🚅 US Railroad Industry Primer - The Picks & Shovels of the US Commodities Sector
🚅 US Railroad Industry Primer - The Picks & Shovels of the US Commodities Sector
What If You Could Combine The Radical Efficiency of the LCC Airline Sector with the Railroad Industry? You'd Get Precision Scheduled Railroading (PSR)
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Class 1 Railroads have historically been a sleepy sector - but they are poised for a Renaissance due to the aggressively improving prospects of US Commodities - by virtue of the former being the lowest-cost freight mode for the latter.
Hyper-ambitious US government policy towards decarbonization will manifest in two ways - a shift of US energy mix towards Renewables, and a transition from ICE cars to EVs. Both will lead to an exaggerated mismatch between demand & supply for commodities - both in the renewables & fossil fuel space, primarily copper.
Class 1 Railroads possess both incredible market & pricing power over their customers - enabling real rail rates to increase at 2x both US trucking rates & US inflation between 2004-2019 (despite flat shipment volume).
Hunter Harrison’s legacy has been firmly immortalized with his introduction of Precision Scheduled Railroading (PSR) to the railroad sector. PSR has kept overall increases in railroad operational costs across the sector >500% lower than increases in real rail prices over the past 15 years.
Chapters:
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Introduction
During the Gilded Age of America (1870-1900), one of the famed robber barons who dominated the business landscape of the then-fledgling American industrial economy was a magnate known as Cornelius Vanderbilt. He got his start by making a name for himself in the steamship industry, where he earned his affectionate nickname “Commodore” - and then went on to build a Railroad empire with the help of another robber baron, John D. Rockefeller.
As their namesakes implied, one of the traits that the Commodore was known for was his brutally efficient approach to enterprise. At the time, US labor laws were nowhere near as robust as they are today - and the robber barons exploited that to the max in the treatment of their employees. On top of that, robust antitrust or anti-competitive laws hadn’t been developed yet - which led to the worst facets of capitalism being exposed in coercive business tactics and rampant M&A activity. While this was certainly a net negative to society, it also led to “Commodore” Vanderbilt’s railroad empire growing into a veritable force of nature - as its rail lines slowly but gradually consumed the American landscape.
One reason for the stock market’s obsession with the railroad industry at the time was because they represented a newfangled technology - effectively making them the Big Tech stocks of their time. Without laws against stock market manipulation, the market for Railroad stocks turned into a den for thieves - with obtuse levels of fleecing of both minority AND majority shareholders by management; as well as bucket shops which were basically unsanctioned casinos (where Jesse Livermore earned his infamy). The prevailing sentiment could perhaps be best described with Charles Dicken’s quote from his bestselling book The Tale of Two Cities:
“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of light, it was the season of darkness, it was the spring of hope, it was the winter of despair.”
If you’d like to learn more about the Gilded Age, the above-linked docu-drama The Men Who Built America by The History Channel wonderfully details the travails of the biggest robber barons (i.e. Vanderbilt, Rockefeller, Carnegie, JP Morgan, Edison, Ford) in the most entertaining way possible. It is a highly entertaining watch, and I must recommend it.
Unfortunately, all things must eventually come to pass - and so it was with the US Railroad industry as well. After antitrust regulations were developed in the post-Rockefeller era and Henry Ford popularized the automobile, US Railroads began their downward slide into imperceptibility as they were gradually eclipsed by the former’s more personalized mode of cross-state transport. Since then, the Railroad sector was relegated to the pile of “has-beens” and went into a downward spiral which lasted the better part of a century.
However, the beauty of being a shareholder of a Class 1 Railroad - defined as any carrier with annual revenues in excess of $500M - is that they are oligopolies. Over the decades, industry consolidation has led to the “rights-of-way” of the entire US rail network falling into the hands of just seven Class 1 railroads - which means that if you want your goods shipped to a certain part of the US, you have to rely on that railroad. And while some of their railways do overlap, the entire rail landscape of North America can basically be split into 3 duopolies - CNI 0.00%↑ and CP 0.00%↑ (now the merged CPKC) in the North & South, BNSF and UNP 0.00%↑ in the Midwest, and CSX 0.00%↑ and NSC 0.00%↑ in the East. This means that at worst the competitive landscape is a duopoly - you can see this phenomenon at work in the rail map below:
This was likely why Buffett acquired BNSF in 2009 for 18x PE at the time - which he has publicly considered to be one of the most valuable assets held by Berkshire Hathaway. The thing about rail lines is that you can’t just lay out track anywhere you like - most Americans have a NIMBY problem, which means that new railroad companies can’t just lay new track in places which bypass the rights-of-way that existing railroad companies own. This effectively gives the existing incumbents huge barriers to entry in certain parts of the US rail “highway”.
