Supply Chains, Railroads & Where Things Go Wrong - Part 3

(Graphics courtesy of huckkonopackicartoons.com) -- (Series ©2022 by Charles A. Turek)

If we go back to the beginning of the Covid pandemic, we find American railroads probably in the best financial positions of their entire history. Even going back to the Robber Baron Era, when railroads wielded extraordinary power, both political and financial, and had to be restrained or constrained, the business of railroading never earned such a good return on investment.

Such a good financial position attracted those who would invest solely for financial gain, and they were legion. Activist investors have become normal fixtures of the economic scene, and wield their power like robber barons to increase and cement their financial positions. The Class I railroads, currently those earning revenue of over $250 million a year, found themselves under great pressure to turn as much of that revenue into profit, and as much of that profit as possible into the value of railroad securities. Activist investors did not invest to watch trains run, or even to watch a well-oiled business serve its customers. In the back of the mind of every railroad board member, I guarantee, was the fear that an activist investor would force a change in management that would signal the beginning of the end for the business.

How is that possible? You may ask. The answer is simple. Activist investors consider themselves owners, and, as owners, consider all kinds of activities and assets as fair game to turn a profit. For railroads, this might mean anything from cutting payroll to selling assets to curtailing routes to outright sale of the whole business or merger with a competitor. Rarely does it ever mean spending money on promotion, solicitation of new business, or starting or building new routes. In other words, the investors generally take the business as they find it, cut payroll and assets to the bone, and demand performance better than what had attracted them to the investment in the first place. A tall order.

The Class I railroads, with certain exclusions, responded by reinventing something called Precision Railroading. In the new vernacular, this is Precision Scheduled Railroading (or PSR), because over the century since the moniker was used before, the railroads had essentially divested themselves of schedules that involved departures and kept only those that involved required or advertised speeds. Norfolk & Western developed the concept in the 1940s to describe their ability to move freight amidst a sea of passenger schedules and without delay. A gentleman railroader, not long deceased, named E. Hunter Harrison, picked up the moniker, added one word, and used the title to describe his method of maximizing asset utilization while squeezing a benchmark statistic called Operating Ratio (OR) down to its lowest possible number. (An operating ratio of 50 would mean that no more than 50 percent of revenue was spent paying for all other operations of the railroad, suggesting that there would be a profit of 50 percent of revenue, which is never true.)

Of all the places that the other 50 percent of revenue go, the greatest is, by far, payroll, followed by capital expenditures, followed by fuel and locomotive maintenance. Therefore, under PSR, the first thing to go is payroll (layoffs). Then, if you use fewer crews to man fewer train starts of longer trains using fewer locomotives, you take care of the rest of the big boys of operating costs. To run fewer trains with fewer starts, you have to cut dwell time, and therefore you have to use exotic computer algorithms to come up with a way to get freight from Point A to Point B without stopping to sort cars, change trains, and/or store cars pending a departure. The best way to accomplish this is having customers that ship lots of stuff from A to B. The next best way is to refuse to take on new customers unless they conform to the shipping methods of big shippers, and that's where the supply chain problems start.

If you only serve the customers you have, only start trains when they are long, and must do this whether your existing customers are happy with the methods or not, you lose flexibility. Those customers who may be attracted to rail will go to trucking, because trucking is infinitely flexible and can turn a profit because of its hugely government-subsidized right of way (highways). Trucking can use the highway asset as much as it like and only pay set taxes which haven't increased in years. But pandemic also resulted in labor shortages, which resulted in driver shortages, which results in that some shippers can't ship reliably by truck and won't be able to pay to ship by rail. And that is, if, and only if, one of the Class I railroads decides to take them on as a customer.

So we have these cascading shortages which are exacerbated, if not caused, by Precision Scheduled Railroading and the investors that have dictated that railroads squeeze every dime out of their assets without regard for what is going on around them.

I will tie this all up next time in Part 4.