C O N F I D E N T I A L | Freight Rail Infrastructure: Will a Re-Regulated Industry Build it? May 28, 2009 John Larew Beyond the Crossroads

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Freight Rail Infrastructure: Will a Re-Regulated Industry Build it?

May 28, 2009

John LarewBeyond the Crossroads

Manufacturing, Transportation & Energy

2CASECODE-FILENAME (YYYYMMDD Descriptor).ppt© Oliver Wyman www.oliverwyman.com

Industries

Capabilities

IndustriesAutomotiveAviation, Aerospace & DefenseCommunications, Media & Technology

EnergyFinancial Services–Corporate & Institutional

Banking–Insurance–Retail & Business Banking

Introduction Oliver WymanA strategy consulting firm built around industry expertise

Industrial Products & Services

Health & Life SciencesRetail & Consumer Products

Surface Transportation


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Freight Rail and Economic GrowthAs a key enabler of economic growth, freight rail production closely tracks the performance of U.S. GDP.

Source: Congressional Budget Office.

Real GDP

($T 2001 USD)

US GDP and Railroad Revenue Ton-Miles

CAGR3.1%

US Rail Revenue Ton-Miles


0

1,000,000

2,000,000

3,000,000

4,000,000

5,000,000

6,000,000

7,000,000

8,000,000

9,000,000

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

Steady growth in Railroad capital expenditures Class I Railroad capital spending has grown significantly, driven primarily by road-related investment

Source: AAR R1 Reports and Oliver Wyman analysis.

Billions of Current Dollars

Class I Capital Expenditures for Road and EquipmentCAGR

1985-’06

2.0%

3.4%

2.8%

CAGR2000-’06

-0.4%

7.4%

4.4%

Road

Equipment

Total

Road as a % of total CAPEX


Road capex projectionUnder conservative assumptions, US Class I railroads will spend $6.6 billion to $7.0 billion annually on road capex by 2013.

$0

$1

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1997

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2013

Historical Road Capex Spend

Long Term Growth Rate

IPI-BasedEconomist

IMF

CBO

UBS

Citi

Merrill Global Insight

Average GDP-based Estimate

US Class I Railroads: Historical and Projected Road Capex Spend1996-2013E, $ billions

CAGR2007-’13

2.6%

Actual Projected

1.3%

By 2013, the gap between the most bullish and bearish GDP-based forecasts is $0.4B

1985-2007 CAGR: 3.2%

2007-2013 CAGR: -0.9% – 2.6%

Source: R-1 Reports filed with the STB; Bureau of Economic Analysis; International Monetary Fund; CBO; AAR – National Freight Capacity Study; Oliver Wyman analysis.Note: Long-term estimate is based on expected rail tonnage growth of 88% from 2006-2035 applied to GTMs. 1985-2007 historical growth rate of road capex adjusted downward for 2007-2013 in proportion to expected adjustment in GTM growth rate. 2008 retained flat based on information from interviews. US Class I dataset includes five US Class I railroads and US operations for two Canadian railroads.

-0.8%

-0.3%

-0.5%

-0.4%

-0.9%0.1%

-0.5%


Growing Demand for Rail InfrastructureTo maintain capacity adequate to demand, U.S. and Canadian rails will have to invest almost $150 bn by 2035

Projected stress on railroad network …Mileage by volume / capacity ratio

Despite recent downturn associated with the economy, the long-term forecast for freight tonnage will nearly double from current levels over the next 25 years

In the short term, North American rails have continued to invest in capex at a pace comparable to pre-crisis levels

An estimated $148B will need to be spent in order to accommodate the rail freight demand in 2035, including:– $95B on line haul expansion– $25B on bridges, tunnels and

clearance– $10B on branch line upgrades

88%

45%

9%

10%

3%

15%

30%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2007 2035 with noadditionalcapacity

Above capacity

At capacity

Near capacity

Below capacity

% o

f m

iles

Sources: AAR Future Capacity Study; Oliver Wyman analysis


Where will this capital come from?

Nowhere? – The world is full of examples of needed infrastructure that was never built.

Shippers?– Industries that rely on expanded rail capacity can expect to pay rates that

fully recover capital costs.– Shippers may contribute capital (as they have with car fleets)– Railroads may manage capacity bottlenecks by pricing some revenue-

inadequate traffic off the system.

