US railways: Back on track

Financial Times | July 22, 2014 | Column by Robert Wright

Train operators are cashing in on shale gas but their improved fortunes could be undermined

The rail yard is busy at Lamberts Point Coal terminal. Coal cars squeal as they roll down a slope towards a pair of vast cylindrical machines. A winch pulls the cars up, draws the coal from them in a cloud of black dust and then they emerge from the other side, empty. From this spot along Virginia's Elizabeth River, the coal heads on to a conveyor belt to the hold of ships destined for overseas markets.

The scene at the rail yard - the biggest coal transfer facility in the northern hemisphere - says much about railroads in the US, which still has the largest network on earth. It is slick and well-maintained, showing how buoyant profits in recent years have enabled the railroads to invest heavily in their networks.

The years since the turn of the millennium have been good for US rail - so good that some have claimed the industry is in the midst of a revival. The change in investor sentiment has been particularly marked since 2009, when Warren Buffett, the veteran investor who had previously shunned railroads, bought BNSF, operator of the US's second-biggest rail network, for $27bn. He said he was making an "all-in wager" on America's future.

Investments have been particularly easy to justify in recent years. Since 2011, all seven big Class I railroads in the US and Canada have been earning returns higher than their cost of capital - a modest achievement in most industries but a mark the US's railroads had missed for the past 70 years. Rising traffic levels are letting railroads sweat their assets harder and work more efficiently.

Matt Rose, executive chairman of BNSF, operator of the US's second-biggest rail network, says the industry is in a "virtuous cycle".

"You make investments," he says. "You make more money on that; you make more investments. That's this virtuous cycle that nobody in the 1970s or 1980s thought was possible."

But the activity at Lamberts Point, owned by Norfolk Southern Railway, also points to the challenges facing the rail industry, many of which are linked to dramatic shifts in the US energy markets. The rail yard is busy partly because, after a sharp decline in US coal demand, miners in Kentucky and West Virginia have little choice but to export. A 15 per cent drop in the past two years in the transportation of coal, traditionally railroads' biggest single commodity, has affected revenues.

Coal is declining because of the US shale drilling revolution, which has brought both new rail traffic and new problems, including a spate of explosions on trains carrying North Dakota's volatile crude oil. The densely packed cars on Lamberts Point's 150 miles of tracks are a reminder of how rapid growth in some parts of the network is leading to severe congestion and forcing railroads to invest more.

The industry also faces the effects of labour unrest . A potential strike at west coast ports could severely disrupt normal traffic flows. Canadian National, Canada's biggest railroad, has imposed restrictions on handling some traffic bound for the US because of the volume of cargo being diverted northwards ahead of the strike.

The critical question is whether the mounting problems - a declining coal industry, congestion, labour problems and safety questions - will halt the industry's record of steadily growing profitability in recent years.

Anthony Hatch, an independent analyst, says railroads face a severe challenge managing their regular traffic growth in some areas and entirely new forms of business, such as crude oil movements, all at the same time. "Everybody thought it was a final act to forestall the ultimate bankruptcy of the industry"

Yet even a pessimist would accept that the US railroads have been transformed for the better over the past four decades. The low point came in 1970 with the first of a series of bankruptcies that led the federal government to form Conrail to keep services going. In 1971 regulators allowed operators to end most of their passenger services and pass the remainder to Amtrak, which eventually became part of the federal government.

Mr Rose says that even the moment usually regarded as the turning point for US rail - the 1980 Staggers Act that deregulated the industry - was seen at the time only as a way of slowing the industry's decline.

"Everybody thought it was a final act to forestall the ultimate bankruptcy of the industry," he says.

Instead of disappearing, however, railroads embarked on a round of closing lossmaking lines and mergers, including the takeover in 1999 of Conrail by Norfolk Southern and CSX. The two divided the railroad between themselves.

More recently, railroads have started to invest in new capacity.

"It put so much pressure on the industry to become more efficient that now we have a freight rail industry that's the envy of the free world," Mr Rose says of the act.

A striking example of railroads' recent investment programmes is the $92m-Charlotte Intermodal Facility that Norfolk Southern opened in December between the runways of Charlotte international airport in North Carolina. Satellite-guided cranes at the facility work their way along trains stacked two-high with containers, lifting containers between the trains and truck chassis lined up alongside. The containers are either coming from or going to local distribution centres, carrying toys, dog food, car parts and other consumer goods.

Such intermodal traffic - movements of goods in shipping containers and truck trailers - provides the basis for much of railroad executives' long-term optimism about the industry's prospects. The traffic is close to displacing coal as US railroads' single biggest revenue source.

High fuel prices and driver shortages have pushed many trucking companies to shift long-distance goods movements from road to rail. Truckers - and logistics companies such as UPS - handle only the short-haul movements at either end of a journey.

Ken Buenker, vice-president for corporate transportation of UPS, the logistics company, says better service has significantly improved railroads' attractiveness.

"Their services have over time certainly sped up measurably," he says.

Mr Rose says intermodal traffic remains railroads' most promising growth area for future decades. "I think it demonstrates how fortunate the United States is to have a first-class, very flexible rail system"

"The long-term sustainable growth in this industry comes from working with truckers to take tons off the road," he says.

