New regulations for railcars transporting crude oil and other hazardous material will be costly for railcar manufacturers and lessors given their short implementation timeframes, Fitch Ratings says.
Since all mandatory expenses are paid at the top of securitization waterfalls, certain outstanding rail car ABS transactions could see decreased available funds for interest and principal, depending on their respective levels of tanker concentrations. In addition, should the pricing spread between West Texas Intermediate (WTI) and the foreign benchmark, Brent, continue to remain at historically low levels, the impact could be broader.
The U.S. Department of Transportation (US DOT) and Transport Canada (TC) issued the regulations concurrently on May 1. They require tank cars constructed on or after Oct. 1, 2015 to meet the new DOT-117 design, which features thicker shells and head shields, heat-resistant jackets, thermal protection, and improved pressure valves. DOT-111s transporting crude oil are to be completely replaced within 2-3 years although they may be modified to carry ethanol, extending their useful life to 2023. The newer CPC-1232s, manufactured since 2011, will generally require retrofit within five years. Overall, the current fleet of tankers carrying crude and ethanol will either be completely replaced or retrofitted within 10 years.
In addition, the regulations also require electronically controlled pneumatic (ECP) braking systems to be installed by 2021, an addition largely unexpected by the industry. The new braking installations are estimated to cost up to $10,000 per railcar by the American Association of Railroads (AAR) and will further add cost pressures despite their longer lead time for implementation.
ABS transactions could take a further hit if these upgrades are conducted during the narrowed WTI-Brent oil price spread, which has negatively affected demand for tankers. The sharp rise in railcar utilization over the past five years has largely followed the substantial increase in North American oil production. According to the Association of American Railroads, average weekly carloads of crude oil increased substantially in nearly each month from 2009 to 2014, as North American oil refineries took advantage of the lower domestic crude transportation.
However, crude by rail traffic declined in each month of the first quarter of 2015 as oil prices decreased and the WTI-Brent spread reached an inflection that made it cheaper for refineries to use shipments of foreign oil. Although the average weekly crude carloads recovered in April and May, the continued low pricing spread will continue to negatively impact demand. Fitch expects this spread to average approximately $5 for the next three years.
In our view, the high excess spread structured into railcar ABS transactions as well as increased lease rates should cover a portion of the retrofit expenses. Substantial increases in average lease rates in recent railcar ABS transactions suggest lessees can tolerate the increased rates, although lessees could turn to foreign oil if lease rates were to increase beyond feasible levels.
Railcar lessors are likely to stagger the retrofits, which will avoid pronounced expense periods. In the near term, with limited pipeline options, including the vetoed Keystone XL Pipeline, refineries should maintain their healthy demand for shipment via rail.
The regulations were created in light of several recent train derailments, including the high profile Lac-Megantic derailment of 2013. Since the beginning of this year, there have been five major derailments, with the most recent occurring near Heimdal, North Dakota on May 6.
The problematic tankers in these incidents have not only been older DOT-111s, but also newer CPC-1232 cars. They have furthered public concern that the current fleet is not adequately designed to safely transport the highly volatile crude from the Bakken formation. These concerns compelled the US DOT and TC to act with the regulations issued. Fitch believes that, over time, these regulations could potentially lower the negative impact of derailments to ABS transactions.
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