THE STB IS WORRIED. The shippers are worried, and the railroads are worried. Capacity is the word on everyone's lips, as a buoyant US economy is driving up business faster than the rail industry can handle it.
On June 10 Surface Transportation Board Chairman Roger Nober wrote to the Class I railroads, seeking information on capacity issues and their respective plans for dealing with the annual surge in traffic during the autumn business peak (RG 7.04 p396). The industry suffered serious capacity problems last year, and market pressures are greater in 2004.
Capacity and the fluidity of rail freight operations were major talking points at the national shippers' conference in May. Customers that had been lobbying for re-regulation and open access to drive down freight rates were more concerned this year with getting their traffic moved at all; most railways have been raising prices to improve profitability and return on capital, which some shippers suggested may also have helped to suppress demand.
As a result of growing congestion, average train speeds on Union Pacific fell in April and May to 33·6 km/h, against a target of 38·6 km/h. Longer cycle times reduce locomotive, wagon and crew productivity, further impacting on the railroad's ability to handle its traffic.
Similar trends following the takeover of Southern Pacific led to UP's 'service meltdown' in 1997, and the company has already taken action. An extra 3700 front-line staff should be in place by the end of next month, and UP has increased its 2004 locomotive orders from 150 to 270, with up to 350 more coming on short-term lease. CSX and BNSF are also ordering extra power. NS is bringing forward loco deliveries, and expects to recruit 2000 employees a year for the next five years.
Two years ago, international consultant David Burns pinpointed issues impacting on the ability of the Class Is to earn a profit (RG 8.02 p417). Competition from road and waterways had driven down average revenues over 30 years, to little more than 1·5ó/tonne-km. This in turn had created a strong focus on cost-cutting, with much surplus capacity being stripped out. Today the pressures are all about managing growth and boosting capacity as cost-effectively as possible.
A booming market
The five CEOs report that traffic is up in all sectors. David Goode of Norfolk Southern highlights trucking cost increases caused by higher fuel prices and growing road congestion and 'the impact of new hours-of-service laws', as factors which are 'helping to convert freight from highway to rail'. At CSX, Michael Ward reports that 'intermodal loadings are at record levels and coal is up significantly', noting that there has also been 'strong performance in our merchandise sector, led by chemicals and metals'.
In the west, Matt Rose of Burlington Northern Santa Fe identifies 'strong Trans-Pacific trade, spurred on by China's growing exports to the USA' as boosting the intermodal business. Union Pacific's Dick Davidson says that 'first-quarter earnings reports showed record revenue growth as a result of increased demand and price growth across the board.'
Canadian National's Hunter Harrison agrees that 'major efforts are being made to penetrate truck markets and to increase overall yield, although competition among railroads remains a central feature of the industry.' Thanks to 'significant expansion capital spent across the system in the past five years', notably on line improvements and longer passing sidings, Harrison says CN 'has sufficient track capacity to grow its business by 4% or 5% annually for years to come.'
He has a caveat, though. 'One of CN's main corporate objectives is growing the business profitably. Key to this is providing efficient, quality service. Chasing new business for the sake of new business, however, does not necessarily translate into profitable growth and is not consistent with our strategic and financial objectives.'
Rose puts his finger squarely on the biggest concern. 'One of the key issues facing the industry is our ability to continuously improve our return on invested capital, to justify continued reinvestment to meet forecasted rail demand over the next 20 years.'
Davidson believes 'the key issues are capacity constraints and [quality of] service.' Ward recognises that there are 'shortages of certain car types, stretched locomotive fleets and some network congestion [which are] all challenges that must be met effectively, while balancing capital dollars among several areas. That means an intense focus on getting the most out of these key assets.'
'During the next 18 months, the industry will face important challenges', warns Harrison. 'First, we must grapple with cost inflation. Fringe benefit costs are rising, and will continue to do so in the foreseeable future. Second, key commodity prices have been increasing strongly, and will continue to pressure profit margins. Railroads with the drive and determination to improve productivity will be the ones best positioned to deal with these cost pressures.'
