The economics of rail rate increases

The economics of rail rate increases

Most businesses faced with a downturn in demand respond by reducing prices to attract price-conscious buyers. Not railroads - they have raised rates and customers have accepted the increases.

Railroads are an extremely capital-intensive industry, and that affects pricing policies. Less capital-intensive businesses can charge just a bit more than variable cost - the costs that are directly attributable to a particular movement and which the railroad would not have if the customer didn't buy. Most other businesses operate with a smaller proportion of system fixed costs - costs that continue whether anything moves or not - than railroads. Consequently, they can price closer to variable cost and still be profitable.

Railroads used to price their services that way. A particular movement might not cover all costs, but as long as it covered variable costs and made some contribution to fixed, it was considered "good revenue."

That was particularly true when railroads had excess capacity, and customers knew it. In that environment, customers could dictate maximum rates, knowing the railroad needed the revenue more than the customer needed the rail service. It was particularly true of intermodal service where railroads used surplus equipment and facilities, which allowed them to charge rates that made only minimal contribution to system fixed costs. Service wasn't particularly good or consistent, but rates were low enough that customers could accept the tradeoff of higher inventories for lower rates.

The world was turned upside down when American President Lines began serving landbridge and mini-landbridge markets by stacking international containers two-high on special well cars. APL couldn't afford to serve Asia to U.S. West and East Coast ports. It decided to serve only West Coast ports directly, using rail to reach other U.S. locations. Union Pacific and, later, other railroads became wholesalers to APL and other steamship lines.

Domestic intermodal grew slowly, with the U.S. Postal Service and UPS among the first major customers. They were joined later by J.B. Hunt Transport and, eventually, more motor carriers that saw cost savings from using low-priced rail intermodal and reducing their own long-haul expenses.

Intermodal grew slowly over two decades while excess rail capacity was absorbed by growing utility coal shipments and the explosion of demand triggered by globalization. Utilities objected strenuously to the notion that they should make a greater contribution to fixed costs, and effectively subsidize intermodal shippers. Federal regulators rejected most rate complaints, defending differential pricing.

Demand for rail service finally exceeded capacity halfway through the first decade of the 21st century, and railroads began to raise rates for all customers.

International intermodal movements were made under contracts between railroads and steamship lines. Rate increases were limited by escalation clause terms where they existed. As contracts came up for renewal, railroads sought much sharper increases than the container lines were used to absorbing.

UP and BNSF Railway, east-west railroads serving Pacific ports, aggressively raised rates. In response, some ship operators stopped offering service to many inland points, forcing customers to make separate arrangements for the domestic portion of container movements. Others offered more all-water service to East Coast ports.

That tactic worked. The western railroads experienced declines in intermodal originations that were greater than actual traffic declines.

In the East, Norfolk Southern and CSX were in position to benefit regardless of what the western carriers did. If the traffic moved from the West Coast, they were the receiving interline carriers at Midwestern gateways. If the cargo went to East Coast ports, they became originating carriers moving traffic toward the Midwest.

The spike in fuel prices changed everything. Bunker fuel for ship lines became so expensive that many ordered ships to operate at slower speeds to reduce fuel consumption. Meanwhile, domestic truck operators were paying nearly $1 a mile for diesel fuel and were trying to deal with a consistent driver shortage and the costs of urban highway congestion. More truckers began to use intermodal service for their long-haul needs.

As long as the intermodal rate remained below the cost of all-highway movement, railroads were free to charge all the traffic would bear. In short, railroads are raising intermodal rates for the simple reason that they can.

Larry Kaufman, former intermodal editor of The Journal of Commerce, has worked in and written about railroads for nearly 40 years. He can be contacted at Lkauf81509@aol.com.