The public sector?– Investment tax incentives have a visible impact – Freight rail projects can compete for stimulus funds under American

Recovery & Reinvestment Act– All four major Class I railroads have officers assigned to developing

public-private partnerships.

Investors and lenders? – Markets may make more capital available if…

Railroads earn their cost of capital (equity investment) Railroads maintain their creditworthiness (debt investment)


What could “derail” this infrastructure development?The prospect of renewed economic regulation of freight rails jeopardizes the economic basis of freight rail expansion.

Since the passage of the Staggers Act in 1980, the economic deregulation of freight rails has produced staggering improvements in productivity and lower rates for shippers– For more than 20 years, shippers enjoyed the windfall benefits of

overcapacity and vigorous competition for business

In recent years, complaints have mounted from the shipper community about service levels and higher rates; the prospect of partial re-regulation looms

Oliver Wyman’s analysis of the impact of re-regulation suggests two clear conclusions:– Re-imposing rate regulation would put the sustainability of freight rail

infrastructure at risk– The likely alternatives to market-based rate setting are unlikely to

benefit shippers on the whole


The Deregulated Status Quo: A Success Story? The current regulatory process results in some of the lowest rail freight rates in the world.

Comparative International Rail Freight Charges(US cents per tonne-kilometer)

0.0 2.0 4.0 6.0 8.0 10.0 12.0

Germany

Austria

Switzerland (SBB)

Italy

France (SNCF)

Japan

Spain

Poland

Canada

Korea

United States

South Africa

Source: Before the US House Subcommittee on Railroads, Hearing on the Status of the Surface Transportation Board and Railroad Economic Regulation: Testimony of William J. Rennicke, March 31, 2004, page II-38.


Rail Rates Since DeregulationThe case for a deregulated freight rail industry used to be very simple…

STB Rail Rate Index, 1985-2007Real revenue per ton-mile (index, 1985 = 100)


Rates since the “Rail Renaissance”…but advocates of re-regulation are getting more of a hearing now that real rates are no longer in long-term decline

STB Rail Rate Index, 1985-2007Real revenue per ton-mile (index, 1985 = 100)


Dating the Rail Renaissance

2005 — BNSF Railway’s earnings cover its cost of capital (Q3)

2004 — Industry revenue per carload increases in real terms — Aggregate employment at class ones increases

2003 — Revenue per carload increases in nominal terms — Revenue per ton-mile increases in real terms

2002— Ratio of track miles to route miles ends 20-year decline— Industry revenue per ton mile increases in nominal terms

2001 — Gross ton miles shipped by rail grows faster than by truck

1998 — First published complaint in Scrap magazine of inadequate supply of gondola cars


…and the Post-Renaissance

2005

— Trend to declining rail unit costs (adjusted RCAF) reverses

— Price of rail wheels increases 40 percent year over year

2006

— Carloads in Q4 decrease versus prior year quarter

— GAO investigates rail competitiveness

— STB introduces “maximum markup” methodology

2007

— Re-regulation bills introduced in U.S. House and Senate

— STB introduces small-shipper rate challenge procedures

2009 — Bill to subject STB-regulated common carriers to federal antitrust enforcement clears Senate Committee


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Class I Railroads

Utilities: Electric

Nonmetallic Minerals Mfg

Computer & Elec

Paper Mfg

Chemicals

Plastics & Rubber

Metal Fabricating

Wood Products

Motor Vehicles & Parts

Petroleum & Coal

Capital Expenditures as Percent of Revenue for Various IndustriesAverage 1996-2005

Source: Lefthand chart: U.S. Census Bureau. Righthand chart: Value Line 2005. Industries are not exact matches across charts due to different data sources.0 10 20 30

Computers, Office Equip.

Household & Personal

Petroleum

Packaging, Containers

Trucking

Metal Fabricating

Chemicals

Electronics, Electrical equip.

Motor Vehicles & Parts

Utilities: Water

Utilities: Electric

Railroads

Return on Equity (%) forVarious Industries, 2005

How Attractive is Freight Rail for Equity Investors?Freight rail is among the most capital-intensive industries, but ranks lowest in return on equity.


