Article

The Pre-Buy Ride

Federal emissions regulations have sent truck purchasing cycles on a roller coaster ride that has far-reaching effects.

August 2007, TruckingInfo.com - Feature

by Deborah Lockridge, Editor in Chief - Also by this author

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"It's hard to remember now what the air was like in the 1960s," says the American Lung Association. "Pollution streamed from factories and cars; heavy clouds of smog settled over many American cities. Office workers tell stories of taking an extra white shirt to work to replace the one they wore that grew dirty from soot during the day." In New York City in 1966, hundreds of people died in a November killer smog.

This all began to change with the passage of Clean Air Act in 1967. Amendments and new EPA regulations over the next 30-plus years set ever-tighter standards for diesel exhaust emissions, taking effect in 1984, 1985, 1998, 2004 (which were later moved up to 2002), 2007 and 2010. The current generation of engines, meeting the 2007 emissions regulations, no longer even smell like diesel engines when running.

During the past decade, with more complex technology needed to meet the emissions regulations, these laws set into motion a roller-coaster cycle of fleets "pre-buying" trucks ahead of each new iteration of lower-emissions engine. The idea was to wait until other guinea pigs tried out the new engines before purchasing their own.

AFTER THE PRE-BUY

At this writing, we're right in the trough of the current pre-buy cycle. Heavy-duty retail truck sales in the U.S. fell 51 percent in May from year-ago levels – the largest year-over-year decline ever. That followed a record numbers of truck sales in 2006, as fleets and dealers rushed to buy before the 2007 emissions regulations took effect on Jan. 1.

There were several concerns driving this pre-buy. Fleets were put off by new aftertreatment technology, including a diesel particulate filter that will require periodic maintenance. There were questions about reliability, and about potential higher maintenance costs. Fuel economy was expected to decrease with the new technology and the new cleaner fuel mandated to use in these engines. There were concerns about the availability of the new ultra-low-sulfur diesel fuel. And perhaps most important, trucks with the new engines would come with a hefty price tag – $7,000 to $12,000 more than the previous year's models.

"The early bird catches the worm, but the early technology adapter is going to catch the bug," says Kenny Vieth, partner, ACT Research. "Nobody wants to beta test the latest Microsoft operating system; (we say) let's let the computer geeks go out and buy it and poke holes in it for a year before we upgrade. And I think truckers are the same way" when it comes to new engine technology.

To avoid being the new technology guinea pig, fleets can either wait to buy – meaning older equipment and likely higher maintenance costs – or they can go ahead and buy trucks early, before the technology change.

As a result, last year more than 284,000 heavy trucks were sold in the United States. It was expected that coming out of such a massive pre-buy, demand for heavy-duty trucks would be weak. But an unexpected slowing of freight demand has exacerbated the slump. Some fleets that made large pre-buys still have trucks with 2006 engines sitting, unused. Dealers who made large pre-buys still have the trucks on their lots. Vieth reports that there were 55,000 Class 8 units in inventory at the end of May, and his estimate is that at least 80 percent of those are trucks with the old engines.

"If the economy didn't head down in the fourth quarter of '06 and stay down in first quarter '07, I don't think there would be as many unused trucks lying around," Vieth says. "I think there was a little bit of bad luck as far as the economic cycle was concerned."

ON THE PRE-BUY RIDE

One of the fleets pre-buying trucks was Marten Transport. When asked about reports that the company has a few hundred of those trucks still waiting to be put into service, President Randy Marten replied, "We pre-bought at the end of the year, and based on market conditions today, used truck valuations and overall general economic conditions, shall we say, we do not intend on purchasing tractors until late in 2008. We have enough '07-model tractors with '06 engines to more than take care of our needs.

"Nobody anticipated the economy slowing with the breadth and speed that it did, so you have the question of whether the pre-buy had to be as big as it was," Marten says. "We pre-bought back in 2002, and at that time I regretted the fact that I didn't buy more, because our initial foray into the 2003 engines was quite painful."

Some dealers reported in early summer that they had yet to sell a truck with an '07 engine. Among those that had, buyers were reported to be mainly municipalities and vocational fleets, not over-the-road haulers.

