COLUMN-Coal demand set to drive new U.S. rail boom: John Kemp

-- John Kemp is a Reuters columnist. The views expressed are his own --

By John Kemp

LONDON, Nov 4 (Reuters) - Warren Buffett's investment in the Burlington Northern Santa Fe (BNSF) railroad is a shrewd move and highlights the tangled relationship between coal, rail and electricity industries. [ID:nN03483590]

It gives Berkshire Hathaway exposure to an industry with formidable entry barriers and pricing power, where capacity constraints will quickly emerge as the economy picks up, and could become severe if coal demand continues to grow in the decade ahead.

* For U.S. railroads, coal is their biggest customer by both tonnage and revenue. It accounted for 44 percent of the total tonnage moved by rail in 2007, and 21 percent of the gross revenue for the major Class I railroads, according to the Surface Transportation Board (STB), which regulates rail rates.

* For miners, rail is the most important mode of transport, taking 71 percent of the total tonnage shipped, far ahead of road (11 percent) and water-based vessels (11 percent).

* Power producers depend on both. Coal-fired plants generated 50 percent of all U.S. electricity last year, far ahead of natural gas (21 percent), nuclear (20 percent) or conventional hydro (6 percent). In most cases, coal moved from the mine to the power plant on a railcar.

UNDER-INVESTMENT, RISING RATES

Before the financial crisis, severe capacity constraints were emerging in the industry. The volume of coal shipped each year rose almost a third between 1995 (625 million tons) and 2007 (850 million tons). Despite efforts to boost efficiency by using larger railcars, running 24 hours per day, and loading coal into "unit trains", the number of railcars originated grew almost a quarter from just over 6 million a year to 7.5 million.

Investment failed to keep pace. Building new rail infrastructure is at the mercy of the economic cycle. Construction and investment is very capital intensive. Costs take years to recover but demand increases can be short-lived. Railroad companies have often been punished by Wall Street for making capital investments, according to the STB.

Between 1987 and 2004, rail operators' rates for carrying coal fell by more than half in real terms, as an overhang of excess capacity from previous periods and pressure from rail regulators put a fierce squeeze on charges.

But by the early part of this decade, most of this capacity cushion had disappeared, and rates rose sharply in 2005, 2006 and 2007, with the largest increases for the short journeys where one rail operator often had dominance over the market.

Even after recent rate rises, real revenues per ton-mile were 34 percent lower in 2007 than in 1990.

In the STB's judgment, rail carriers were still not earning "adequate revenues", which the Board defines as "sufficient -- under honest, economical, and efficient management -- to cover operating expenses, support prudent capital outlays, repay a reasonable amount of debt, raise needed equity capital, and otherwise attract or retain capital in amounts adequate to provide a sound rail transportation system" (STB Ex Parte 657, page 6).

This was a strong hint the Board was prepared to accept further rate rises. In the event, the recession has seen the emergence of excess capacity. But as the economy recovers, this excess will disappear and upward pressure on rates looks set to resume.

INCREASING COAL-FIRED GENERATION

The main long-term source of uncertainty for the rail industry is whether coal-fired generation will continue to expand in the medium term.

The United States has the world's largest recoverable coal reserves (about a quarter of the total) sufficient to last more than 200 years. Increasing coal-fired generation would help curb dependence on crude oil imports.

With its high ratio of carbon to hydrogen atoms, however, coal produces more carbon dioxide (CO2) on combustion than natural gas, and is regarded as one of the dirtiest of the fossil fuels. Tough cap-and-trade proposals would probably have made further development uneconomic and even seen the industry shrink.

But two developments this year have seemed to resolve this uncertainty in favour of an expansion in coal-fired generation:

(1) Cap-and-trade proposals before the U.S. Congress contain generous allocations of emissions permits for power utilities over the next two decades, which will help ease the pressure on coal producers.

(2) The Obama administration has committed itself to an expansion of coal-fired generation linked to new technologies for integrated gasification and combined-cycle generation (IGCC) and carbon capture and storage (CCS) to limit the emissions impact.

In a letter to other energy ministers, Energy Secretary Steven Chu acknowledged "coal … is likely to be a major and growing source of electricity generation for the foreseeable future". Chu called for an "aggressive effort" to develop and deploy CCS technology.

The Obama administration has restored $1 billion of federal government funding to the FutureGen partnership with coal and power producers to develop a "zero emissions" power plant in Illinois that will use IGCC and CCS technology, injecting liquid CO2 into saline aquifers. The aim is to have a commercial-scale plant operating by 2016.

In addition, the administration has committed $1.3 billion to five demonstration projects retrofitting existing industrial facilities and power plants with CCS.

The administration's enthusiasm for IGCC and CCS technologies has lifted the Damoclean Sword hanging over the coal industry -- and in turn provided guaranteed growth for the rail companies.

WRANGLING OVER COAL RATES

The STB has legal authority to set maximum rail haulage rates per ton where a railroad has "market dominance" (defined as the absence of effective competition from other rail carriers or modes or transportation to which a rate applies).

In the event a carrier sets its rates at more than 180 percent of its variable costs (the threshold level for intervention) customers can ask the Board to investigate. If the Board finds the rate is "unreasonable" it can prescribe a maximum rate in future and order the railroad to pay "reparations" for overcharging on past movements.

Following a review in 2006, the Board has replaced the old rate-case guidelines. The new system fixes future rates as a maximum mark up over allowable variable operating costs, with adjustments for productivity and certain other limited factors.

BNSF v WESTERN FUELS ASSOCIATION

Ironically, the first case brought under the new system was a complaint by the Western Fuels Association (WFA) against coal rates fixed by Burlington Northern for a short journey between mines and a power plant in Wyoming.

In a stinging rebuke to BNSF, the Board found that "Although the challenged rates are among the lowest … any utility pays to receive [Powder River Basin] coal, WFA has shown that its rates far exceed the level BNSF needs to charge to earn a reasonable return … because the plant is located so close to the PRB … As such it is now clear that BNSF has been forcing WFA to cross-subsidise other parts of BNSF's broader rail network that WFA does not use".

BNSF was ordered to cut rates as much as 60 percent for 2009 and pay reparations for past overcharging.

As the Board thundered: "This amounts to the largest single rate reduction in rail rates ever ordered by this agency. We estimate reparations are roughly $28 million per year. We further estimate that the total relief WFA will obtain as a result of this order -- including both reparations and the lower prescribed rate through 2024 -- will approximate $345 million (in current dollars)". On Oct 21, BNSF was given a final order to repay WFA $120 million.

But the details of the WFA case should not obscure the fact coal and other rates are set to rise substantially in the coming years to fund the massive investment that will be needed to ease congestion and create new capacity to meet growing demand.

Coal presentations by the Surface Transportation Board:

* here

* here

Key cases before the Surface Transportation Board:

* Major Issues in Rail Rate Cases: here

* WFA vs BNSF (Feb 09): here

* WFA vs BNSF (Jul 09): here

* WFA vs BNSF (Oct 09): here

Energy Secretary Steven Chu's letter on CCS:

* here