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Railroads: Cartel or free market success story?

September 13, 2011, 1:00 PM UTC

With 90% of U.S. rail freight now controlled by only four companies, shippers claim the giants have unfairly banded together. Unapologetic railroads refuse to back down. An epic battle of business vs. business.

By Mina Kimes, writer

Trains wait to connect to a main line (far right) owned by CSX at a siding outside M&G Polymers’ factory in Apple Grove, W.Va.

FORTUNE — From the roof of M&G Polymers’ factory in Apple Grove, W.Va., the freight trains on the ground look like children’s toys. Several hundred cars wait to be filled with tiny pellets destined to become plastic containers. Every evening, M&G workers send the loaded cars to the main tracks operated by the freight carrier CSX. There they latch onto long trains like dancers joining a conga line. Looking down, the traffic appears seamless — a quick handoff between producer and transporter.

On the ground, though, the relationship is far more fraught. M&G’s factory delivers nearly all its goods by rail, and it has access to only CSX’s lines. In railroad lingo, that makes M&G a “single-served shipper” — a captive, in plainer English. Whatever term you use, the result is the same these days: soaring shipping prices.

At the end of 2008, M&G’s long-term contract expired, and the railroad nearly doubled its rates. “We couldn’t believe it,” says Fred Fournier, M&G’s sales chief. He says M&G’s captive plant is now being charged rates that are 140% to 500% above the railroad’s variable costs for labor, fuel, etc. (the industry’s yardstick for valuing contracts). By contrast, M&G’s factory in Mexico has access to two U.S. railroads and pays less than 100% above the variable costs.

Fournier, an earnest, affable type, seems almost tormented by his anger as he describes his dealings with CSX (CSX). When M&G protested the hike, he says, the railroad’s response could be summed up in three words: “Because we can.” Desperate, Fournier lobbied CSX to lower its rates. He visited the railroad’s headquarters and all but begged. He claims he even chased down a CSX executive at an airport in Charlotte. To no avail. In 2010, West Virginia’s then governor, Joe Manchin, heard about M&G’s plight and invited executives to dinner at his mansion with Michael Ward, the CEO of CSX. The governor conciliated the two sides. But the glow didn’t last long: After the dinner, CSX once again refused to slash its price.

Ward is unapologetic. He says CSX is simply charging what’s appropriate (and the company maintains that M&G is overstating how much its rates are marked up). If shippers don’t want to use trains, he says matter-of-factly, they can use trucks. Fournier counters that trucks aren’t a viable option; both M&G and its customers have built their supply chains around rail. He charges that CSX is exploiting its monopoly status. “This is dangerous what they get away with,” he sputters.

Shippers and railroads are natural adversaries, and have been for as long as the iron horse has existed. In the 19th century, farmers banded together to resist railroad power. So potent were the carriers that one, the Pennsylvania Railroad, was cocky enough to enter the oil business against John D. Rockefeller, sparking an epic conflict the likes of which hasn’t been seen again — until today.

It’s a war that pits business against business, and the central charge is one that would’ve been familiar to Rockefeller: monopoly power. Since freight railroads were deregulated in 1980, the number of large, so-called Class I railroads has shrunk from 40 to seven. In truth, there are only four that matter: CSX and Norfolk Southern (NSC) in the East, Union Pacific (UNP) and Burlington Northern Santa Fe in the West. These four superpowers now take in more than 90% of the industry’s revenue. And they’re shielded by a potent advantage: an exemption from key antitrust laws. Not coincidentally, the Big Four’s profits and stock prices have soared; their success was ratified when Warren Buffett’s Berkshire Hathaway (BRKA) purchased Burlington Northern Santa Fe for $26 billion in 2010.