However, the same past century which afforded the Class 1 Railroads such concentrated levels of industry consolidation also resulted in complete market penetration of the US economy. Most of the stuff that US Railroads are best at carrying tend to be very heavy stuff that needs to be affordably shipped in bulk (e.g. coal, automobiles, chemicals) - since shipping by rail is over 50% cheaper per tonne mile than shipping by truck. This means that the main customers of US railroads tend to be industrial businesses like manufacturers, refineries or energy companies - whose priority is to ship their raw material inputs at the lowest cost per tonne mile. And by virtue of the latter’s end-products being present in virtually every American’s home, US Railroads tend to serve as a barometer for the health of the entire US economy - resulting in their low GDP+ growth profile.
The New Age of Commodities - Renewables
However, recent events have dramatically changed the growth potential of the US Railroad sector. Namely, the recent radical shift in global government policy towards ESG, Renewables and EVs implies that there will be a huge shortage of commodities over the next generation - both in the US and globally. And with Class 1 Railroads being the cheapest form of transport for bulk commodities, this makes them the Picks & Shovels of a US Commodities gold rush investment thesis.
The podcast below does a great job of painting the secular undersupply of commodities in the coming decades - and fortunately, there’s a transcript of the podcast as well. This podcast explains the secular landscape for commodities so well that I’m just going to summarize their content, in the interest of brevity. However, I’d highly recommend going through it yourself for the full details:
Firstly, unless you’ve been living under a rock for the past two years, you will have known by now that all the first-world economies are in the midst of an ambitious transition towards decarbonization. Both the USA and the EU have set an unbelievably aggressive deadline of 2035 before banning the further sale of new ICE automobiles; and they also have a 33% renewable energy penetration target within 10 years. Both of them also have insanely aspirational goals of reducing net greenhouse gas emissions by 50% by 2030 - and down to zero by 2050.
The global scientific consensus is that the best way to achieve these ridiculously enterprising decarbonization objectives is via a war on two fronts:
Shift the energy generation mix away from fossil fuels towards renewables; and
Encourage a transition away from ICE vehicles to electric vehicles (EV).
However, as you can see from the chart above, 82% of the USA’s energy generation is currently still sourced from fossil fuels - with only an extremely meager 2% being generated by wind & solar as of 2019. Adding hydro & nuclear to the mix would increase the share of renewable energy to about 15% - but there also isn’t any concrete plan to significantly increase energy contributions from hydro and nuclear. Hence, most of this 50% renewables target by 2030 will have to be met by wind & solar - which implies shifting 35% of the existing grid away from fossil fuels towards them.
Just think about the practical implications of such a massive endeavor. Firstly, you’d have to pretty much convince half the US population to adopt solar panels in some form. The economics of shirting to solar basically grants you effectively zero marginal energy costs at the expense of large upfront CAPEX to install rooftop solar panels. That’s like asking everyone to pay 10-20 years worth of energy bills upfront - for the prospect of future savings which will only enjoyed 10-20 years later. Clearly this isn’t an optimal solution for everyone.
Furthermore, solar panels actually require large quantities of commodities to manufacture - namely copper, aluminium, silicon & zinc. At the scales we are talking about, the USA will require gigachad quantities of copper to be shipped around the country just to meet the theoretical bare minimum energy mix targets that US government policy demands - and that’s before considering the EU, much less the rest of the world. Just think about the amount of inflationary pressure that will put on scarce levels of copper for the next 30 years (and beyond) - or to put it differently, just think about how large copper’s margin of safety is.
The other ancillary problem about the US shifting towards a 50% renewables energy mix within just 10 years is that they are also shutting down fossil fuel power plants at the same time. It’s one thing to add wind & solar energy to the national grid - it’s another thing completely to be subtracting coal and gas plants at the same time. This actually doesn’t end up increasing the productive capacity of the US economy (i.e. GDP) - all it achieves is reduce the carbon intensity of their energy generation. And even if we assume that the US merely maintains its 2% GDP growth over the next 30 years, that’s a lot of room for further inflationary pressure on commodities - both in the renewables and fossil fuels segment.