"We anticipated a strong demand for pre-emissions vehicles, and entered the new year with what we expected would be a 90-day supply," says Glenn Bergey, president of Bergey's Truck Centers in Franconia, Pa. "When the manufacturers continued to build pre-'07 vehicles through the first quarter of 2007, the demand for our inventory didn't materialize."

Bergey is referring to the fact that while engine makers legally could only make power plants that meet the stricter federal emissions mandates after Jan. 1, they made extra 2006 engines last year that could legally be stockpiled and put into trucks being built after the first of the year. (Most trucks made with the 2007 engines are being marketed as 2008 models.)

David Thompson, President and CEO of TEC Equipment, Portland, Ore., says his dealership pre-bought 450 units with '06 engines. "I probably bought heavier than I needed to. We are now down to 52 units; they are now moving. They didn't sell as fast as I thought they would, but they are going away."

The sluggish sales may also be pushing down prices for the trucks with '07 engines in some areas. Instead of the approximately $10,000 price premium announced by OEMs, many dealers report it's more like half that. However, cautions Buddie Carroll, CEO of Freightliner of Knoxville in Tennessee, "in the real world, dealers have not sold enough of the '07 trucks to clearly define the price premium. I think it will take almost a year for this question to resolve itself."

The '07 price premium hasn't yet been a factor, according to TEC's Thompson. "We are just now getting product in our hands, which has probably been the saving grace because it's allowed us to work through our '06 inventory." Other dealers are reporting that the higher pricing is holding firm.

Many analysts and dealers say truck sales are starting to pick up, with several factors – including a recent increase in industrial production – leading to a pickup in freight demand. Dealers we spoke with predict that sales will start to head back to more normal levels by the fourth quarter.

"We are already seeing some increased activity in the Class 8 market," Carroll reports. "Customers are requesting quotes and discussing deliveries toward the fourth quarter."

STAYING THE COURSE

Not everyone bought in to the pre-buy mentality.

"We did not 'double up' on old technology engines," reports Jim Maddox, president of Tri-State Truck Center in Memphis, Tenn. "We considered it, of course, but decided that the additional floor plan cost would negate any benefits of having extra trucks in stock. As it turned out, business has slowed, so our decision was right on. We have very few 2007 models in stock and are just now getting our first 2008 models," he reported in early July.

At Knight Transportation, they've been taking delivery of 2007 engines for several months.

"We probably brought a few trucks in just so we didn't get some of the very first units (off the line), but we didn't do what we call a pre-buy," says CEO Kevin Knight.

"You know, I just think it's the right thing to do," he says. "We've got to get there sooner or later anyway, and I think the pre-buy creates a lot of negative consequences for our industry. We end up with an oversupply of equipment every time another one of these new engine regulations comes out, so we create what I would call an unbalanced operating environment when we pre-buy. I just think it's the right thing to do to get the new technology and have cleaner air and not create oversupply in our industry."

At Swift Transportation, there reportedly was some talk back in 2004 about developing a pre-buy strategy. But when Michele Calbi came in from Freightliner as vice president of procurement in 2005, she started focusing on the 2007 emissions standards.

"We watched very carefully with regard to the quality and the production of the trucks, and we determined that we were just going to continue buying as we normally purchase," she says. "Everything I saw indicated that the engine companies and the OEs had a good handle on the '07 engines. Plus we're environmentally friendly. I think it's a good thing for the environment to be able to run cleaner trucks."

Making the decision easier for fleets like Knight and Swift, perhaps, was their ability to get pre-production 2007 engines from the builders to test last year.

"We've logged many miles on our Cummins test engines," Knight says. "Cummins I think did a very good job – better than in '02 – of getting test engines out there. So there really were no surprises."

For some fleets, their strategy was somewhere in the middle.

"I'm a firm believer in 'let's not change our trade pattern, let's just get it over with and move on,' " says Steve Williams, CEO of Maverick Transportation. However, he says Maverick and other fleets he knows did tweak their trade cycles to lessen the number of '07 engines they would have to take this year, especially in the first part of the year. "We kind of set it up several years ago to get the rhythm right."

