Resilient…Responsive…Determined: Rails Focus on the Future

Tags: Legislation, Public Policy, and Regulations, Intermodal, Rail

Despite economic headwinds, rails are investing heavily for future growth. Inbound Logistics gets the full story at the annual RailTrends conference.

The U.S. railroad is nothing if not resilient. That's to be expected for a transport mode that spans three centuries and remains as relevant now as ever.

It was that relevancy, along with resolution and optimism, that was displayed in full force during the annual RailTrends conference in New York City in December 2012. Inbound Logistics attended the two-day meeting, which was sponsored by Progressive Railroading magazine, and hosted by Tony Hatch, president, ABH Consulting, and featured an audience of rail carrier and supplier executives.

Ed Hamberger, president and CEO of the Association of American Railroads (AAR), summarized the industry's position in his opening comments, stating that not enough leaders in Washington understand that freight railroads are privately owned and privately maintained, and that $500 million in private-sector money has gone into this freight system since 1980.

"While the federal government has been borrowing 40 cents of every dollar it spends, AAR's members have been spending 40 cents of every dollar they earn putting it back into the network," Hamberger said.

With headstrong defiance comes a protectionist impulse—both traits have served the railroad well, but have also inured criticisms against it. Carrier-shipper antipathy was equally palpable at the conference, and without significant shipper representation—apart from National Industrial Transportation League (NITL) President and CEO Bruce Carlton—sentiment clearly skewed toward rail interests.

Outside the industry, divisiveness also exists between freight and passenger interests, especially when it comes to government spending. But RailTrends attendees presented a unified front.

Amtrak CEO Joseph Boardman was bullish in his assessment of the rail industry and economy at large, noting "this country needs to start thinking about growth rather than survival."

And while Amtrak has always been an odd duck—it depends on Congress for funding and isn't a private industry, except when it gets turned down by states for FEMA assistance, according to Boardman—it provides the freight railroads with an operational barometer and competitive push when necessary.

Despite debate over funding and regulation, the railroad is an undeniable force that is rounding a mountain of political and economic discontent as it heads into a new growth curve. It serves as an example of private-sector ambition, and a model for transportation investment and planning—impulses that are sorely lacking in Washington.

Moving into 2013, a number of challenges and opportunities await the railroad industry—developments that will similarly frame how well the United States rebounds from recession to recovery, and eventually growth.

Two Levers and Four Headwinds

Railroads have endured criticism over the past few decades that they were late to the game in meeting customer service requirements. But that sentiment is changing. Rising yields and scheduled railroading—the latter a consequence of Class I railway Canadian National's pioneering approach—are the two primary levers driving value and cash flow within the industry, according to Jeff Ward, partner and vice president of consulting firm A.T. Kearney.

"The U.S. rail system is the envy of the world," he said, while also cautioning against government intervention that may threaten to tip the status quo.

New regulatory developments are among the four headwinds Ward cited, along with rising commodity costs, shifts in traffic mix, and supplier market change—the latter being a major factor in how railroads manage their own supply chains.

The decline in coal and the emergence of natural gas, shale oil, and containerized intermodal freight are impacting rail traffic patterns. Domestic intermodal growth in new corridors with less density is placing more pressure on traditional lanes.

Another factor is increasing global competition for railroad equipment supply as new projects in Africa and the Middle East create higher materials costs throughout the industry. "The question remains whether the railroads' procurement functions are capable of addressing these headwinds," said Ward.

"Most of the dollars we spend in the industry go outside the organization, whether it's fuel, capital projects, or equipment," he added.

Railroad procurement is an important function within the industry as it confronts rising operational costs and seeks greater efficiency levels.

Switching Tactics

On the flipside, there is no discounting the outward investments railroads have made over the past 30 years in equipment, track, and facilities. Hamberger labeled the railroad's current form as a "renaissance," and credited private investment following the Staggers Act and de-regulation as the primary influence behind this resurgence.

"It wasn't so long ago that freight rail service was an oxymoron," he noted. "Not anymore. UPS is our single largest customer, and variations in delivery time are getting much smaller. We're providing more consistent service. That is why we are continuing to grow market share."

The railroads have certainly won business—leading some captive rail shippers to feel Class I's have shunned their constituency in favor of more lucrative growth opportunities.

"When the economy starts to pick up, we'll be in trouble if we aren't focused on our supply chain infrastructure and building out for the future."—Michael Bourque, president and CEO, Railway Association of Canada

As an example, Michael Bourque, president and CEO of the Railway Association of Canada, described an ongoing dispute with shippers who are lobbying the Canadian government to introduce legislation that would guarantee shippers service contracts.

"Oil producers like the fact that they don't have to enter into a contract," Bourque said. "They get to use the rail network and share the cost."

Hamberger addressed similar criticisms—notably from the fertilizer industry—that suggest some shippers are investing overseas because of high freight rail rates and bad freight rail service.

