Political Risks for Railroads
The recent derailment in East Palestine, Ohio has negative implications for the industry. Berkshire Hathaway's ownership of BNSF could be an advantage as politicians and regulators pursue reforms.
On February 3, a Norfolk Southern train carrying hazardous materials derailed in a small town in Ohio. The incident was not initially covered as a major news story, but it quickly gained momentum due to reports from the scene that spread virally on social media networks such as Twitter.
Politicians on the left and the right soon formulated strategies to capitalize on the derailment and, as they say, the rest is history. The national news media began to cover the story in earnest and politicians began visiting the site of the accident. One month after the incident, the situation has become a classic political firestorm.
Given the risks involved, one might reasonably ask why railroads agree to carry hazardous materials at all? Is it worth taking the risk?
The railroad industry is heavily regulated and operates subject to common carrier requirements. As common carriers, railroads must agree to transport chemicals and other hazardous materials. Whether we like it or not, these materials are necessary ingredients for producing the products we use every day. The common carrier requirement is an acknowledgement of this fact and a major risk for railroads.
BNSF’s recently filed 2022 10-K contains the following language in the section detailing operational risks. This is much more than a boilerplate warning and worth taking a few minutes to read in full:
“As part of its railroad operations, the Company frequently transports chemicals and other hazardous materials, which could expose it to the risk of significant claims, losses, and penalties and operating restrictions.”
“BNSF Railway frequently transports chemicals and other hazardous materials and is required to transport these commodities to the extent of its common carrier obligation. A release of toxic inhalation hazard chemicals or other hazardous commodities could result in significant personal injury or loss of life and extensive property damage as well as environmental remediation and restoration obligations and penalties. The associated costs could have an adverse effect on the Company’s operating results, financial condition, or liquidity, as the Company is not insured above a certain threshold. Further, the rates BNSF Railway receives for transporting these commodities do not adequately compensate it should there be some type of accident. In addition, insurance premiums charged for some or all of the coverage currently maintained by the Company could increase dramatically or certain coverage may not be available to the Company in the future if there is a catastrophic event related to rail transportation of these commodities. Regulatory imposition of routing or speed or other restrictions on the transportation of such products could adversely affect train velocity and network fluidity and adversely affect the Company’s results of operations, financial condition, or liquidity.”
There is no doubt that the people of East Palestine are justified to be worried about short and long term health implications. Doomberg, a popular publication on Substack, recently published a detailed account of the chemicals involved in the accident and the risks they present. Making an independent assessment of the situation is beyond my circle of competence, but I did find Doomberg’s article (and links provided) to be persuasive. The bottom line is that the situation could have been far worse if it had involved more hazardous chemicals in a densely populated city.
In recent months, I have studied the railroad industry in detail. In August, I published a report on BNSF, a subsidiary of Berkshire Hathaway that I have been following for many years. In September, I published a report on Union Pacific, BNSF’s primary competitor in the western United States. As part of my work on railroads, I also studied the life and career of Hunter Harrison, the man who is credited with the operational improvements known as “precision scheduled railroading”, or “PSR”.
PSR became a political lightning rod in recent months in the context of labor disputes that required intervention by Congress and the President to finally resolve. Railroads have steadily reduced operating costs over the past several years, having figured out how to operate their networks with fewer employees. Labor groups have alleged that railroads are sacrificing both safety and the well-being of their employees in their perennial efforts to deliver quarterly earnings that meet Wall Street’s approval.
Railroad safety depends on maintenance of physical infrastructure and the humans who oversee and operate the network on a daily basis. PSR has certainly reduced the number of employees, as discussed in my reports on BNSF and Union Pacific. Hunter Harrison, who died in 2017, adamantly denied that PSR sacrificed any safety at all, and his followers make the same claims today. The American Association of Railroads, the industry’s main trade group, predictably insists that the industry is a responsible actor.
It seems worthwhile to take a look at key statistics from BNSF and Union Pacific and consider how these figures will impact the political debate. The following exhibits show the operating ratio for BNSF since Berkshire Hathaway acquired the railroad and the operating ratio for Union Pacific over a longer timeframe:
A railroad’s operating ratio is calculated by dividing operating expenses by operating revenues. A lower ratio is a sign of efficiency and represents the most important metric that Wall Street looks at when evaluating the financial results of a railroad.
Union Pacific is a publicly traded railroad under continuous and relentless pressure to reduce the operating ratio as much as possible. Union Pacific recently announced that Lance Fritz, who took over as CEO in 2015, would depart this year under pressure from Soroban Capital Partners, a hedge fund that has expressed dissatisfaction with the company’s performance. Union Pacific posted a higher operating ratio in 2022 but has generally shown improvements during Mr. Fritz’s tenure.