What this means is that it is highly unlikely for the US energy mix to realistically shift towards the targeted net-zero emmissions by 2050. It goes without saying that the commodities involved in manufacturing Wind & Solar plants will see a huge spike in demand - but at the same time, fossil fuel supply will also need to be dramatically ramped up if the expected energy gap from reduced energy sector productivity materializes.
Now throw in the once-in-a-decade spanner like the Ukraine War, and you have all the ingredients for peak catastrophe. In all likelihood, we’re probably not going to see a complete transition away from fossil fuels until the end of this century (i.e. 2100) - which might explain Warren Buffett’s recent obsession with Occidental Petroleum.
Check out my recent Hibiscus stock report below!
But Wait… There’s More! Electric Vehicles (EV)
The situation for EVs is similar - although its story revolves more around copper exclusively. Copper is the 2nd most conductive metal after silver (and nearly 99% cheaper) - which makes it ideal for use in both the wiring and batteries of EVs. Nickel will arguably experience an even larger ramp-up in demand - but for the purposes of this article, they’re both commodities that will likely be shipped by Class 1 Railroads in the USA.
Both the US and EU have a similar EV penetration rate target - i.e. 50% by 2030. Currently, the global EV penetration rate is closer to 9% - with China and Europe taking up the lion’s share of EV ownership. This means that for the US to reach its EV penetration rate target of 50% in 10 years, the domestic demand for copper is likely going to be as eye-popping as renewables across the next generation. The five charts below are all that’s needed to convince you of copper’s bright future in the USA:
Here’s the problem: the top 10 copper mines by production in the world today were all discovered over 100 years ago. While global copper reserves are estimated at >800 million metric tons, the global annual demand of copper today is currently only 28 million metric tons. To achieve the aforementioned 50% EV penetration by 2030 in both the US and EU, we’re talking about annual global copper demand growing to at least 60 million metric tons within the next decade or two. This means that the price of copper is going to be unelastic for the foreseeable future - as demand for copper far outstrips supply.
Now add in the demand for copper from the previously mentioned renewables sector and you begin to see where the connundrum lies. Typically, global annual demand growth for copper is around 2% - let’s conservatively add 100 bps until 2030 for electrifiction of the energy grid, and another 100 bps for the EV transition. This implies at least a doubling of global demand growth for copper within the next decade alone - and it is highly unlikely to subside beyond that if things don’t go spick-and-span perfect. Contrast this with Rystad Energy’s forecast of future global copper production below (i.e. supply):
The result of all this is that US Commodities are expected to benefit from an immense secular uplift that will last decades - easily a generation of investors. And guess which sector is the cheapest mode of transporting all those commodities around the USA? That’s right, it’s the Class 1 Railroads. This has led some analysts to describe US Railroads as “the picks & shovels of US Commodities” - essentially a way to gain exposure to the latter sector without being subject to the whims of volatile commodity prices. Coupled with the oligopolistic nature of Class 1 Railroads - where Buffett’s favorite pricing power is plainly evident - and you have the perfect growth investment thesis hiding in the most unlikely of places.
As such, this super-bullish macro thesis for US Railroads stands in stark contrast to the sector’s historically dismal micro thesis - as growth is expected to supercharge and pummel the stratosphere. As US railroads have their tendrils in all corners of the US economy, they tend to act as a barometer for the latter since the US Consumer is 70% of GDP - effectively making them leveraged industrial plays. This might explain why Sarah Ketterer of Causeway Capital recently added to her stake in CNI 0.00%↑ - or why Berkshire-owned BNSF’s CEO Katie Farmer described railroads as having “a great opportunity” in the coming decade in the interview below:
For more on the LT secular bullish thesis on the Commodities sector, check out these great articles below!
US Railroad Primer - Hunter Harrison & The Legacy of PSR
The aforementioned investment thesis for US Railroads actually first caught my attention after I read this excellent sector writeup by The Diff. In that article, he links to the aforementioned exquisite podcast which explores the bullish prospects for US Commodities - where the guest sidetracks into the discussion about US Railroads being the picks & shovels of US Commodities at around the 28:48 mark (click this link to jump to timestamp). Both of these are must-read/listens in my opinion.
The Diff also did a separate writeup of CSX - so head over there if you’d like to find out more about how Hunter Harrison performed at the last Class 1 railroad he worked at. However in my next article, we’ll be taking a look at the first Class 1 Railroad that Harrison took the reigns at, Canadian National Railway (CNI 0.00%↑) - which is the same one that Causeway Capital initiated a stake in. However, to do that we first need a bit of background context about the US Railroad sector.
