Companies & Industries

After Lac-Mégantic, railways discreetly prepare for showdown with regulators

"You cannot afford to incinerate another town"

Workers comb through the debris after a train derailed causing explosions of railway cars carrying crude oil Tuesday, July 9, 2013 in Lac-Megantic, Que. (Photo: Paul Chiasson)

Workers comb through the debris after a train derailed causing explosions of railway cars carrying crude oil Tuesday, July 9, 2013 in Lac-Megantic, Que. (Photo: Paul Chiasson/CP)

The Lac-Mégantic disaster has claimed its first non-human victim with the demise via bankruptcy of Montreal, Maine & Atlantic Railway. But new safety regulation that may arise in the wake of the devastating explosion could yet lead to more business casualties.

On August 13, Transport Canada stripped MM&A of its license to operate in Canada, adding insult to fatal injury. While no other rail-related companies appear to be on the verge of either bankruptcy or being barred from operating in Canada as a result of Lac-Mégantic, that doesn’t mean extra costs aren’t on the way.

The Association of American Railroads has complained that any moves to mandate a retrofit of the existing stock of DOT-111A tanker cars—which were the type transporting oil through Lac-Mégantic—would cost US$1 billion. In fact, the push to retrofit the cars was on months before Lac-Mégantic. About 40,000 cars are potentially subject to retrofitting. (Cars built after 2011 have been built to higher standards recommended by the National Transportation Safety Board in the U.S.)

Financially, regulatory changes have the possibility to hit certain players in the supply chain more than others. It’s not, however, the railway operators themselves who are most at risk of increased costs because of regulation. CN and CP, Canada’s two largest railway operators, own and lease very few railway cars; they just haul them. In fact, it’s some combination of leasing companies, shippers and railway car manufacturers that are in line to take a hit.

In Canada, shippers of note include companies like Cenovus, Imperial Oil, Suncor and Valero. Of these, only Valero ships any significant quantity of oil by rail, and it has recently ordered thousands of new tanker cars to help do it. Cenovus operates about 300 cars and ships less than 5% of its oil by rail; Imperial ships less than 10% of its oil by rail. Both confirm they plan to significantly increase the amount of crude produced between now and 2020, and that rail will be a part of the solution. A spokesperson for Suncor said the company does not speculate on possible or potential regulation and declined to elaborate. However, it has announced it plans this year to ship oil from its Western operations by rail to its Montreal refinery. A spokesperson for Valero, which owns about 12,000 cars and is the largest refiner in the U.S., said all the new cars it is buying meet updated safety standards but also declined to elaborate.

Michael J. Baudendistel, an analyst at Stifel Nicolaus, says he expects the leasing companies to bear the brunt of the up-front costs and take a hit to earnings per share, but that increased costs will eventually be passed on to the shippers—the petroleum, chemical and agricultural companies. The distribution of costs will also be highly dependent on what fraction of a given fleet is leased vs. owned, and for the former, what the specific contractual arrangements are in terms of responsibility for repair or retrofit. However, leases typically run from four to eight years, “so [rate increases are] not something that might get passed through right away and the companies that lease the cars might bear the cost for a period of time,” Baudendistel says.

With the exception of Oakville-based leasor Procor, all the major rail leasing/manufacturing companies (a total of about 180,000 cars or 70% of the tanker fleet) are American: GATX Corporation, CIT Group, GE Capital Rail Services, Trinity Industries, The Greenbrier Companies and American Railcar Industries. Procor declined comment and referred inquiries to the AAR.

The $1 billion cost advanced by the AAR is questioned by some analysts, either as being insignificant or because the association’s methodology is too opaque for the figure to be verifiable. While no specific figure is available for the Canadian industry, De Groote School of Business assistant professor and rail expert Manish Verma estimates the size at a 10% equivalent, or $100 million. But Fadel Gheit, an analyst with Oppenheimer & Co., doubts the AAR’s math. Yes, there will be a cost to shippers and especially leasers, he says, but “it will add a few pennies.”

For oil shippers, he doesn’t see earnings being hit either. “It’s a volume business and if you amortize it it’s really not significant. So it is not an excuse for oil companies to say, ‘Oh we’re having big costs now.’ You’re not going to see oil companies or rail companies fighting regulation and asking for leniency.”

