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