"Shippers were investing in places such as Doha, Quatar, and Oman, but not because they have better freight rail services than the United States," he said. "Maybe it's because that's where the natural gas is.

"In September 2012, two fertilizer company CEOs stated in their third-quarter earnings reports that they were re-investing back in the United States—that shale natural gas was a game changer," he continued. "One CEO predicted more investment centered in the United States over the next five years than ever before because of natural gas prices."

Hamberger believes a balanced regulatory system is critical to sustaining growth within the rail industry, which has seen productivity increase 173 percent and inflation-adjusted rates fall 50 percent since 1980, when 25 percent of the industry was beset by bankruptcy.

A Touchy Subject

Currently, the principal "jousting ground" between rail shippers and carriers is Surface Transportation Board (STB) proceedings regarding Ex Parte 711 legislation that seeks to adopt new rules governing reciprocal switching. Class I railroad CSX defines this practice as "the movement of a railcar, in switch service between the interchange tracks of one railroad to a customer's private or assigned siding on another railroad, for the purpose of loading or unloading freight. The service precedes or follows a road haul and is bi-directional to include both the loaded and empty railcar."

"In June 2011, we submitted a petition to STB to introduce a measure of head-to-head competition between Class I railroads in the United States," said NITL's Carlton. "This petition is built on discussions of competitive switching—the rights, privileges, and responsibilities."

NITL introduced the proposal in an effort to eliminate existing competitive access rules and precedents as they apply to reciprocal switching. The revised rule would require a Class I railroad to enter into a competitive switching arrangement whenever a shipper or group of shippers demonstrates that certain "objective operating conditions" exist, thereby providing more efficient, reliable, and cost-effective rail transportation, according to NITL.

Those extenuating conditions would be triggered if: the shipper's facility is served by one Class I carrier; there is a lack of effective inter- and intramodal competition; there is or can be a "working interchange" within a "reasonable distance" of the shipper's facility; and switching would not be unsafe, impractical, or hurt existing service.

"This is about competition, not about regulation or re-regulation," Carlton said. "NITL members do want a strong, profitable, well-functioning freight rail industry. They need it. They depend on it to move product in and out."

The STB has solicited additional comments from both shippers and carriers as to potential impacts on their respective operations. Hamberger similarly pledged that AAR would demonstrate impacts on not just freight rail revenues, but also on service and efficiency.

"To spot a car, take it after it's loaded, and bring it back into service on a single line move can be as few as six discrete moves of that car," Hamberger stated. "With mandatory reciprocal switching, that can grow to 16, 18, or 20 moves. Each move is an opportunity for something to go wrong—each one takes time, equipment, and personnel, and clogs up yards.

"We believe there will be an adverse impact from 711 not only on revenues, but also on operations," he said.

Natural Gas Explosion?

While many railroaders are wary that Washington's regulatory overreach threatens to disturb a finite balance within the industry, shifting commodity trends are doing much the same—signaling a new wave in U.S. rail development that, in time, will likely benefit all users.

"Natural gas is at historically low prices, causing a tremendous ripple effect through the energy and energy consumption industries," said Carlton. "It has a displacement effect in freight rail, hitting the coal industry significantly. Where we go from here, whether there will be natural gas exports or not, will impact pricing. It could move the freight rail industry in one direction or another in the short term."

The coal industry is on a precipitous downward trend, largely because of the economy, increasing environmental regulation, and energy competition. In its stead, natural gas—and the materials necessary for extraction, such as frac sand—and crude oil have become a bonanza for railroads.

"Coal now accounts for only 35 percent of U.S. electricity generation, down considerably from 50 percent not too long ago," said Toby Kolstad, president of Rail Theory Forecasts, a rail freight traffic and equipment consulting firm. "Natural gas use is almost even with coal. The two will probably switch places in the next few years."

While North American demand for coal is ebbing, emerging export markets are opening, setting the table for more outward growth.

Carlton cited the Cove Point LNG Terminal in southern Maryland as one example of this changing paradigm. The offshore processing facility, which was built as part of a long-term contract for natural gas exports out of Algeria, never materialized and was eventually shuttered.

"We forgot the Algerians had their hands on the valve, and could shut off the gas," explained Carlton.

A few years ago, Cove Point re-opened for imports. Now the LNG terminals may be converted for liquefaction and export.

Canada is experiencing similar change. The country has an abundance of natural resources—wood, potash, minerals, grain, crude oil—and the developing world wants them.

Canadian National has been a welcome beneficiary. Thirty-one percent of its business is related to global trade, according to Jean-Jacques Ruest, executive vice president and chief marketing officer at CN.

He believes the rise of natural gas and related commodities is forcing the industry to react. "One benefit of the North American energy renaissance is that it is teaching railroads to be nimble and fast," Ruest said.

