Falling Oil Prices Will Help Union Pacific’s Fuel Costs But May Hurt Its Volumes

Fuel cost is a significant expense for any transportation company and it’s no different for Union Pacific (NYSE:UNP). However, it is difficult to rein in the fuel expenses that is largely driven by the global macroeconomic events. The volatility in crude prices is so high that projections made are very likely to go wrong. The rail-road companies like UNP have the flexibility to recover some of the cost in terms of fuel surcharges, but even these measures may fail to control costs when prices surge beyond a limit. In view of that, UNP continually replaces less efficient freight cars with new ones with low carbon emissions and better fuel efficiency. The recent fall in oil prices bodes well with UNP’s operations as margins may see improvement.

We have $121 price estimate for Union Pacific, almost in line with the current market price.

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Fuel expenses alone form nearly 20% of the revenues earned by Union Pacific and is the second largest expense after employee compensation and benefits. The crude oil prices surged earlier this year on account of Iranian oil disruptions. However, prices cooled down lately because the outlook for demand in the U.S. remained poor and China’s growth slowed down. Amid all of this, UNP looks to benefit and we can expect a gain in margins if the oil prices remain subdued. Drag the trendline in the chart below to better understand the impact of improving EBITDA Margin on the company’s value.

However, falling fuel prices does improve margins, but there is another factor that needs to be considered relating to the rail-road traffic. As oil prices increase, a sizable traffic diverts away from trucking to rail-road transport because rail transport becomes relatively cheaper. Moreover, the absence of pricing regulation in the rail industry helps railroad companies to pass on some of their increasing fuel costs to customers.

So, in a increasing fuel price scenario, revenues increase, but margins fall, whereas in a decreasing fuel price scenario, revenues fall, but that is offset by a gain in margin. We have earlier witnessed that rail-road profits increased when oil prices surged. We expect profits to be upbeat while oil prices fall as well. We will have to wait for the Q2 results to see a noteworthy effect because starting this quarter, oil prices saw a downward slide.

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