BNSF, as a subsidiary of Berkshire Hathaway, is not subject to direct pressure from Wall Street and has taken a much more measured approach to cost cutting. It is interesting to contemplate what Soroban Capital Partners would say about BNSF’s performance given that Union Pacific’s numbers have been quite a bit better, at least as measured by the all-important operating ratio.
Although BNSF has posted meaningful improvements in its operating ratio since Berkshire acquired the railroad in 2010, management has not driven costs down as far as Union Pacific because it has not adopted all of the tenets of PSR. The following exhibit from my report on Union Pacific shows a comparison of the operating ratio trend among the major Class I railroads over the past decade:
Here is what I wrote in my report on BNSF regarding PSR:
“The question of whether BNSF should adopt PSR has come up at several annual meetings and Warren Buffett has commented at other times as well. While Berkshire appears open to considering adoption of PSR in the future, Mr. Buffett has noted that the operating ratio has declined without implementing PSR while BNSF has taken market share and maintained customer satisfaction.”
Berkshire Hathaway is known for playing a very long game and being willing to sacrifice current financial results for a better long term outcome. While BNSF’s management does not have the type of pressure Union Pacific is experiencing from Wall Street, presumably Warren Buffett is acting with restraint for good reasons, not because he wishes to purposely leave money on the table. Mr. Buffett is not directly involved in running the railroad but certainly exerts influence over major policy decisions at one of Berkshire’s most important subsidiaries.
Critics allege that in addition to cutting operating costs, railroads are not investing adequately in infrastructure, and that this is resulting in less reliable service and a greater risk of accidents. Bipartisan legislation has been introduced to strengthen regulations and impose new penalties and fines for wrongdoing.
BNSF invests billions of dollars annually in infrastructure, far in excess of depreciation charges (partially due to the effects of inflation). During Berkshire’s period of ownership starting in 2010, the railroad has spent $39.5 billion on capital expenditures plus an additional $8.1 billion acquiring equipment. During the same period, depreciation and amortization charges totaled $28 billion. Unlike trucking companies which can use government funded roadways, railroads must spend massive sums to maintain tracks, bridges, tunnels, rail yards, and other infrastructure assets.
Since acquiring the railroad, Berkshire has taken total distributions from BNSF of $50.6 billion. During the early years of ownership, annual distributions exceeded free cash flow and were effectively partially financed by increasing the railroad’s leverage. In recent years, distributions have roughly equaled free cash flow.
It should be emphasized that free cash flow is the cash remaining after the railroad funded all capital expenditures and equipment purchases.
There is no evidence to suggest that Berkshire has hollowed out the railroad. While critics have aimed mostly at publicly traded railroads when they complain about return of capital to shareholders, Berkshire could be criticized as well based on BNSF’s distribution history, although in my view there is no basis for the criticism.
Warren Buffett is well known for his long term outlook and willingness to forego short term profitability when necessary. But this does not mean that he tolerates sloppy operations that cost shareholders money in the short run. BNSF’s relative underperformance relative to Union Pacific and other Class I railroads, when measured by the operating ratio, is almost certainly a strategic move intended to limit political and regulatory consequences.
We should also keep in mind that Greg Abel, the man identified as Berkshire’s next CEO, has a long history of managing Berkshire Hathaway Energy which operates in an even more tightly regulated industry. At the recent Daily Journal annual meeting, Charlie Munger alluded to the value of Mr. Abel’s skills with respect to regulators:
Charlie Munger: “… The system at Berkshire is working pretty damn well. We’re very lucky to have a 92-year-old in such good shape as Warren and we’re very lucky to have a chief executive like Greg. Greg is very remarkable. Greg is trusted by utility regulators — and rightly so. He is trying to run all those utilities as if he were the regulator. How many people think that way? But it’s such a smart way to think.”
Becky Quick: “As a show of good faith?”
Charlie Munger: “Yeah. Why not do it the way that you would want it done if you were on the other side of the transaction? How can you fail if you treat other people the way you’d like to be treated yourself? It’s the golden rule. Of course it works.”
As I continue to follow the aftermath of the derailment in East Palestine and the railroad industry in general, I would much rather have ownership in BNSF than in another Class I railroad that might be showing better current operating results but is exposed to far greater political and regulatory risks, not to mention the relentless pressure of activist shareholders who are far more interested in next quarter’s results than in the railroad’s performance and financial results in the 2030s and beyond.
I am skeptical that PSR at Norfolk Southern is the culprit behind the derailment but there is no doubt that PSR will be used as a political cudgel against that railroad. Berkshire’s more deliberate approach to handling BNSF’s costs could turn out to be a long run competitive advantage, especially with Mr. Buffett and Mr. Abel in a position to communicate Berkshire’s commitment to safety and regulatory compliance.
Union Pacific Profile, September 2022
BNSF Profile, August 2022
Railroader: The Unfiltered Genius of Hunter Harrison, September 2022
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