Union Pacific Earnings: Soft Performance, Bleak Near-Term Outlook

Union Pacific’s (NYSE:UNP) stock declined after reporting poor second quarter results. ^[1] Plagued by coal and fuel surcharge declines, Union Pacific’s revenues tanked 10% to reach $5.4 billion, missing analyst estimates of $170 million. We anticipate that the situation might worsen over the second half of the year as natural gas and fuel prices remain low. In addition, any fuel lag benefit that Union Pacific has been enjoying will likely disappear or turn negative. We also expect that intermodal volumes will remain sluggish throughout the year.

The low fuel prices hardly made an impact on Union Pacific’s second quarter operating ratio (operating expenses expressed as a percentage of revenues), which increased 60 basis points year-on-year as a result of the low revenues. This also impacted its bottom line, which declined 3%, to $1.38 per share, in line with analyst expectations.

In a time of weak volumes, Union Pacific seems to be operating at overcapacity. In the first quarter, the railroad decided to cut back on its fleet and employees strength in order to better balance its resources with the current demand. To this end, Union Pacific has furloughed around 1200 of its train, engine and yard employees. ^[2] It has also put 900 locomotives into storage. 

See our complete analysis of Union Pacific here

Fuel Lag Benefits To End Soon

Crude oil prices have declined significantly over the past year, leading to a sharp drop in fuel prices. The average price of the U.S. on-highway diesel fuel declined 28% year-on-year in the second quarter. ^[3] This led to a $382 million, or 41%, decline in Union Pacific’s fuel expense.

While the lower fuel prices reduced Union Pacific’s fuel bill, they also brought down its fuel surcharge revenue, leading to a net negative impact. For the second quarter, the railroad operator reported a 6.5% decline in fuel surcharge revenues as a result of the drop in fuel prices. ^[2] Going forward, we expect that the fuel lag impact will likely remain negative through the remaining half of the year. This is because the fuel surcharge is based on two month lagged values of U.S. on-highway diesel prices, while fuel expenses are based on spot prices. Earlier, since fuel prices were declining continuously, spot prices were lower than prices two months back, leading to lower fuel expenses than fuel surcharge revenues and resulting in a net positive benefit. However, the trend appeared to have changed in the middle of the first quarter.

The price of U.S. on-highway diesel fuel had been fluctuating around its lows in the first half of the year, as crude oil prices showed some upwards momentum. In the first week of February, the average price of U.S. on-highway diesel fuel declined to $2.83. It climbed to $2.94 by the second week of March. In the second week of April, the average price of U.S. on-highway diesel fuel declined to a low of $2.75. ^[3] However, it climbed to $2.91 by the fourth week of May. Thereafter, the U.S. on-highway diesel fuel price continued to decline, ending the fourth week of June with an average price of $2.84. Since fuel prices had been fluctuating around the same level over the past couple of months, spot prices were relatively in line with prices two months before. This led to a $0.06 per share negative fuel lag impact for Union Pacific in the second quarter. ^[4]

The U.S. Energy Information Administration (EIA) expects that the price of U.S. on-highway diesel will increase over the second half of the year. ^[5] Iran’s crude oil exports are unlikely to have an impact on oil prices this year, since increasing its oil output will take more than a year. ^[6] Therefore, there is very little chance of crude oil prices going down any further. This could negatively impact Union Pacific over the next couple of quarters, as diesel spot prices will likely be higher, leading to higher fuel bills and comparatively lower fuel surcharge revenue. As a result, the railroad operator might see a drop in earnings and increase in its operating ratio. However, since the fuel price would still be lower than what it was in 2014, the impact may not be major.

Coal Declines Could Become Heavier

Union Pacific reported a 26% decline in coal volume for the second quarter as a result of weak domestic and export demand and flooding at the Powder River Basin. ^[1] The domestic demand for coal has been severely tempered as a result of electric utilities moving to natural gas for power generation because of its lower price. This is also evident from the rise in natural gas consumption at electric utilities, which grew 25% year-on-year in April, ^[7] while coal consumption declined 11% year-on-year. ^[8]

Going forward, domestic coal demand will likely remain low as electric utilities are currently well stocked with coal. According to the EIA, electric utilities’ coal stock piles in April were 30% higher than the previous year. ^[9] The EIA expects the average price of Natural Gas to be around $2.97 per million btu in 2015, which is low enough for utilities to stay away from coal. ^[10]

Export coal demand will remain weak as a result of a strong U.S. dollar and low prices. Metallurgical coal prices are likely to go down further as a result of new contracts for the third quarter, which have been priced at $93 per ton. ^[11] Thermal coal is also trading at lows of $50 per ton, compared to its peak of $338.75 per ton in 2011. According to Citi, the low price environment will likely persist. ^[12] This should keep the pressure on U.S. metallurgical and thermal coal producers and temper exports, which will likely lead to a decline in Union Pacific’s export coal volumes in the future, as well as its coal revenue per carload.

Intermodal Carloads Could Remain Weak

In the second quarter, Union Pacific’s intermodal volumes grew a sluggish 2% year-on-year due to the aftereffects of the labor contract negotiations between the International Longshore and Warehouse Union (ILWU) and the Pacific Maritime Association (PMA). ^[1] Though the negotiations have ended, recovery will take some time.

Since most retailers had expedited their shipments in order to protect themselves from any disruptions due to the negotiations, their inventories are well stocked. This could lead to lower shipments over the coming quarters with repercussions extending to Union Pacific’s international intermodal volumes. Apart from this, the segment could suffer due to difficult comparisons with the previous year, when retailers were expediting shipments, leading to exceptionally high international intermodal volumes. Additionally, the lower price of fuel is taking away some of the cost advantages that railroads have over trucks, which could temper domestic intermodal volumes.

View Interactive Institutional Research (Powered by Trefis):

Global Large Cap | U.S. Mid & Small Cap | European Large & Mid Cap
More Trefis Research

1. Union Pacific’s 2015 Q2 News Release, July 23, 2015, Union Pacific’s Earnings Releases and Management Presentations [↩] [↩] [↩]
2. Union Pacific’s 2015 Q2 Slides, July 23, 2015, Union Pacific’s Earnings Releases and Management Presentations [↩] [↩]
3. U.S. On-Highway Diesel Fuel Prices (dollars per gallon), www.eia.gov [↩] [↩]
4. Union Pacific’s (UNP) CEO Lance Fritz on Q2 2015 Results – Earnings Call Transcript, July 23, 2015, Seeking Alpha [↩]
5. Diesel Fuel Retail Incl Taxes U.S. Average, July 7, 2015, EIA’s Short Term Energy Outlook Report [↩]
6. Iranian Oil Exports Won’t Flood The World’s Crude Markets Anytime Soon, Energy Experts Say, July 14, 2015, International Business Times [↩]
7. Table 2.4.A. Natural Gas: Consumption for Electricity Generation, June 25, 2015, www.eia.gov [↩]
8. Table 2.1.A. Coal: Consumption for Electricity Generation, June 25, 2015, www.eia.gov [↩]
9. Stocks of Coal: Electric Power Sector – April 2015, June 25, 2015, www.eia.gov [↩]
10. Natural Gas Henry Hub Spot Price, July 7, 2015, EIA’s Short Term Energy Outlook Report [↩]
11. Met Coal Hits Lowest Price in a Decade, June 17, 2015, Wall Street Journal [↩]
12. Coal headwinds tipped to drive down prices, May 28, 2015, The Sydney Morning Herald [↩]