coal exports to Asia, South America and Europe may need to reconsider their strategy, as it seems that coal might not be their key to better profits in the long term.
EPA regulations a blow to coal demand from utilities
Furthermore, recent regulations by the U.S. Environmental Protection Agency (EPA) requiring a reduction in mercury emissions from power plants will likely lead to the eventual closure of several old coal-fired plants.  These new rules could cost utilities as much as $9.6 billion per year, but the EPA contends that the health benefits will outweigh the costs substantially. The agency has extended some concession to the industry by allowing companies a longer period of time to implement emission-reduction technology. These regulations are a setback to domestic demand for coal, which was already competing with the currently low-priced natural gas used for electricity generation.
We believe that while coal may capture a significant portion of total freight carried by railroads in the next few years, in the long-term this trend might not hold and other commodities such as agricultural, industrial and consumer products will likely drive the volumes and profits of railroads in the future.
You can modify the chart above to see how a reduction in U.S. rail carloads of coal would impact our price estimate for CSX.Notes: