(The following story by Scott Deveau appeared on the Financial Post website on April 23.)
OTTAWA — Canadian Pacific Railway Ltd.’s inability to pass the soaring cost of fuel on to its customers contributed to the railway lowering its earnings estimate for a second time this year yesterday.
While harsh winter weather and reduced forestry and auto volumes contributed to the 29% decline in its first-quarter earnings, management said it was the 47% run-up in its fuel expenses that was the primary driver for its reduced outlook.
CP said it now expects earnings per share between $4.40 to $4.60 in 2008, down from its previous estimate of $4.65 to $4.80. Following the news, the stock fell 4.25% to close yesterday at $68.22 on the Toronto Stock Exchange.
The move follows a similar downgrade to its outlook in February, after the federal government capped the amount of revenue the railway could reap from shipping grain.
At issue this time, however, is not so much the soaring price of crude, which it can pass on to its clients through fuel surcharges, but the cost of converting it into diesel, the so-called crack spread, which it cannot pass on. Only about 40% of the railway’s current contracts are based on highway diesel prices, which implicitly include the cost of refinement. For the remainder of its contracts, CP takes any increases to the crack spread on the chin.
This means that for every $1 increase to the crack spread, CP’s earnings per share take a 2¢ hit, while every $2 increase to the West Texas Intermediate price affects it by only 1¢.
Fred Green, CP chief executive, said the fundamentals of the business remain strong, but the cost of refinement is an issue CP is working to resolve.
“We are paying for fuel,” he said. “It’s not a fundamental flaw but rather, unfortunately, a contractual set of arrangements that we have to work our way through.”
When these contracts were negotiated, cost of refinement tended to be a constant at under $10 a barrel, according to David Newman, National Bank Financial analyst.
But, in the aftermath of Hurricane Katrina, he said the spreads started to grow on their own as refining capacity came under pressure.
In the past year, the crack spread has grown from $11 a barrel in the first quarter of 2007 to about $17 in the first three months of this year, he estimates. It now sits at $23 a barrel.
“The old normal doesn’t exist anymore,” Mr. Newman said. “You not only have the rising WTI costs, but also the refining cost as well. They never anticipated this.”
Mr. Green said he expects half of the railway’s fuel surcharges to be based on highway diesel by the end of the year, and up to 75% of them by the end of 2009.
CP is not the only one to get caught out by the increased cost of refinement. Canadian National Railway said on Monday only about 40% of its fuel surcharges are based on highway diesel prices, but that it hoped to increase that figure to about 85% to 95% in the next 18 months. CN also lowered its earnings estimates this week on increased fuel prices, winter weather and reduced forestry volumes.