Consolidation, not mergers
One way for the Class Is to cut costs has been to concentrate traffic onto fewer corridors, close duplicate routes and spin off secondary lines to smaller operators.
Davidson says 'UP went through a period in the early to mid 1990s where it was focused on network rationalisation, but we really don't see much of that activity going forward.' Noting that 'most of our capacity-constrained areas are not related to locations where we sold or closed track and/or facilities', he does not rule out future sales like the 2002 deal with Utah Transit Authority which released rights of way for commuter rail operations in Salt Lake City.
At CN, too, the 'focus on network rationalisation peaked in the late 1990s.' The emphasis has since been on expansion, with the acquisition of Illinois Central in 1999 and Wisconsin Central in 2001. CN has recently completed the purchase of Great Lakes Transportation, and Harrison says the 'partnership agreement' with BC Rail 'will again expand CN's market reach and drive new efficiencies.' Whilst CN 'is always on the look-out' for opportunities, he sees 'no reason to significantly modify CN's network of partners at this time.'
But BNSF's Matt Rose believes that line sales will continue. 'As long as the industry in general does not exceed its cost of capital, the network will continue to change as it has in recent years.' This view is supported by Ward, who says CSX has targeted 'up to 1900 km for sale or lease' during 2004. 'We believe selective line dispositions are an important part of concentrating scarce capital on key corridors that are heavily utilised.'
Goode agrees. NS continues 'to downgrade duplicate and parallel routes, and to judiciously pare down the gathering network as circumstances warrant. We have not had to reopen rationalised lines to restore capacity. Our practice has been to resolve bottlenecks by adding incremental capacity selectively to principal routes - we are careful not to jeopardise capacity or restrict routing options.'
This ongoing search for seamless service, cost savings and better capacity utilisation helped to drive what Harrison calls 'a wave of major mergers in the mid to late 1990s'. However, the railroads are still working to obtain many of the benefits promised at that time, and the five CEOs agree that the pressure for further mergers has been reduced.
'A new round of merger activity would seem much less likely in the short or medium term', says Goode, noting that STB's new merger rules 'have raised the bar for applicants to demonstrate public benefits and enhanced competition.' Customers would have to be convinced that 'any future consolidation would be implemented with minimal disruption.' He also fears that any 'end game' of final industry consolidation 'would be accompanied by increased regulation'.
Davidson believes that 'we can extract many of the same benefits as a merger through our alliance work.' UP's management team meets the top managers of the other railroads on a quarterly basis 'to discuss joint operating and marketing initiatives.' Ward agrees. 'Industry alliances are providing many of the customer and revenue benefits upon which prior mergers were based.'
Return on investment
Rose believes that any future mergers would be driven 'either by customer demands for much better transcontinental service, or by deterioration in the financial position of one or more Class Is.'
He warns that 'BNSF and the other Class Is have seen a steady erosion of their Return On Invested Capital, and a growing gap between this ratio and their cost of capital. We need to be able to invest more vigorously in our infrastructure. We can't, because our ROIC has been in the 6·6% range and some two or three points below our cost of capital.'
In 2004, Rose expects ROIC to improve 'for the first time in seven years'. But 'unless we continue to have similar annual improvements until we get into the 9% range, we cannot invest the capital necessary to meet future forecasted demand.'
'At CSX', says Ward 'we remind ourselves that we must earn our right to capital dollars' through better performance. 'If capital dollars are limited, our ability to use capital is also limited.' NS 'is working hard to earn our cost of capital and to increase earnings towards that end.' But Goode insists that 'our capital investment programme is being adequately funded through cash flow from operations, and at the same time we are paying down debt.'
Harrison says 'continued improvement in CN's financial performance' since privatisation in 1995 has 'translated into growing cash flow and a solid overall return on investment', enabling it to fund major projects. 'The constraints imposed on capital investment reflect the requirements for sound returns as well as the need for prudent financial management on an ongoing basis.'
One avenue now being explored is to tap public-sector funding for future investment projects, although Goode says 'concrete sources of public funding are slow to develop - many initiatives have been under study for a number of years.'