Shippers claim the railroads have amassed too much power and the gaudy profits prove they’re gouging customers. The railroads scoff, pointing to modest returns on capital. Over the past 30 years they have invested some $480 billion in their equipment and tracks. With the nation’s highway system deteriorating, they’ll need to spend even more, says CSX’s Ward, but they won’t be able to if regulators crack down. “If we make less money,” he says, “we will have to invest less, period.”

Skirmishes have broken out on multiple fronts. Battles are being waged at the Surface Transportation Board (STB), an obscure federal agency tasked with overseeing the industry; in Congress, where senators are proposing bills that would reregulate the rails; and in court, where a group of shippers has filed a class action accusing the railroads of a conspiracy to fix prices. “It’s below the surface, but it’s intensely being fought,” says Bob Szabo, a longtime lobbyist who works with utilities and manufacturers. “To the shippers, this is all very easy to see,” he says. “You have four big railroads that divide the country up. What’s complicated about that?”

The industry gets back on track

Rail America: Scenes from CSX lines in West Virginia near the borders with Ohio and Kentucky

In the 1970s the railroads nearly collapsed. The trucking industry had taken off after the development of the Interstate Highway System while railroads were shackled by burdensome regulations that made it difficult to abandon unprofitable lines or lay off workers. Railroad rates were strictly controlled. Faced with meager 2% to 3% returns on capital, the carriers didn’t invest in their tracks, and the system decayed. By the late ’70s nearly a third of the industry was bankrupt or close to it.

Salvation came in 1980 with the Staggers Act, a law that, coupled with the earlier Railroad Revitalization and Regulatory Reform Act, granted the freedom to shed tracks and workers, set rates, and enter into long-term contracts. The railroads embarked on a wave of mergers and cost-cutting. They passed on most of those savings to shippers, chopping rates to win back business from trucks.

Then, in 2004, the dynamic changed. Rail prices, which had been steadily declining since 1980, suddenly reversed course. For the next seven years rail rates steadily marched upward at a rate of 6% a year, according to Scott Group, an analyst at freight research firm Wolfe Trahan. By comparison, prices for trucking and air freight have increased by about 1% to 2% a year.

Shippers of all stripes cried foul — but none more so than captive companies like M&G, which say they have borne the brunt of the rate hikes. As the number of railroads has decreased, the number of captive shippers has grown. Szabo, the shippers’ lobbyist, estimates that more than one-third of all shippers are now served by only one railroad.

Their rates are skyrocketing. OxyChem, a division of Occidental Petroleum (OXY), says its rates have jumped by as much as 160% over the past five years. Dairyland Power, a utility in Wisconsin, reported a single-year increase of 93%. Chemical maker PPG Industries (PPG) says the rates it pays to ship chlorine, which must be moved by train, have climbed more than 100% since 2004. By contrast, the rates it pays for other chemicals that have alternate transportation options have risen by just 20%.

And rates tell only part of the story. Like airlines, freight railroads now impose a bevy of “extra” fees, such as charges for storage and the diesel fuel that powers their engines. The carriers have also raised indirect costs by pushing customers to provide their own train cars.

The railroads’ power is amplified by an unparalleled set of antitrust exemptions. The industry’s regulator, the STB, permits several practices that severely restrict competition: The Big Four are allowed to sign secret agreements, known as “paper barriers,” with short-line railroads, in which the small fry agree to funnel all their traffic to just one big railroad. They are also permitted to refuse to connect customers to a competing freight line.

If these long-held, special protections weren’t in place, the Justice Department has said, such practices could violate antitrust law. Indeed, 20 state attorneys general have protested the railroad exemptions. And in 2008 the American Bar Association’s Section on Antitrust Law blasted them as “naked economic protectionism.”

Needless to say, the balance of power between customer and carrier has shifted. “I literally had a railroad employee tell my traffic manager, If you don’t like it, buy your own railroad,” says Bill Auriemma, the president of a small Illinois-based specialty-gas maker. He says his company, Diversified CPC International, now pays rates marked up by around 300%. “There’s an institutional arrogance.”

Even Fortune 500 giants feel powerless. Keith Smith, the chief procurement officer at chemical giant DuPont (DD), says the company used to start contract talks with railroads a year in advance to leave plenty of time for discussion. But after 2004, he says, the railroads were no longer willing to negotiate. “We saw rate increases on average of 100%,” says Smith. “At the end of the day, there was less effective competition. That’s the bottom line.” DuPont says the combination of higher rates and increased fees puts it at a disadvantage to foreign importers, which can cherry-pick ports with access to multiple railroads.

Railroad executives point out that unhappy customers can file complaints with the STB, which can reduce a shipper’s rates and make a railroad pay reparations if a shipper can prove that the carrier is dominant and charging more than 80% above its costs.

But shippers have come to be deeply skeptical of the agency. “They were awful — awful, awful, awful,” says Mike Connors, a Washington potato farmer, recounting a complaint he brought to the STB a few years ago. “They threw up their hands and said there’s nothing we can do, so sorry. The best phrase is that they were impotent.” (An STB spokesperson disputes Connors’s claim and says, “The board works actively to help try to solve problems.”)

The rate relief process is expensive and notoriously complex. Some companies, such as those shipping iron, lumber, or cheese, aren’t even allowed to appeal. The STB has excluded customers in those industries from the relief process, concluding that they have sufficient competitive options. In the past 10 years there have been just 14 rate decisions, with victories evenly split between the two sides. Railroads say the dearth of cases shows that customers are happy; shippers say they don’t file complaints because the deck is stacked against them.

Certainly the STB has a history of rulings that benefit the railroads. And a number of its high-level staffers have gone on to work for the industry. Roger Nober, the STB’s chairman from 2002 to 2006, is now the chief lawyer at BNSF; Linda Morgan, his immediate predecessor, became an outside counsel to Union Pacific.

But the STB is essentially the only option for shippers, since other government agencies are mostly shut out. The Federal Trade Commission has no ability to intervene; neither does the Justice Department, which can only offer advice on mergers. The DoJ issued a stern warning against the last big railroad merger, the 1996 marriage of Union Pacific and Southern Pacific, estimating that it could result in annual price increases of $800 million. “The UP/SP merger proposal would result in overwhelming competitive harm in a large number of markets,” it said. The STB, seemingly unperturbed, let the merger sail through.

Convention or cabal?

Every spring, the National Freight Transportation Association holds a multiday convention. In April 2003 the meet-up took place at the Wigwam Resort, an Old West-style luxury hotel in Litchfield Park, Ariz., with a spa and three championship golf courses. Top executives from the Big Four dined and talked shop. Depending on whom you believe, it was either an innocent gathering of rivals at an industry schmoozefest — or the beginning of a massive price-fixing conspiracy.

Price-fixing, as it turns out, is an area not covered by the railroads’ antitrust exemptions. Three years ago a group of shippers filed a class action against the four major railroads accusing them of colluding on a scheme starting in 2003, not long after the Arizona meeting. The class, which is represented by Stephen Neuwirth, a high-profile trial lawyer, contains an estimated 30,000 shippers.

The alleged scheme involves surcharges for fuel. Such fees aren’t illegal. Plenty of industries, including trucking, tack them on to cover volatile oil prices. It’s that the railroads colluded to impose them, Neuwirth alleges in the complaint, that broke the law. He argues that the railroads turned fuel surcharges into a massive profit center, citing estimates that they made a combined $6 billion on them from 2003 through 2007. The railroads deny any conspiracy or that they made profits on the surcharges.

Lonely passage: An estimated one-third of shippers have access to only one railroad.

Historically, oil was included as one of the standard expenses in a train contract. If fuel prices rose during the term of the contract, a formula that weighed different costs would adjust the charge. The railroads, however, say that method didn’t fully capture escalating prices.

About a decade ago some began switching to a surcharge approach whose salient feature was that an increase in fuel costs was applied to the entire cost of the contract, not just the fuel portion. Unsurprisingly, some customers resisted, and with railroads applying the surcharges intermittently, the new approach failed to gain traction, according to Neuwirth. (The railroads say surcharges were rare at first because they were new and oil prices were lower.)

The railroads understood that without their competitors on board they wouldn’t have the leverage to impose the charges, according to company documents read in a court hearing during the class action. For instance, in an internal risk assessment from 2002, BNSF complained that its efforts to impose surcharges were being held back by Union Pacific. “UP does not use a fuel surcharge in the competitive marketplace,” they wrote. “The trucking industry uses fuel surcharges, but our rail competitors do not, and we therefore are hard-pressed to achieve it.”

That changed in the spring of 2003, when top executives from the Big Four railroads held what Neuwirth alleges were a “remarkable series of meetings.” Records show that at many of these rendezvous — including the convention at the Wigwam Resort — fuel surcharges were on the agenda. The railroads’ spokespeople maintain that the communications between rival executives concerned specific shipments, not general surcharge practices.

Either way, shortly after the meetings, the railroads began to align their surcharge programs. Union Pacific announced it was going to base its surcharge on the same oil index that BNSF used. Both companies began charging the same fees, with matching schedules. A Union Pacific spokesperson responds in a written statement that the railroad “developed its fuel surcharge program independently and endeavored to make it responsive to the needs of our customers, some of which also are served by BNSF.”

Several months later Norfolk Southern announced a fuel surcharge program that was identical to the one used by CSX. From then on, all four railroads worked to make the surcharges an industry standard. An internal BNSF document from the fall of 2005 reveals that the railroad understood that the success of its program depended on cooperation. “While fuel surcharges are working well now,” it said, “it would only take one competitor to abandon this in an attempt to gain market share to cause this to fail.”

Over the next four years the railroads succeeded in adding surcharges to the vast majority of contracts. Executives touted the benefits in earnings calls. “Where we’re able to institute fuel surcharges, we’re doing it,” said Hank Wolf, Norfolk Southern’s CFO, in 2004. “The other railroads are doing it. The trucking companies are doing it.”

How significant were the charges to the railroads? In 2005, Norfolk Southern reported that a full one-third of its revenue growth came from surcharges.

But while the railroads exulted on Wall Street, they worried about how the fees would look to outsiders, as one Norfolk Southern document shows: “It seems like if all merchandise revenue per car increases are coming from fuel surcharges, I’m not sure that Don Seale [Norfolk Southern’s CMO] would be in agreement with having this widely known.” (Spokespeople for both Norfolk Southern and BNSF say the quotes cited by Neuwirth in court were “taken out of context.”)

As surcharges grew more and more pervasive, complaints bubbled up. In January 2007 the STB surprised shippers with a dramatic ruling: It stated that applying fuel surcharges to overall rates was “unreasonable” and put an end to the practice.

In 2008 the railroads tried, unsuccessfully, to dismiss Neuwirth’s suit, which is now awaiting a decision on whether the court will certify its class. This June, Oxbow, a coal producer with $4 billion in sales, hired super-lawyer David Boies to bring its own suit. Oxbow claims Union Pacific overcharged it $30 million in fuel surcharges and collaborated with BNSF to allocate markets. Union Pacific blasted the suit in a statement, calling it “a grab bag of accusations that mischaracterizes Union Pacific’s actions and efforts to compete fiercely for rail transportation business.”

Oxbow is helmed by billionaire Bill Koch, whose brothers Charles and David Koch are CEO and executive vice president, respectively, of Koch Industries. Bill Koch is notoriously litigious; he sued his brothers repeatedly after he was ousted from the family business. Like his Tea Party-supporting siblings, Bill Koch isn’t a fan of big government — but he’s advocating that railroads be tamed by regulation. “They’re in a position of virtually absolute power,” he tells Fortune. “They’re a bully to us. And if we don’t stand up to a bully, we’re going to be pushed all over the playground.”