Intermodal traffic growth rates look pedestrian compared with the re-emergence of crude oil on railroads for the first time since the 19th century. The seven Class I railroads moved about 400,000 carloads of crude oil in the US past year, against 234,000 in 2012 and only 9,500 in 2008.

The US's domestic energy boom would have been impossible without the railroads transporting both crude oil, pipes and "frac" sand used for hydraulic fracturing of shale rock, according to Jack Koraleski, chief executive of Union Pacific, the US's biggest freight railroad.

"I think it demonstrates how fortunate the United States is to have a first-class, very flexible rail system," he says.

Although the railroads' financial viability gives executives confidence, the industry faces serious problems.

The most pressing is that the rapid growth in crude oil traffic has shown up deficiencies in certain safety systems, particularly the design of the North American standard Class 111 tank car. The point was most tragically proved last July when a runaway train of Class 111s carrying North Dakota crude derailed at speed in Lac-Mégantic, Quebec. The cars exploded, devastating the small town and killing 47 people.

There have been several further incidents since, including a derailment and explosion on April 30 on a train operated by CSX by Virginia's James River, but no further fatalities.

Wick Moorman, Norfolk Southern's chief executive, accepts that the industry's safety record - which he says is already good - has to improve further, if only because of the huge potential liabilities from a catastrophe. "Every time we pick up a car, we're making a bet on the company," Mr Moorman says.

The US Department of Transportation has drawn up a revised standard for operating trains with hazardous materials and for the design of a new Class 111 car. But it has yet to publish them.

"You're always going to have certain things that happen," Mr Rose says of derailments. "We believe that we ought to strengthen up the tank car standards."

In the longer term, there remains the risk of a revived campaign by shippers for tougher regulation of railroads' charges. Some customers, particularly chemical shippers, started demanding new rules in the middle of the past decade when fees rose sharply. The campaign became far less vocal after they dropped again during the recession.

Canada's government illustrated the risks on March 8 when it unexpectedly imposed rules obliging Canadian National and Canadian Pacific to move set amounts of grain each week or face significant fines. "A wide range of customers have complained that it has grown harder to move their products to where customers need them"

The most immediate challenge is to expand capacity in the busiest places. Growing crude oil volumes, along with a bumper harvest in the western US and a severe winter, have contributed to growing congestion during the past six months.

A wide range of customers - from wheat shippers in the plains of the US and Canadian west, to ethanol producers, to Ford, the carmaker - have complained that it has grown harder to move their products to where customers need them. Average speeds on BNSF, the worst affected US railroad, in June were 12 per cent below the average for last year's second quarter.

BNSF has embarked on a $5bn capital expenditure programme for this year, aimed at restoring service levels. It has started adding a second track to its northern main line across Montana.

Mr Hatch points out that North America's railroads have absorbed in the past five years the greatest recession most executives will experience and the "body blow" of coal's decline.

"It's a great achievement for some of these people to be only saying, 'We're going to need to move our targets out a year'," Mr Hatch says. "If this had happened in the 1990s, you'd have had bankruptcies."

Quebec: The disaster that forced a safety rethink

Late on the evening of July 5 last year, a driver for the Montreal, Maine & Atlantic Railway, a regional railway, left his train of 72 crude oil tank cars in the small town of Nantes, Quebec, and took a taxi to a hotel. An hour later, the town's fire brigade arrived to deal with a blaze on one of the train's five locomotives, which the driver had left running. They put out the fire, shut down the engine and left.

But the running engine - through the power it supplied to the train's air brakes - had been holding the poorly secured train in place. Air leaked slowly out of reservoirs controlling the brakes and, just before 1am, the unattended train started to roll down a slope. About 15 minutes later, it crashed at high speed in nearby Lac-Mégantic, setting off an explosion that devastated the town and killed 47. "The most alarming discovery has been the vulnerability of the standard North American tank car to rupturing and explosion in a crash"

The tragedy spurred tighter operating rules for crude oil shipments. Trains are no longer left unattended or operated by only a single person. Regulators in Canada and the US issued emergency reminders about the need to secure trains properly when parked. Tests on the oil in the few undestroyed tankers revealed that it was far more liable to explode than
previously thought and much of it had been labelled as safer to transport than it actually was.

Wick Moorman, chief executive of Norfolk Southern, one of the US's biggest railroads, says the industry was initially puzzled by the explosions.

The most alarming discovery in both Lac-Mégantic and some other crashes has been the vulnerability of the standard North American tank car - known as the DoT Class 111 - to rupturing and explosion in a crash.

Bill Furman, chief executive of Greenbrier Group, one of the US's biggest tankcar manufacturers, says that for modern rail speeds, cars need stronger ends and thicker steel. They also need better valves to release the pressure that can build up and cause an explosion in a derailment, as well as insulating jackets to prevent fires spreading.

It should be possible within five years to phase out Class 111 cars from crude oil service through a mixture of building new cars and fitting equipment to make existing cars more robust, he says.

Until then, railroads will have to stick carefully to new operating rules agreed last month with the US's Department of Transportation. Among a slew of additional rules, crude oil trains are limited to 40mph and tracks carrying the traffic need to be inspected more regularly.

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