The company was scheduled to take delivery of about 100 trucks with the '07 engines at the beginning of the third quarter.

"We're not going to not buy equipment if there's demand and we think it's a good investment," says Charles "Chuck" Hammel, president of LTL carrier Pitt Ohio Express. "We've been through these new engines before; in past years it was the same way. There was always fears (that) they're not going to be able to make these high government standards, yada yada. Next thing you know they do it and they work the kinks out. Anyone that has a problem with it really should get over it."

Nevertheless, when asked if the company pre-bought any trucks, he chuckled and said, "Of course we did."

HOW WE GOT HERE

The first emissions standards for nitrogen oxide, or NOx, were put in place in 1984: 10.7 grams brake horsepower hour (g/bhp-hr). In 1988, a particulate matter (PM) standard of .6 g/bhp-hr was added. NOx standards continued to be tightened – 6 g/bhp-hr in 1990, 5 in 1991, 4 in 1998.

Electronic controls, introduced in the early '90s, were used to meet many of these limits, and all engines had them by the 1998 standard. As a bonus, throughout the '90s, the new lower-emissions engines also ended up being more fuel-efficient.

In 1997, EPA adopted new emission standards for model year 2004 and later heavy-duty diesel truck and bus engines: a NOx plus hydrocarbon standard of 2.5 g/bhp-hr, with an HC limit of .5 g.

In October 1998, a court settlement was reached between the EPA, Department of Justice, the California Air Resources Board and engine manufacturers (Caterpillar, Cummins, Detroit Diesel, Volvo, Mack Trucks/Renault and Navistar) over the issue of high NOx emissions during certain driving modes.

Since the early 1990s, the manufacturers used engine control software that caused engines to switch to a more fuel-efficient – but higher NOx – driving mode during steady highway cruising. The EPA considered this engine control strategy an illegal "emission defeat device," even though the engines passed the EPA's engine certification tests, which were mainly designed to emulate urban driving cycles.

In addition to $1 billion in civil penalties and a requirement to upgrade existing engines to lower NOx emissions, the consent decree required the engine manufacturers to meet the 2004 emissions standards by October 2002 – 15 months early.

(Meanwhile, during the last days of the Clinton Administration in 2000, EPA approved the next set of emissions standards, for model year 2007 and later engines. This required particulate matter, or PM, to be cut to .01 g/bhp-hr with the 2007 engines, and .20 g/bhp-hr for NOx. The regulations also called for limiting the sulfur content in on-highway diesel fuel to 15 ppm, down from the previous 500 ppm, by fall of 2006, in order to help engines meet these standards.)

In the time frame leading up to 2002 deadline there was buzz of a pre-buy. Fleet managers were concerned that the engines would not get enough testing because of the moved-up deadline. There were reports that the engines would add $3,000 to $5,000 to the trucks' price. And there were durability and maintenance concerns about the exhaust gas recirculation being used to meet the new standard. Don Schneider called the situation "the single biggest issue trucking has faced in 10 years," and talked about buying used trucks to avoid the 2002 engines.

Trucking groups even sued, taking their challenge all the way to the U.S. Supreme Court. In 2001, the court rejected arguments that the federal government did not consider financial costs and that EPA exceeded the intent of Congress.

As the deadline got closer, engine makers and truck buyers lobbied Congress and the EPA, asking them to extend the deadline. The message was that the engines were not ready, that they had not been adequately tested, and that the costs would far exceed the benefits. There was talk of providing a tax credit to engine manufacturers to ease the burden of penalties for not meeting the deadline. Just months before the deadline, only Cummins and Mack had EPA-certified engines, and the Cummins certification was being challenged in court by Caterpillar.

All this brouhaha led Lud Koci, then-CEO at Detroit Diesel, to say, "We need to move forward. Quit acting like Chicken Little and saying the sky is falling. It didn't fall with any of the other emissions hurdles."

Despite all the activity, because of the economic situation at the time, there was not as great a pre-buy in 2002 as there has been with the 2007 engines.

"A lot of people said there wasn't even a pre-buy in 2002 because the economy was so bad," says ACT's Vieth. "If you go back to 2002, we were just coming out of a recession. We were at the bottom of the truckers' profit cycle. We think there was about a 30,000-unit pre-buy in 2002. This time we think it was about 115,000 or 120,000 units."

