2 Reasons Union Pacific Must Watch Falling Oil Prices

Source: Union Pacific.

The railroad industry has thrived in recent years, as demand for cheap transportation has skyrocketed along with the improving prospects for the U.S. economy. Union Pacific in particular has been in an ideal position to capitalize on better conditions among the railroads, as its geographical reach gives it valuable proximity to markets along the Pacific Rim. The recent drop in oil prices has also helped push Union Pacific shares toward all-time highs, as the entire transportation sector faces substantial fuel costs that appear headed to decline substantially in the months to come. Yet given how much Union Pacific has come to rely on transporting oil from hard-to-reach places, too steep a drop in oil could actually be counterproductive for the railroad. Let's take a closer look at how these two factors offset each other.

How falling fuel costs help Union PacificEvery railroad company spends substantial amounts of its operating budget on fuel to run its locomotives and move trains. In the third quarter of 2014, Union Pacific spent a total of $882 million on fuel, up 2% from the year-ago quarter. That amount represented 23% of the railroad's total operating expenses, and it used up more than 14% of Union Pacific's revenue. With earnings for the quarter coming in at $1.37 billion, it's evident just how much impact fuel has on Union Pacific's overall financial condition.

From a longer-term standpoint, Union Pacific has routinely spent $3.5 billion to $4 billion annually on fuel in recent years. The only exceptions were 2009 and 2010, when crude oil prices fell to extremely low levels following the commodity bust and the financial crisis.

WTI Crude Oil Spot Price data by YCharts.

Clearly, as Union Pacific has seen its volume increase, the total fuel it needs rises as well. Even though the price of diesel fell 5% year over year, the increased demand for Union Pacific trains sent overall fuel costs up 2%. Nevertheless, with spot prices for diesel now more than $0.50 per gallon below what Union Pacific paid on average during the third quarter, the potential for truly monumental earnings improvement could help send the railroad's shares even higher.

Biting the hand that feedsOn the other hand, Union Pacific needs to remember that its business also relies on transporting oil and energy products. A drop in prices could lead to a reduction in the amount of crude oil shipments that the company can make. Moreover, Union Pacific has also gotten a lot of business from delivering the specialty chemicals that oil and gas exploration and production companies need for their drilling activity, with innovative methods like hydraulic fracturing requiring materials to enhance the recovery process.

In Union Pacific's 2013 annual report, the company said that roughly three-quarters of the railroad's chemical business involves the petrochemical industry. Union Pacific specifically called out increased shipments of crude oil from the Bakken area of North Dakota, the Permian Basin in Texas, and the Niobrara shale formation in Colorado, Wyoming, and Nebraska as being the primary driver of growth in the segment, with the company posting a 19% rise in crude shipments compared to 2012. But the railroad has admitted that the flow of petrochemicals is dependent on prices, especially the level of discounting between domestic oil and the oil available on the world market.

Source: Union Pacific.

All told, the chemicals business makes up a sizable but not dominating portion of Union Pacific's overall operations, bringing in about 16% of the company's revenue in the third quarter and making up about 12% of Union Pacific's total carloads. The railroad's industrial and agricultural segments have seen much greater increases in revenue recently, and while chemical transport earns fairly high revenue per carload, it's not the highest in Union Pacific's network.

In the long run, expansion of pipeline capacity would already be a threat to the future growth of the energy-transportation business, and so Union Pacific couldn't really count on past levels of revenue from the segment lasting indefinitely. Nevertheless, if producers start to ramp down on production levels due to falling prices, then Union Pacific could see a near-term hit that would offset the lower expenses from reduced fuel costs.

Keep an eye on oil pricesUnion Pacific investors need to pay attention to what happens to oil prices in the future. As beneficial as lower fuel costs will be, a drop in its energy-transport business could lead to offsetting declines in sales and earnings that will temper investor enthusiasm about the railroad going forward.

The article 2 Reasons Union Pacific Must Watch Falling Oil Prices originally appeared on Fool.com.

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