Case in point: Union Pacific's (UP) West Texas origin and destination business flourished due to the oil boom. Initially, UP didn't have capacity to meet demand, and there were operational constraints, explained Joe Santamaria, vice president of engineering, UP. The railroad set up a just-in-time operation to serve the region, rebuilding yards, increasing leads, doubling capacity, and expanding throughput.

In the long term, many believe new energy will more than offset the loss of coal business—and there is a silver lining. Major industrial growth opportunities exist where companies are looking to locate manufacturing activity proximate to energy supply, said Patrick Ottensmeyer, executive vice president and chief marketing officer at Kansas City Southern Railway.

And while the U.S. and Canadian markets for natural gas are just beginning to develop, Mexico remains untapped, providing further incentive for the new government there to engage reform and bring in foreign capital to begin exploration.

If the first rail renaissance is defined by customer service improvements and intermodal traction, the second resurgence will feature intermodal volume growth and a manufacturing rebound, stated Donald Broughton, chief market strategist for investment banking company Avondale Partners.

An Intermodal Awakening

Rail/intermodal is becoming a bigger part of the conversation among North American transportation circles. Mixing and matching rail's long-haul economy with trucking's short-turn responsiveness is a natural synergy. But it has always been an awkward proposition for a railroad industry perceived as self-reliant and inwardly focused. Intermodal not only forces shippers and consignees to step beyond the comfort zone, but industry as well.

The international play has been a relatively easy quarry for railroads. Rail/intermodal at U.S. ports helps alleviate congestion and speed throughput. The domestic front, however, presents a more dynamic challenge.

While Kolstad was previously optimistic that rail intermodal volumes appeared to be growing faster than imported containers—suggesting domestic intermodal traction—he's no longer certain that's the case. "Although I see a lot of J.B. Hunt and Schneider containers on the highway, I don't know yet if we are containerizing U.S. traffic as much as we thought," he said.

Demand for intermodal railway equipment is down as the market absorbs what already exists—although Kolstad expects that trend to reverse itself sooner rather than later. And as the economy recovers and volumes return to normal, capacity constraints will again raise the efficacy of rail/intermodal solutions and equipment demand.

Intermodal is still a foreign concept for many outside the industry. "The story of intermodal and containerization is not well-known," Bourque says. "We need to do a better job of explaining how it works and the opportunities that exist."

One example in Canada is the development of intermodal export opportunities at British Columbia's Port Prince Rupert. While the port has always had strong inbound flows from China, it has doubled its exports to $5 billion since 2009. A lot of that volume is focused on forestry product moving in containers out of Prince Rupert.

Closer to home, the lead intermodal story features Florida East Coast (FEC) Railway's continuing growth in the Southeast region. Jim Hertwig, president and CEO of the 351-mile railroad, was quick to deflect any shortline stereotypes. "We're an extension of two Class I's," he said. "We run trains."

The railroad is gaining new interest, largely due to the Panama Canal re-opening. The South Florida market is a traditional dead-head zone, with four trucks moving in for every one heading out. Carriers don't like to go there, so FEC has captured share and interest from shippers that can run containers via rail into the market from Jacksonville.

Seventy-five percent of FEC's business is intermodal volume, 60 percent of which comes from Norfolk Southern and CSX. The railroad recently opened an intermodal facility in Cocoa Beach, where Walmart is a big customer. And its relay services from Nashville, Memphis, Charlotte, and Atlanta provide truck-competitive service into the Florida market.

FEC has effectively created a regional intermodal bridge between the rail and truck industries. Many see it as a new direction for transportation in the United States—one that can economically and efficiently absorb new freight flows and help alleviate capacity constraints.

The Railroad's Supply Chain Play

An underlying theme during the RailTrends event was the railroad's positioning in the broader supply chain. The industry faces its own fresh concerns with regards to material costs and supply management as global demand for equipment amplifies.

But the railroad's "renaissance"—a phrase used often during the conference—is now forcing carriers to consider their interplay in a much broader supply chain framework.

The issue is why Hertwig's presentation about the efficacy of short-haul intermodal resonated so well among audience members. It's also why CN is addressing a unique need in the Detroit market to create a single-lane service from Prince Rupert and Vancouver through Chicago so automotive shipments don't get hung up at interchanges.

"Automakers aren't interested in buying a rail service—they want a supply chain solution that stretches from Asia to Detroit," said Ruest.

A number of transportation and logistics pundits and policy makers have pegged intermodal as an anchor for establishing a much-needed freight transportation policy in the United States. The infrastructure exists, and railroads have become more efficient and timely. Additionally, the mainstream potential of natural gas—and the railroad's role in bringing this to reality—adds a vital energy component to transportation planning discussions.

"The growth of rail is phenomenal. In some parts of our supply chain, we are already at capacity," said Bourque. "We're still in a recession and growth is flat. When the economy starts to pick up, which it will, we're going to be in trouble if we aren't focused on our supply chain infrastructure and building out for the future."