Click the link below to check out our follow-up stock report about Canadian National Railway (NYSE:CNI)!
Revenues - The Incredible Market & Pricing Power of Class 1 Railroads
As I’ve mentioned above, Class 1 Railroads have long since saturated their respective TAMs - with the sector’s unit of account for total cargo delivered being flat over time (i.e. Gross Tonne Miles (GTM). However, as we’ve also mentioned above, US Railroads have pricing power - which has historically allowed the sector as a whole to raise rail rates by about +5.7% CAGR or 230% over the past 15 years (i.e. 2004 - 2019).
For reference, this implies that unit rail rate have increased by ~2x more than both domestic inflation and US Trucking rates over the same period - coinciding with when Hunter Harrison first became CEO of a Class 1 Railroad in 2003 (i.e. CNI 0.00%↑). We can see this trend in the charts below (from the PDFs attached below):
This is a notable trend because prior to 2004, real unit rail rates across the industry had actually fallen consistently over the past two decades - starting from when the Staggers Rail Act was passed in 1980, which deregulated the US rail industry. That the upward reversal of that trend coincided with when Harrison began preaching PSR to the masses has to be the biggest coincidence in the railroad industry’s history.
Also, the first chart above demonstrates the immense latent pricing power that lies within the business of Class 1 Railroads. Given their oligopolistic status, they can cow customers into bending the knee with little fear of reprisal - in the ultimate tribute to the robber baron. Also, despite US Railroads having hiked their prices at twice the rate of US Trucking, current rail rates per tonne mile are still just half of trucking rates per tonne mile.
In fact, this ripoff is going so well for them that there is a legitimate concern about antitrust action being taken against them by regulators - customers, employees and even the communities their rails bypass are mad about how the introduction of PSR has greatly inconvenienced them. Just do a search for “BNSF strike” on Youtube if you want to learn more - there are enough CNBC segments on the topic to bore you to sleep.
Another way to illustrate the market power (and therefore pricing power) that Class 1 Railroads have over their customers is to look at how the sector’s market share has changed over time. When the Staggers Act was passed in 1980, the market share of railroad grain origination was split between 13 players - with the largest player holding just 19% market share (i.e. BNSF). By 2011, the playing field had been whittled down to just 7 players (all Class 1 US Railroads) - with BNSF owning 47% market share, by virtue of its commanding presence among railroads in the US West Coast & Midwest.
In fact, Grain Origination isn’t even the worst offending market segment - which makes sense when you consider that Canadian laws impose a cap on the total revenues that railroads are allowed to charge for grain shipments (i.e. maximum revenue entitlement). While not an apples-to-apples comparison, the table below shows how Chemicals represented the largest percentage of non-competitive revenue between 2004 and 2019 - possibly due to the fact that chemicals which are classified by law as “hazardous materials” are only allowed to be shipped via rail:
Lastly, real rail rates have increased by 43% between 2004 and 2019, while real rail costs increased by only 8.1% over the same period - despite relatively flat shipments as measured by GTM (i.e. absence of improving economies of scale). While part of this gap can be justified by industry consolidation - the major part of it is most definitely simply due to the presence of pricing power amongst Class 1 US Railroads.
There’s actually also a third reason which explains why real rail costs have increased by just +0.5% CAGR between 2004 and 2019 - even less than domestic inflation of about +1.5% CAGR over the same period. That’s due to the radically efficient approach to operational efficiency which was first introduced by Hunter Harrison - Precision Scheduled Railroading (PSR).
Costs - The Magic of Precision Scheduled Railroading (PSR)
Read more: What is Precision Scheduled Railroading (PSR)? | Breakthrough
The implementation of PSR in the Railroad industry can be visualized as the sector importing the radically efficient approach employed by the Low-Cost Carrier (LCC) airline industry. Both Hunter Harrison of the former and Herb Kelleher of the latter were mavericks of their time - who were comfortable dashing the status quo in their search for ever new ways to save an extra penny or two. Hunter Harrison’s radical approach to railroad operations drew parallels to Cornelius Vanderbilt all those decades ago - he could have easily been mistaken as the reincarnation of the “Commodore” himself.
