An impartial observer could be forgiven for thinking that the current market for rail transportation of coal is somewhat schizophrenic. On the one hand, there have been several recent, highly publicized battles between the Burlington Northern Santa Fe (BNSF) and Union Pacific (UP) railroads in the west for contracts to haul Powder River Basin (PRB) coal to competitively-served generators. Trade press reports indicate at least three major contracts (for service to Georgia Power's Scherer plant, Dynegy Midwest Generation, and the Omaha Public Power District) have been shifted from one carrier to the other as a result of this competition. On the other hand, rates for plants that do not have access to competitive transportation alternatives have begun to increase substantially.
A look at recent and historical rail rates for PRB coal movements to competitively-served destinations confirms that, as has been the case for roughly the past decade, rates have stayed nearly flat in nominal terms at about 8 mills per ton-mile, which is close to the railroads' long-run marginal costs for these movements. So, competition for PRB coal movements appears to be healthy, if not quite as aggressive as it has been at some times in the past. Although there is not as much reliable data available for eastern movements, PA's analysis indicates that rates for the most competitive movements of Central and Northern Appalachian coal have also stayed essentially flat for several years.
At the same time, however, the Surface Transportation Board (STB) currently has 12 rail rate reasonableness cases on its docket, which is a very high caseload by historical standards. Furthermore, a review of the outcomes of recently decided cases suggests that both the eastern and western railroads have been very aggressive, and mostly successful, in pushing through large rate increases at generating plants that do not have access to transportation competition. (One of the conditions that must be proven in order to successfully bring a rate case before the STB is that there is no "effective competition" for the transportation at issue.)
Three of the recently decided rate cases have resulted in rates that are between 25 percent and 50 precent higher than the rates in effect prior to the filing of the rate case. Although it is still undecided whether the railroads will be required to phase in these rate increases over a period of several years, they are large by any measure, and are likely to serve as benchmarks for the rates applied to other generators that do not have access to transportation competition when their current rail contracts expire. As such, these rate increases likely represent the leading edge of a revolution in rail pricing.
Another recent revolutionary change in the pricing of coal transportation is that both BNSF and UP have introduced "public" or tariff-based pricing plans for a portion of their coal business. Although it is unclear how successful BNSF and UP will be in their stated long-term goal of moving the majority of their coal customers to these plans, there has clearly been a substantial shift in how BNSF and UP are thinking about the pricing of their coal business. After a decade or more in which both railroads put most of their coal business under 3-10 year contracts, BNSF is now saying they would like to have most of their coal business under 30-day contracts.
So, what is driving this revolution? And more importantly, how can shippers respond to it effectively in order to reduce their risk of being hit with large rate increases?
The performance of the “big four” railroads’ (BNSF, CSX, Norfolk Southern, and UP) stocks relative to the S&P 500, provides one important clue. From January 1994- May 2004, only BNSF has (marginally) out-performed the S&P 500, and the other three major railroads have substantially underperformed, with CSX actually losing value during this decade. Furthermore, most of BNSF's gains came in the late 1990s as a result of the merger of the Burlington Northern and Atchison, Topeka, and Santa Fe railroads in 1995, followed by the effects of UP's meltdown during late 1997-mid 1999. BNSF's stock has recorded essentially no net gain between April 1999 and May 2004.
Many of the executives from these railroads have been forthright in saying that their financial returns are not at levels they consider to be acceptable, and that rates will go up as a result. All of the "big four" railroads are also facing increased scrutiny from Wall Street, and have a corresponding need to be more sensitive to Wall Street sentiment. This is particularly true in the East, where CSX and NS are faced with paying off a total of $10 billion worth of debt incurred to finance the acquisition of Conrail in June 1999.
Wall Street sentiment is one reason why all four railroads (but especially BNSF and UP) have put so much effort into expanding their intermodal business, even though the margins for most types of intermodal traffic are lower than the margins on most non-intermodal traffic. Wall Street puts a high value on revenue growth (sometimes without adequate consideration of profitability - witness the dot-com boom and bust), and intermodal is one of the few high-growth opportunities for the railroad industry.
However (at least in the case of the railroad industry), there is an important kernel of truth behind Wall Street's bias towards revenue growth. Railroads are a high fixed cost business, and as such, losing volume often hurts them more financially than having to concede some ground on rates. Thus, shippers who are able to threaten the railroads with a loss of volume (as a result of having competitive alternatives for their transportation) are likely to gain significant leverage.
This dynamic also helps explain why CSX and NS have tried to increase rates for Central Appalachian coal movements to non-competitive destinations so steeply. Faced with a declining coal resource base in Central Appalachia (which has led to declining coal volumes), and large fixed costs, CSX and NS appear to have concluded that, in most cases, the only way they can maintain (or increase) profitability is to raise rates steeply.
Ideally, the railroads would like to increase rates across the board. However, the events of the past two years (and the analyses presented earlier in this article), indicate that, in practice, most of the burden of the rate increases will fall on shippers who do not have access to competitive transportation alternatives.
Thus, the obvious answer to the question of “What should generators do to reduce their risk of being hit with a large increase in rail rates?” is, “Pursue competitive transportation alternatives by all available means.” Most generators have probably done some analysis of how to create competitive transportation alternatives at plants that do not currently have them. However, since the value of having competitive transportation alternatives (or the cost of not having them) is likely to increase significantly in the future, some alternatives that were previously considered infeasible may need to be dusted off and re-evaluated.
It is also worth keeping in mind that (at least in the East) not all competition is created equal. Because there are so few plants served by both CSX and NS, the eastern railroads have been successful in “dividing and conquering” this market. In other words, there is a long-standing tacit understanding that “if you don't challenge me over here, I won't challenge you over there.” Thus, the shippers in the East who have the most leverage are those with access to barge, vessel, or truck service (possibly including the ability to import coal) that can take volume completely away from the railroads. In the West, there are many plants served by both BNSF and UP, and therefore any shipper who gains (or can plausibly threaten to build) access to both carriers instantly gains leverage.
One possible “win-win” opportunity in the East involves PRB coal. The recent re-bidding of the Scherer contract at very competitive rate levels, and NS's recent agreement to haul 100,000 tons/year of PRB coal to Conectiv's B.L. England plant in New Jersey show that the eastern railroads are often willing to quote competitive rates for PRB coal as a way of maintaining (or increasing) their coal volumes in the face of a declining resource base of Central Appalachian coal.