A different kind of bottom line

Trains often evoke a sense of nostalgia in men of a certain age. Jim Young, the CEO of Union Pacific, is not one of those men. Born and raised in Omaha, Young joined the company in 1978 and has been immersed in the business ever since. But he keeps hardly any models or trinkets in his spacious, minimalist office, which overlooks the Missouri River. Lithe, with white hair, sky-blue eyes, and a clipped manner of speaking, Young doesn’t blink when asked whether he liked trains when he was growing up: “Not at all.”

Union Pacific, headquartered in Omaha, is the country’s biggest railroad by revenue. Its performance has been spectacular: Profits have risen at an annual rate of 25% over the past five years.

In most industries rising profits are cause for celebration. In the railroad business they are a touchstone for controversy. The Senate Commerce Committee issued a report last year that flayed the industry for excessive profits. (That committee is headed by Jay Rockefeller [D-W.Va.], ironically, the great-grandson of the monopolist John D.) A recent Citigroup report noted that railroad profitability has increased 121% since 2004, “despite the industry actually moving less volumes.” Shares of Union Pacific, Norfolk Southern, and CSX have returned a cumulative average of 439% since 2000, vs. the S&P 500’s 9% return. BNSF has generated sizable rewards for Berkshire, and is expected to boost the company’s pretax earnings power by 40% in a typical year.

Yet much to shippers’ frustration, the STB still posits in its annual “revenue adequacy” report that none of the railroads are earning sufficient returns to necessitate greater regulation. The Rockefeller report panned the STB’s determination, asserting that “these claims need to be more carefully scrutinized.”

Such indictments are misinformed, says Union Pacific’s Young. To hear him tell it, Washington just doesn’t get how the industry works. “Listen, I spend a lot of time back there,” he says. “I have a lot of respect for what people do; they work hard. But many of them don’t understand the financial realities that are out there.”

Before becoming CEO, Young spent most of his career in Union Pacific’s finance department. “You learn a lot of lessons walking around Wall Street, trying to raise money on the fixed-income side or talking to shareholders,” he says. Railroad investors, he continues, don’t focus on profits; they care about returns on invested capital. The carriers spend massive amounts on capital expenditures, which are not reflected in net income. As a result, while their profit margins look enormous, their returns are middling: 11% last year, or slightly more than the average industry, according to Value Line.

If railroads lose the ability to price as they wish, Young says, returns would drop — and so would capital expenditures. “If you reduce the profitability of the industry, you’re going to reduce capital,” he says. “The math is pretty straightforward.”

Young is hardly the first CEO to warn that increased regulation will harm end users. That said, it’s true that the nation’s highway infrastructure is deteriorating rapidly, and railroads are facing a capacity crunch. A recent report by consultants Christensen Associates projected that rail carriers will have to spend $89 billion on new infrastructure by 2035 to meet demand.

Young is quick to point out that, while rates have jumped in recent years, they are still lower than they were in 1980. He disputes the idea that the recent rise in pricing is tied to the railroads’ increased market power. “They’re saying we don’t compete, which is total baloney,” he says. “I just came out of a meeting this morning; we lost $40 million of business to the other guys.” The CEO attributes the recent spate of rate hikes to the soaring costs of inputs like oil and steel. “There’s an economic reality of what’s going on out there,” he says, “and I don’t see how the government solves that problem.”

Railroads and shippers are, unsurprisingly, divided over the issue of whether rates accurately reflect costs. The Christensen study’s authors concluded that rate increases through 2008 were reasonable based on its examination of railroads’ marginal costs. But the research firm Escalations Consultants found that, based on the company’s SEC filings, revenue per carload has risen 65% since 2004, while operating expenses have climbed 45%. In response, the Association of American Railroads (AAR) wrote in an e-mail: “Any expectations that operating revenue and expenses should increase in concert are nonsense.”