UP and BNSF have both benefited from the Alameda Corridor in southern California, a public-private partnership to upgrade the rail link to the ports of Los Angeles and Long Beach (RG 2.02 p243). Both railroads are partners in the $1·5bn Chicago Region Environmental & Transportation Efficiency Project to alleviate rail and road congestion. CSX is also involved with Create, and with another partnership with the Port Authority of New York & New Jersey.
Rose says that 'in situations where there are public benefits from investment in rail infrastructure, we will pursue public funding and public-private partnerships to finance those investments.' Davidson too welcomes 'opportunities to join specific projects on a community-by-community basis, where they are beneficial to all parties involved.' But he is wary of Washington: 'we do not see federal funding as a part of the solution in earning our cost of capital.'
Reversing the price curve
One way of improving financial performance is to raise freight rates on the back of the strong market. 'This is an opportune time to focus on pricing', says Goode. NS has 'begun to reverse the industry's years-long declining price curve. Today's environment clearly is one in which we have a valuable product to sell, and we've been very open with our customers about it.'
He sees a virtuous spiral. 'Exceptional performance creates better service. That attracts more business and has higher value, allowing us to pursue pricing that improves our margins. That makes our returns better, which flow to everyone - the communities and customers we serve, our own people, and of course our investors.'
Noting that 'markets set prices', Davidson agrees that 'economic demand is creating strong earnings potential.' UP's goal is 'to achieve at least 1% of price growth per year - but today we believe that could be even greater.' Ward says CSX has adopted 'a "value pricing" approach', focusing on commodities which he believes were traditionally under-priced. He sees scope for 'additional price increases in the future, though they are linked to service'.
Harrison says that 'increasingly the market is recognising the value of reliability and speed.' Whilst the 'highly-competitive marketplace' still constrains pricing, 'it also allows shippers to better measure the value of quality service.' CN's customer satisfaction has improved steadily, enabling the railroad to 'enlarge its share of merchandise traffic and deliver a turn-around in pricing.'
Union Pacific's Yield Strategy was introduced in 1999, and Davidson reports success in charging premium prices for premium products. Rose confirms that BNSF revenues were up by a record 11% in the first quarter of 2004, with units handled up by 8% and price levels 'by about 2% overall', with some surcharges help cover increased fuel costs.
Revenue improvements are coming across the board. 'Tight motor carrier capacity, increasing demand and higher over-the-road costs are providing a favourable climate for intermodal', says Goode. BNSF is marketing 'an expedited truckload service designed specifically to meet the operational needs of motor carriers.' This 'modal partnering initiative' has seen a 'great response', and Rose anticipates that it will generate $200m of new business by the end of 2004.
Both NS and CSX have seen a significant resurgence in bulk coal movements, which Goode attributes to growing demand in China diverting competing flows and reopening opportunities in Europe. Ward says CSX coal traffic was up by 10% in the first quarter of 2004. 'We continue to focus on the natural advantages of railroads to haul bulk goods economically', he explains, noting that 'coal, coke and iron ore represent about 23% of our revenue base.'
Goode says 'the near-term challenge is not demand but supply', because 'we lost a good deal of eastern US coal production capacity in the last export downturn'. His 'medium to long-term challenge will be a continued shift in coal sources for the domestic market', from Appalachian mines to the Powder River and Illinois basins.
Scheduling boosts efficiency
Capital investment is a relatively-long-term solution to capacity issues. In the meantime, there is pressure to make better use of existing resources. One early win is a return to scheduled operations. In the 1960s there was a general move away from timetabled services, allowing business to be aggregated into fewer trainloads to reduce operating costs. Today, information technology allows better and faster operations planning.
'CN recognised years ago that scheduled operations improve both service quality and asset utilisation', explains Harrison. 'Over the past five to six years, CN has improved rolling stock productivity by more than 25% without jeopardising, indeed while improving, service quality.' CN adopted Scheduled Railroading for its carload business in 1998. It applied the same principles to intermodal last year as part of its IMX initiative, and Harrison reports that 'the results have been significant - we have made major strides in improving the productivity of our intermodal fleet.'