WHAT'S NEXT?

The regulations that created the 2007 emissions standards also set a new lower standard for NOx that is to be phased in between 2007 and 2010.

There are a great many questions about how these regulations are going to be met. Mack and Volvo have announced that they will use selective catalytic reduction, or SCR, which requires the use of urea. Most other manufacturers remain tight-lipped about their planned approach.

How much urea will have to be used to reduce NOx in order to get the engines EPA-certified? How do you size the urea tank? How often do you refuel it? The bigger the tank, the more space it takes and the more weight it adds to the truck, but, of course, you can drive further between refills. How will urea be distributed? Will it be available at truckstops? What's involved with trucking companies keeping it at terminals? What if you have to travel into Mexico? How do you insulate the lines in cold weather? What about the purity of the urea? Is there a self-contained way to produce urea without having a tank? Will we need another new oil standard?

With all these questions, it's a pretty good bet we're going to see another pre-buy.

"We do think there's going to be another pre-buy," Vieth says. "You start doing the math of higher new purchase price, fuel economy is supposed to be better – but then you've got to buy the urea. And it gets down to the trucker's comfort level with the technology, and that can't be divorced from the calculation."

In addition, he says, truckers who did not pre-buy this time around are going to want to upgrade their trucks in 2008 or 2009 so they don't have to buy the 2010 technology. "We think that used truck pricing should be fairly good, which will allow the pre-buyers that bought a lot of trucks in 2005 and 2006 to have a good market for their used equipment, which will allow them to update their fleets ahead of 2010."

Investors are so sure there's going to be another big pre-buy that they are buying truck manufacturer stocks, wanting to own these stocks early, reports Bear Stearns. "We believe the market is pre-buying the pre-buy," analysts said in a July newsletter. "We think investors are disregarding weakness in the U.S. truck cycle and buying the 'emissions cycle.' With U.S. truck demand likely to improve into 2008 ahead of the next EPA emissions deadline, our sense is that momentum could continue to move these stocks higher."

On the other hand, John Nichols, president of Kenworth of Indianapolis, thinks the spike may be less severe next time. "Too many '06 trucks got delivered and are still waiting for drivers," he says. "Freight is off and rates are under pressure and these guys got hurt. I don't think they will allow that to happen again."

Randy Marten says the good news about his company's 2007 pre-buy is that it may well take them on over the 2010 hump. "I think we're going to be in a real good position, because if we finish putting these '07 trucks into service six or eight months from now, and they've got a four-year lifespan, you could be looking at 2012."

One hard-to-predict variable is the prospect of another economic downturn. For several decades, there has been a pattern of recessions coming on approximately 10-year cycles. Vieth says he believes this cycle may be running a little longer this time, and we could see our next major downturn in 2011 or 2012 (this year's slump is simply a mid-cycle correction, he says).

"If everyone pre-buys in 2008 and 2009, you'd expect 2010 to be a bad year anyway, but if the economy slows down in 2011, you could end up with a two-year downturn in the truck manufacturing sector," Vieth says.

Maverick's Williams is one truck fleet executive who is upbeat about the 2010 technology. "We're pretty optimistic that all of this will get figured out," he says. Last year, he and other key trucking industry figures went to Europe to look at some of the technology being used over there. "It was a real eye-opener," he says. "If one sees what is already being used (to meet Europe's emissions regulations)... and the urea they're already using over there, it makes it a lot easier to understand how well it will work here."

The roller-coaster effect of these "emissions cycles" reverberates throughout the industry, as truck and engine makers beef up to produce enough trucks for the pre-buy then must lay off workers during the post-buy cycle.

"This pre-buy/post-buy is really a train wreck," says Tri-State Truck Center's Maddox. "It is hard on all the parties. The OEM is struggling to get the product to market on time. The dealer has to have all of our employees up on the training on the new product. And the customer not only is paying a premium for equipment, he has the same training issues as the dealer. I think we are hopeful that 2010 will be a product that we will be able to sell and service for numerous years," without another round of government-mandated technology changes.

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