To understand why PSR is so efficient, we need to contrast it with the way US Railroads used to be run prior to its introduction. Up to the early 2000’s, US Railroads basically had two ways to optimize costs and pass on those savings to customers:
Hold-For-Tonnage; and
Schedule Adherence.
The Hold-for-Tonnage method advocates having longer trains per trip in order to minimize unit shipping costs - since the incremental unit costs of shipping an extra load tends to justify the incremental unit revenue generated. This results in operators delaying shipments until the maximum train load has been reached - which increases yard complexity & costs, and makes rail service inconsistent and unpredictable to customers. Railroads utilizing this method would sometimes even delay a particular shipment to the next day - simply because they didn’t want to pay for an extra shift of labor.
The opposite approach is Schedule Adherence - which prioritizes trains following a fixed schedule. Naturally, this would mean shorter trains and shipping smaller loads - resulting in higher unit costs. However, advocates of this approach say that this method requires less equipment due to higher car velocity - and reduces yard complexity & costs due to running shorter trains. Obviously, running trains according to schedule also improves customer service.
What PSR does differently is that it aims to combine the best of both worlds - running longer trains according to fixed schedules. In order to effect PSR, Hunter Harrison basically had to uproot the entire status quo of how railroads were traditionally run - e.g. removing hump yards to reduce network classification, and insisting on manifest trains rather than unit trains. If you’re confused by this industry jargon, get used to it - one hundred years of operations has resulted in the railroad sector having a proper mouthful of unintuitive industry terminology.
There is frankly way too much to explain about how PSR employs its operational magic in minute detail here - but allow me to provide some examples taken from this PDF report titled “The Operational Nuts and Bolts of Precision Scheduled Railroading” (attached below):
Removing Hump Yards - Hump yards are tiny hills used to classify railcars by attaching them to different locomotives. By removing hump yards, operators use an alternate method of car switching called “flat switching” - which basically means connecting cars without an incline by kicking them. The latter is a far slower method and disincentivizes car switching - thus reducing dwell time and speeding up yard operations.
Using Manifest Trains not Unit Trains - Manifest trains refer to trains which carry many different types of cargo (i.e. classification) - while unit trains only carry one type of cargo. Unit trains first gained popularity in the 80’s as they could provide better service by dedicating them to one customer in advance. However, they also tend to return empty unless properly assigned - which increases unit operating costs.
Balancing train network - Historically, train yards tended to be run as separate independent entities. PSR views the entire train network as a single unit, and ensures maximum car velocity by ensuring that trains are running on all lines in both directions at all times. This requires planning routes across the network in advance so that inbound & outbound locomotive demand vs. supply are optimized at each yard across the entire network.
Minimizing Staff - By insisting on as many point-to-point routes as possible, trains can bypass time-consuming classification yards and shave days off their delivery times. Having multiple yard outlets instead of only one per station also allows the same number of staff to service higher car velocity within yards - this can be maximized by only using manifest trains across a balanced network.
Longer Trains & Fixed Schedules - By employing manifest trains instead of unit trains, different types of cargo from different customers can be attached to the same outbound locomotive - which allows the maximum train length to be reached more quickly. This also facilitates fixed schedule adherence, as trains can still leave the station even if certain customers do not adhere to pre-determined schedules.
If you’d like to learn more about how PSR has contributed to the improved operational efficiencies of Class 1 Railroads, I’d recommend reading this article which explains it all using pretty charts.
The standard operating metric that investors use to benchmark railroad performance is the Operating Ratio (%). Essentially, this key performance indicator estimates the unit costs as a % of unit revenue generated - similar to the Combined Ratio of the insurance industry. PSR aims to consistently reduce the Operating Ratio as much as possible in order to generate maximum efficiencies within railroad operations. While there have been complaints about how the definition of Operating Ratio has changed over time, it is generally regarded as an all-inclusive metric in the Railroad industry similarly to how the Same-Store-Sales metric is likely overrated in the Retail industry.
To summarize this section, PSR is today considered the paramount cost-cutting method employed by Class 1 Railroads today - and its financial results are expressed in a declining Operating Ratio. For reference, the industry’s holy grail is to achieve an Operating Ratio of about 60%.
Thus, at this point we’ve seen how Class 1 Railroads have essentially optimized efficiencies on both the revenue and cost side. In our next article linked below, we shall explore how this radical practice of PSR has applied to CNI 0.00%↑ specifically - the first Class 1 Railroad that Hunter Harrison worked at - as well as the revenue & cost drivers which will influence the railroad industry’s growth for the next generation.
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