Why the fuss over deregulated rates? Market-based pricing means differentiated pricing; shippers with fewer competitive options pay more.

16.2%

52.5%

31.3%

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40%

50%

60%

R/VC < 100 R/VC 100 - 180 R/VC > 180

Distribution of Shipment Revenues by Revenue-to-Variable Cost RatioPercentage of total revenues in 2005

Highly Competitive Competitive Less Competitive

Source: Surface Transportation Board Commodity Revenue Stratification Report for 2005: Summary of Revenues and URCS Variable Costs by Two-Digit STCC and Revenue-to-Variable Cost (R/VC) Ratio Category, based on 2005 Waybill data; Oliver Wyman analysis.

In a deregulated environment, less competitive shipments pay a higher contribution over variable costs


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Share of Total Revenues Generated by Traffic with R/VC Ratio >180, By Major Commodity Percentage share, 2005

Which industries contribute more? Coal and chemicals are examples of commodities with a higher proportion of traffic moving at R/VC ratios of 180 or greater.

Average for AllCommodities = 31.3%

Source: Surface Transportation Board Commodity Revenue Stratification Report for 2005: Summary of Revenues and URCS Variable Costs by Two-Digit STCC and Revenue-to-Variable Cost (R/VC) Ratio Category, based on 2005 Waybill data; Oliver Wyman analysis.

Preliminary


Potential Impact of Re-RegulationProposals to re-impose rate regulation on freight rail could severely deplete the cash flow that sustains infrastructure investment.

-$4.0 B

-$3.0 B

-$2.0 B

-$1.0 B

$0.0 B

If rates were capped at a revenue to variable cost ratio (R/VC) of 1.80, railroads could lose ~$3.7B of revenue and 30% of their contribution to fixed costs

Impact of lowering rates to 180 R/VC Analysis of rates >180 R/VC, 2005

Coal Products

Chemical Products Misc

Farm Products

Petroleum & Coal

Products

Stone & Glass

Products Transportation

EquipmentFood

ProductsNonmetallic

MineralsMetal

Products Other Total


How significant are “captive” shippers? Virtually all major traffic origins/destinations are served by two or more rail carriers.

Number of Class I Railroads Serving Economic Areas, 2004

Source: Freight Railroads: Industry Health Has Improved, but Concerns about Competition and Capacity Should Be Addressed, GAO, October 2006. GAO analysis of BEA and GIS data.

In 1994, 21 percent of tonnage had access to only one railroad.

By 2004, that number had declined to 10 percent.

# of railroads (includes ownership/trackage rights)

5 or more (11)

2-4 (137)

1 (27)

0 (2)


Does deregulation penalize the little guy? Oliver Wyman research suggests that small shippers are not systematically disadvantaged in rate-setting.

% of shippers ranked by magnitude of deviation off formula

% d

evia

tion

from

form

ula

Percent Deviation of Actual Shipment Price From Predicted Rate Ranked

-60%

-40%

-20%

0%

20%

40%

60%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Large shippers: >100 cars/year

Small shippers: between 50 & 100 cars/year

Disguised Waybill Sample

Source: Before the US House Subcommittee on Railroads, Hearing on the Status of the Surface Transportation Board and Railroad Economic Regulation: Testimony of William J. Rennicke, March 31, 2004, page II-38.

Comparison of actual freight rates with expected (formula) prices indicates that there is not a significant pattern of preferential pricing for any one group. Any shipper, large or small, is just as likely to receive discounts or pay a premium price.


So what about vulnerable shippers?Competition—in all its forms—continues to be a powerful protection

Rail competition — commercial negotiation– Largest users (utilities) leverage their generation portfolios– Industrial development as a competitive lever

Modal competition– Before the downturn, fastest growing freight rail segment was the

truck competitive intermodal segment– Bulk shippers make strategic use of barge-competitive sources

Source competition– Railroads do not have true monopoly power even over “captive

shippers”

For the exceptions, there is the possibility of regulatory relief

…But, the freight rail industry cannot change economic geography


Documents

C O N F I D E N T I A L | Freight Rail Infrastructure: Will a Re-Regulated Industry Build it? May 28, 2009 John Larew Beyond the Crossroads