Train supporters say disgruntled customers are rare — a small, vocal group of dissidents. Young points to a survey, commissioned by Union Pacific, that shows a big bump in customer satisfaction since 2005. “You get this disconnect to some extent between D.C. and the reality out in the field,” he says. “It’s kind of frustrating to me.” Perhaps. But a survey conducted by Wolfe Trahan found that more than 80% of shippers wanted regulatory changes, including increased access to the STB.

The fate of railroad regulation

On June 22 the STB held a public hearing on rail competition, its first forum on the issue in 13 years. The agency’s lobby was jammed with rail executives, shippers, and lawyers. Jim Young was there; so was CSX CEO Michael Ward, as well as top executives from BNSF, Norfolk Southern, and DuPont. Fred Fournier of M&G Polymers flew in. As the line snaked to the door, people slapped each other’s back and shouted greetings; it felt like a high school reunion.

But the jovial atmosphere quickly dissipated once the hearing began. Francis Mulvey, one of the three board members, opened with a grim statement: “Railroads and shippers are as far apart on the issues as ever,” he said.

That was clear at the hearing. Ed Hamberger, a hard-boiled lawyer who heads the AAR, ticked off reasons why reintroducing regulation would hurt the industry and, by proxy, shippers: Forcing big carriers to interchange traffic with other lines would interfere with operations, hamper rail revenue, and hurt the industry’s ability to invest. “Let’s face it,” he said, “customers that are calling for forced access really want lower rates by eliminating differential pricing.”

It’s certainly true that shippers want lower pricing. At the hearing, customer after customer offered tales of escalating rates and anticompetitive behavior. But perhaps the most emotional testimony came not from a shipper but a senator. By the time Al Franken (D-Minn.) showed up, the hearing room was nearly empty. When the former comedian started to speak, the board members couldn’t help but smile like an audience expecting a routine. But Franken spoke plaintively. His family had moved to Minnesota when he was 4 years old, he said, when his father opened a quilting factory. The plant failed after just two years — in large part because the local railroad charged too much. “Basically, the railroad shook him down,” he said. Today Franken wants to bring back rail regulation.

There have been numerous attempts by Congress to do that. The two senators leading the charge are Herb Kohl (D-Wis.), whose bill would eliminate the industry’s antitrust exemptions, and Rockefeller, who aims to make over the STB. (Both senators represent states with large numbers of captive shippers.) In 2009 the two came close to passing a bill but failed, Rockefeller later said, in the face of railroad opposition. In today’s locked Congress, both bills seem likely to die once again.

So the fate of railroad regulation lies with the STB, which is debating whether to outlaw some of the railroads’ practices. Shippers’ groups are holding out hope. The board’s Obama-appointed chairman, a former union lawyer named Daniel Elliott, is seen as a nonpartisan reformer. He has already made shipper-friendly changes, like lowering the fees required to file for rate relief.

M&G Polymers is still waiting for the STB to issue a decision on its appeal. Fournier is confident he’ll win but frustrated by how long the case is taking and how expensive it is. Because the company is paying astronomical rates while it waits for a verdict, he says, CSX benefits from dragging out the process. “They’re trying to bleed us dry,” he says. “I don’t begrudge them anything on what they have to invest to keep it safe, to build infrastructure. I understand all of that. But what I don’t understand is how you can take a captive shipper and you can just rip them till there is no more.”

For several years M&G was hoping to expand its West Virginia factory, a potential boon for a depressed corner of the state. But in July the company announced it will instead build a new plastic plant in Texas. In addition to creating 250 factory jobs, the project will bring an estimated 700 related positions to the area, as well as 3,000 construction jobs. Fournier says the decision to build there was a no-brainer: The new site has access to three railroads.

–Reporter associate: Doris Burke

This article is from the September 26, 2011 issue of Fortune.