Demand falling for oil, lumber, and wheat from Canada
Several market forces are threatening the value of the key commodities that the Canadian freight industry depends on.
After reaching record highs, lumber futures (LSX18) have fallen back to earth, crashing 46% since mid May. International Maritime Organization regulations on the sulfur content of the fuel used by ships will not come into effect until 2020, but they’ve already caused a massive devaluation in Canadian oil reserves. The heavy sour Western Canadian Select dropped from $58 per barrel in May to $30.32 per barrel today. Furthermore, the American and Canadian crude varieties are diverging in price: WCS (IWGY00) is down 1.46% today, while West Texas Intermediate (CLV18) is up 1.99%. Meanwhile, Canada is exposed to the same grain headwinds as the United States, with higher land prices, transportation costs, and input costs making the country’s wheat less competitive on global markets.
The threat to Canadian oil sands is probably the most important aspect of the commodities story.
“This is a very straightforward issue,” Allan Fogwill, president of the Canadian Energy Research Institute (CERI), told the Financial Post. “What we’re facing is a devaluation of oilsands assets in the marketplace.” Up to 20% of Canadian oil is expected to be rendered uneconomical to produce, once the IMO 2020 regulations are fully priced into the market. The global maritime shipping industry consumes about 5M b/d, about 5% of the world’s daily production.
Who are the losers in the decimation of the Canadian oil industry besides producers, refineries, and pipeline owners? Canadian railways, who are overweight on oil volumes. Canadian National’s (NYSE: CNI) total carload volumes are about 4.8% petroleum products including crude oil and are up 2.3% over 2017 year-to-date. But it’s really Canadian Pacific (NYSE: CP) that’s in trouble: 6.9% of their carloads are oil-related, and they’ve grown their dependence on petroleum volume an astonishing 47.4% over 2017 year-to-date.
A further 12.3% of Canadian Pacific’s volume is classified as ‘chemicals’—again the most of any Class 1 railroad—but it’s unclear how closely those volumes are tied to the Canadian oil industry. Petrochemicals like olefins and aromatics are derived from oil and gas refining, but are classified as ‘chemicals’ rather than actual fuels like diesel, gasoline, and crude oil, which are ‘petroleum products’. Depending on the mix of chemicals hauled by Canadian Pacific, a significant amount of their volumes could be exposed to falling demand for WSC.
However, Fogwill told FreightWaves that CERI thinks the outlook for chemical volumes is positive, due to the lower cost of natural gas.
The structural factors making it expensive to farm in North America relative to South America and Russia have hurt American farmers as much as Canadian farmers. The diffusion and intensification of global wheat production, much of it closer to wheat-importing markets than the United States and Canada, has cratered demand for North American wheat exports. Although prices appear to have found a bottom after a 36% decline since 2014, they’re still just below the widely quoted United States break-even point at $4.89 per bushel. As long as that’s the case, acreage devoted to the crop will continue to dwindle while inventories pile up in silos, waiting for a more favorable price environment to go onto the market.
Canadian lumber exports to the United States have also been in decline due to tariffs placed on Canadian lumber by the Trump administration. President Trump argued that Canadian timber companies harvest trees from public lands according to prices set by the government and were unfairly undercutting American timber companies, which harvest from private land and pay prices dictated by the market. As American home starts begin to slow due to rising interests rates tamping down demand and a lack of construction-ready real estate constraining supply, there will be even less need to import tariffed lumber from our northern neighbor.
In the United States, railroads reacted to declining coal volumes by shifting to intermodal, which now comprises 40-50% of the volumes of the big four American Class 1s. It took them a while to catch on, and some railroads still have not been able to rationalize their intermodal networks (looking at you, CSX (NASDAQ: CSX)). Intermodal, by the way, is much less profitable for railroads than rolling coal downhill out of mountains, and sweetheart deals like the one JB Hunt (NASDAQ: JBHT) has with BNSF don’t help margins, either.
In the next few years, especially after IMO 2020 takes effect, we’ll see how the Canadian rails and trucking companies adapt to a freight economy where natural resource extraction and agricultural production is less profitable than it has been in decades past. Time will tell.