Norfolk Southern's Thoroughbred Operating Plan was 'the right move', according to Goode. 'It has produced benefits for customers in all our merchandise commodity groups. We are learning how to do it better all the time. Performance metrics have continued to improve, even as volumes strengthen', and he believes that 'we can continue productivity improvements' in the strengthening market, as 'we have the capability to add business profitably.'
CSX Transportation's ultimate goal is 'to schedule and operate its entire network with a higher degree of precision and reliability', says Ward. 'We are preparing to implement ONEPlan on our merchandise and automobile networks.' This network redesign is intended to minimise re-marshalling and optimise train and car routing. 'With each car handling adding an average 24h delay, we see the potential to reduce 1 million handlings a year, or an 8% improvement.' A separate network simplification plan is also being initiated for the CSX intermodal business.
Rose recognises that 'scheduled train service, based on accurate forecasts, does benefit many areas of BNSF's business, from planning locomotive and crew availability to scheduling track maintenance windows. The ability to plan ahead does make our operation more efficient.'
In or outsourcing?
Savings have also come from outsourcing administration and maintenance services. Davidson says that UP outsources some IT, contract maintenance and 'other "non-core" competency-related activities.'
Rose describes BNSF's approach as 'right-sourcing', which involves 'determining how we can meet our workforce requirements most efficiently and at lowest total cost.' According to Harrison, 'CN has long believed that where the market can provide a specific service more effectively and efficiently, there is really no justification for in-house activities.' However, he recognises that 'this requires an ongoing review of market-provided services as the competitive environment evolves.'
Ward believes that 'outsourcing should only be done when it makes good business sense. Railroading has many unique characteristics that do not lend themselves to "one size fits all" models.' However, he highlights one 'beneficial outsourcing partnership' where General Electric has assumed responsibility for managing locomotive maintenance at Waycross, using CSX employees.
Goode favours a somewhat different approach. 'NS has not outsourced key services, such as locomotive maintenance, that have competitive in-house costs and are considered core competencies.' In fact, 'Thoroughbred Mechanical Services operates an insourcing business for locomotive maintenance and contract remanufacturing', currently filling orders for both the domestic and international markets.
Nevertheless, NS has outsourced the supply of components for locos and freight cars 'when they could not be competitively produced in-house.' It has also achieved significant savings in outsourcing 'other service opportunities', such as preparing freight cars for loading and servicing end-of-train devices.'
Productivity drives R&D spending
All the Class Is are looking to technical innovation for further improvements in efficiency and performance, but there is uncertainty over the responsibility for funding research and development.
'Technical innovation has traditionally been the mainstay of railroads, in line with a vertically-integrated view of the business', explains Harrison. Increasingly, however, 'research has been taking place in the market', and he believes that getting the suppliers involved 'is a healthy and promising development. It allows the railroads to focus on process innovation, on the core value of railroading, on how to improve the quality of service.' Rose too accepts that 'suppliers need to lead and fund R&D work', but he is concerned about 'the relatively low level of investment by suppliers'.
'CSX views responsibility for research & development as a co-operative three-way partnership' between the railroad, its suppliers and the Association of American Railroads, says Ward. He wants to see suppliers 'continue to make their services and products more effective and efficient' and expects AAR and its research subsidiary Transportation Technology Center Inc to 'continue to sponsor research beneficial to our industry'.
Davidson confirms that UP is continuing to invest in research, 'testing new locomotives, new rail compositions, new ties and new technology'. Over the past few years, he highlights the increased use of remote control, 'from distributed-power locomotives to switch operations in our yards.' Harrison says CN is looking to the supply industry for a new generation of freight cars 'with high capacity and low maintenance.'
Goode insists that 'research in rail today is very vigorous. While budgets have been strained in recent years, highly-focused programmes are being progressed by individual railroads and TTCI. First priority is given to developing methods and technologies which improve service. Other targets include fuel savings, improved asset utilisation and reduction of overall maintenance costs.
'Individual railroads will continue to address research that is more specific to their needs, and this is certainly the case for NS. Funding for such research can sometimes be supplemented by grants from federal agencies. Large research efforts that are in the common interest of all are best progressed through the AAR with supplemental funding from the Federal Railroad Administration. Railroads also rely on suppliers for development of new technologies, and academic sources continue to play a role.'