The rail industry has a history of resistance to regulation following a successful struggle for deregulation in the U.S. during the ’80s. For example, in a 2008 document the AAR described its Advocacy Management Committee as being expressly set up to “Reject proposed currently unnamed and other proposals to re-regulate U.S. Freight Railroads.”

The AAR’s position is significant because the North American railway system is highly integrated and the much larger U.S. partner takes the regulatory lead.

The AAR’s sister organization, the Railway Association of Canada, has expressed its condolences over the Lac-Mégantic accident, but has been fairly tight-lipped about potential changes to railway operations.  A spokesperson declined comment, instead directing inquiries to a statement by president Michael Bourque. In it he said, “The industry will wait for the results [of the Lac Mégantic investigation] before reaching any conclusions. … If new rules or regulations emerge from this tragic accident, our members will comply with them in both practice and spirit.”

But in the recent past, even Canadian railways have come out strongly against regulation, such as CN CEO Claude Mongeau’s June criticism of new rules unrelated to Lac-Mégantic; and Transport Canada has been vague and evasive in explaining to media what are the safety rules, has appeared to ignore government reports flagging safety issues and also seems to have underestimated existing safety issues, according to internal documents. This suggests the department may be bending in the face of industry pressure to tread lightly.

Gheit says the resistance to regulation that you do see isn’t because of cost. It’s because the leasors’ maintenance yards lack the physical capacity to retrofit so many trains in any useful amount of time. It’s a view that may have at least some merit.  Some shippers may be counting on access to older freight car stock as a means of offsetting the increasing costs of new cars. This was one of the concerns raised by some industry respondents in Progressive Railroading’s 2013 annual survey. But if new regulations mean older cars can’t be used without potentially expensive retrofitting, any advantage might be lost and existing fleets could become very expensive sunk costs.

Verma agrees, at least in part, that there is a significant logistical issue here. “We do not have that many extra rail car tankers in storage in the sense that if you take these things out of operation and try to retrofit them, then what are you going to move your items with?”

Rail has earned a bit of a reprieve, with the recent announcement by the U.S. that proposed new safety regulation will be delayed for at least one year.

“Considering the way things work in North America, I don’t think it would be surprising if it’s going to push things back in Canada as well,” says Verma. He adds, “Unless it’s imposed in the U.S., I think it would be difficult for the Canadian government to do much.”

The U.S. Pipeline and Hazardous Materials Safety Administration announced its decision in a July report. The agency was originally scheduled to introduce new rules in October 2012, but now says it needs more time to coordinate action with relevant stakeholders.

According to Tim Ehrlich, a legislative assistant to federal transport critic and NDP MP Olivia Chow, “Since quite a portion of oil-by-rail crosses the U.S.-Canadian border, any changes in the U.S. (or delays thereof) will impact this business in Canada as well.” In e-mailed comments, he described Canadian regulation as “reactive,” noting that the mandatory installation of voice recorders in locomotives has yet to be approved, and blames the fact the U.S. hasn’t mandated them. (In June, Transport Canada ruled them voluntary.) “On the other hand they are slow to implement changes that were done in the U.S. in the past,” he said. “In 2008 Congress made Positive Train Control, an automatic braking system, mandatory—but Canada yet has to follow suit.”

A spokesperson for Transport Canada said the DOT-111A cars last had their standards updated in 2008 and will be again in 2014. In the meantime the emergency directive implemented in the wake of the disaster will remain in force until December 2013, at which time it may be renewed by the department.

Chow was away on business and could not be reached for comment. She has been leading a charge from her seat on the Parliamentary transport committee to find out why previous safety recommendations have not been implemented. She has also proposed that the committee study existing proposals for safety and incorporate Lac-Mégantic findings once Transport Canada’s Transportation Safety Board has completed its ongoing investigation, which the government says is still months away. However, she was rebuffed by Conservative committee members who said the focus should remain on the investigation.

For now, Canada’s flagship rail companies are off the hook financially, but eventually someone’s going to pay and rail is almost certain to take a blow. As Oppenheimer’s Gheit puts it, “You cannot afford to incinerate another town, OK? I don’t care how much it’s going to cost. It’s ‘not in my backyard.’ You will see people strapping themselves to rail lines across America when you see this happening.”