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By David Lehlbach, a rail specialist in Oliver Wyman Inc.'s Surface Transportation Practice
Thanks to the rapid pace of development within the crude oil industry, the marriage of crude oil producers, railroads and receivers has resulted in a spirit of cooperation to rapidly develop strong supply chains. Tank cars have become the most critical link in these supply chains, particularly for shippers who were "early adopters" and have their supply chains in place and functioning. Conversely, the risks are increasing for new entrants to the market due to two primary factors: lack of near-term rail-car availability, and a volatile supply and demand environment for tank cars in the foreseeable future.
At the beginning of 2013, the order backlog for all types of new tank cars was cited to be approximately 48,000 cars. It is likely that greater than 80 percent of these backlogged cars are crude-capable.
The current production rate for tank cars is in the vicinity of 16,000 to 24,000 units, which means that unless more capacity is added, orders placed with builders today will not become available before mid-2015, at best. The used market will not provide relief, either — literally all cars are now under contract and reserved for the foreseeable future.
The scarce market for tank cars has changed the dynamics to favor rail-car owners/builders for a few reasons. The first is price; some price appreciation has likely occurred due to increased demand, but there is also significant price appreciation because modernized car designs require increased time and materials for new safety appliances, and rules that require increased steel specifications. Additionally, some builders and lessors are forcing customers to utilize tank cars with insulation and coils, which reduces capacity from a non-insulated size of ~31,000 gallons to ~28,000 gallons. In doing so, these builders and lessors are "insulating" themselves from risk by only producing the coiled and insulated cars so the fleet is more saleable to future lessees.
This seemingly bright outlook for car builders/suppliers has roots growing out of the 2005-2008 ethanol boom. At that time, lessors offered attractive short-term leases of three to five years to capture the upside of the rapid increase in demand for ethanol, which created an approximately 35,000-car production backlog. Some of these short-term leases expired at the same time as peak production, which created a sudden glut of cars and ended the boom. Lease rates then dropped, with lessors scrambling to find new customers. Car suppliers seem to have learned from these painful experiences, and today's customers are reporting terms starting at seven to 10 years for crude cars, symbolizing a shifting of the risk from suppliers to shippers who are new market entrants.
Additionally, some new entrants are concerned that the rapid build pace of new tanks may mirror the "bubble" that occurred in the ethanol supply-demand example. In the current market, tank-car suppliers will need to consider risk-mitigating strategies that address the possibility of excess cars in the future. In the event a bubble forms, what other markets exist for these rail cars? U.S. receivers at the coasts are likely to grow domestic demand, while at the same time not receive significant additional pipeline capacity. The East Coast has consistent demand and a preference for sweet crude. Also, bitumen growth and other unforeseen forces may become wild cards in the future, providing avenues for new builds.
Alternatively, if the "high" demand estimates become reality, tank-car production must continue aggressively so that the rail industry has enough cars to haul the crude and other commodities that use these tank cars. Either way, understanding the long-term supply and demand risks are key considerations for parties leasing/acquiring rail cars now and in the immediate future for their supply chains.
David Lehlbach is a rail specialist in Oliver Wyman Inc.'s Surface Transportation Practice. He specializes in rail industry planning and operations, performance assessment, market analysis and strategy development, and is based in Princeton, N.J.