It is not surprising that the focus of much research is to get the most from existing assets. 'Higher service levels are the key to attracting more shippers and commanding rates commensurate with service', insists Goode. 'To make railroad operations more predictable, disruptions associated with equipment or track maintenance failures must be minimised.' He says NS is particularly interested in advanced condition-monitoring technologies for both track geometry and rolling stock condition, like the Wayside Monitoring Alliance's proposed Supersite concept (RG 7.04 p407).
Ward believes the thrust must be 'focused on applications that improve service and efficiency and benefit our customers.' He says development is continuing on ShipCSX internet-based transaction software to improve the customer interface for car ordering and billing. CSX is also using radio data links to record car deliveries and pick-ups 'so that our customer transaction database more closely represents the real-time environment.'
BNSF has been able to capitalise on IT developments from other industries, notably in a programme to boost the capacity of its intermodal yards, using hand-held devices, radio-frequency data transmission and GPS; only the OASIS scheduling system was purpose-developed for the railway. 'Many technologies will be developed as joint efforts by railways and technology providers', predicts Rose.
Matthew K Rose
Chairman, President & CEO, Burlington Northern Santa Fe Corp
E Hunter Harrison
President & CEO
Chairman, President & CEOCSX Corp
David R Goode
Chairman, President & CEO
Norfolk Southern Corp
Richard K Davidson
Chairman & CEO
Union Pacific Corp
INTRO: Economic recovery in the USA is driving up the freight market, putting pressure on the busiest rail corridors. Chris Jackson asked five of the major players how they are coping with the capacity pressures and funding their investment needs
'One of the key issues facing the industry is our ability to continuously improve our return on invested capital, to justify continued reinvestment to meet forecasted rail demand over the next 20 years.'
Matt Rose, BNSF
CAPTION: Much rail industry research is focused on improving asset productivity; BNSF highlights the advent of automatic equipment identification as a breakthrough that paved the way for advanced wagon health monitoring
'We can extract many of the same benefits as a merger through our alliance work.'
Dick Davidson, Union Pacific
'Over the past five to six years, CN has improved rolling stock productivity by more than 25%.'
E Hunter Harrison, Canadian National
'Higher service levels are the key to attracting more shippers and commanding rates commensurate with service.'
David Goode, Norfolk Southern
CAPTION: Canadian National's acquisition of Illinois Central, Wisconsin Central and Great Lakes Transportation has increased the importance of Chicago as a hub in the CNnetwork
CAPTION: Michael Ward says CSX's decision to outsource the management of locomotive maintenance at Waycross to General Electric has been highly beneficial
'Railroading has many unique characteristics that do not lend themselves to "one size fits all" models.'
Michael Ward, CSX
TABLE: Class Is in perspective
The Class I railroads are defined by the Association of American Railroads as line-haul freight railroads with operating revenue in excess of US$272·0m. In 2003 there were seven US Class Is: Burlington Northern & Santa Fe, CSX Transportation, Grand Trunk Corp (Canadian National), Kansas City Southern, Norfolk Southern, Soo Line (Canadian Pacific Railway), and Union Pacific. They accounted for 70% of the US rail network, operating 160808 out of 228415 route-km.
Railroad Length Locos Wagons Empl- Tonnes Revenue Operating route oyees originated tonne-km revenue -km1 million billion US$m
BNSF 40125 5187 97079 37366 394·3 707·2 8963
Canadian National 31470 1912 88791 23190 170·9 231·5 3891
Canadian Pacific 15446 1510 49115 16116 105·8 155·9 2334
CSX 31380 3381 108978 32425 318·3 330·4 6368
Kansas City Southern 4647 480 15975 2516 26·4 29·2 560
Norfolk Southern 27457 3410 115295 28751 277·0 259·2 6270
Union Pacific 44556 7060 140424 47219 440·4 751·1 11103
Total2 326393 - 1518935 217478 2169 2952 42500
1. Owned length, excludes routes leased or served by trackage rights Source: AAR data for 20022. Includes Canada and Mexico