By GARY ADKINS

The return of the railroads

In the 1970s, it seemed as if a number of changes would be needed to revive the railroads. Now a number of changes have occurred, making the once ailing rail freight industry profitable again. Of these, deregulation provides the strongest thrust in raising profits, while greater energy efficiency has decreased costs in comparison to other modes. Relaxed rules under deregulation have also brought about a plethora of mergers in the railroad industry, another reason for profits

THE NATION'S $35 billion-a-year rail freight industry is today emerging from a century of crippling overregulation. But profit-motivated railroads and deregulated rates aren't entirely welcome developments to heavy industries, like coal producers, in need of low rail rates. As noted in a mid-1982 Business Week "Corporate Scoreboard," railroads were the fourth most improved American industry in the second quarter of 1982. Profits leapt 15 percent over earnings for the same quarter of 1981. Yet those higher profits

Photo by Roger McCredie Railroads are back on the track to prosperity. Profits were up 15 percent for the second quarter of 1982 over the same period for 1981. This increase is even more significant in the face of an all-industry quarter average of minus 16 percent.

were extracted more through higher rates than through any increased level of shipping. (Rail freight car loadings were off 9.6 percent during the first half of 1982.) News of rail revival sprang from the very depths of a recession that resulted in an all-industry second quarter average of minus 16 percent.

How have the stodgy railroads weathered the recession so far so gracefully? A Newsweek article listed the lifting of oppressive federal rate controls — which resulted in a rate increase of 18 percent between October 1980 and October 1982 — and sudden Interstate Commerce Commission (ICC) encouragement of large mergers — which created extensive, more efficient systems — as crucial elements of the rail resurgence. These developments, coupled with the innate energy advantage of rail over trucking, and an important corporate tax break in 1981 made railroads generally healthy for the first time in decades. Increased fuel efficiency, greater car capacity and reduction in number of rail employees were also factors.

A major element in rail profitability is its relative economy. Trains are two to four times more fuel efficient than trucks, and so the rise in the average cost of a gallon of fuel hurt trucking more than rail. In fact, the net operating income of railroads more than doubled when diesel fuel rose from 13.5 cents per gallon (in 1973) to one dollar a gallon (in 1981). This was managed by significantly increasing productivity, boosting it 3 percent per year.

In addition, freight car capacity was increased nearly 11.5 percent over the last decade. In actual use, the average freight car today is made to carry 13.1 tons more per movement than it carried a decade ago. Aggregate horsepower of all locomotives in use increased from 54.1 million industrywide in 1971 to 65 million horsepower last year. And a variety of technological improvements have pumped up locomotive fuel efficiency by 20 percent in the decade.

Laying off many employees also helped railroads make a larger profit — an unfortunate, darker side to the more touted good news about railroading. Between mid-1981 and mid-1982, in fact, fully 11 percent of railroad workers were laid off. On a larger time scale, nationwide rail employment had already fallen off 20 percent between 1971 and 1981. Meanwhile railroads have managed ample wage and benefit increases for those workers who have retained their jobs. The average rail employee earned $26,698 in 1981, as opposed to $11,023 in 1971.

These productivity gains were not the major factor in improving industry profits, however. The best gains have been wrought only since 1980 in the wake of congressional deregulation of major aspects of the industry through the Staggers Rail Act (P.L. 96-448). Prior to Staggers, any shipper could effectively block any individual rate increase just by filing a complaint with the ICC. Whether the ICC upheld it or not, the time and expense spent fighting such a complaint produced a chilling

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effect on future rate increases. Prior to Staggers, also, rates set by the ICC bore little relation to the real cost of transport. For example, in the mid-1970s the ICC approved a general 7 percent boost in freight rates, but decided to exempt rates for 14 key commodities of suffering or depressed industries. Unfortunately for railroads, the 14 commodities were among its most remunerative shipments. "It was as if the railroads were in such good shape they could afford to pick up the burden for General Motors," said Constance Abrams, an ICC policy analyst who opposed the exemption in vain. Again, the trucking industry serves as an illuminating contrast. While deregulation has improved profits for railroads, congressional deregulation of interstate trucking, enacted separately in 1980, produced negative results for that industry for a variety of reasons.

Unlike railroaders, truckers had been satisfied with economic results of ICC regulation because it granted them "route authority" that often added up to a virtual monopoly on many routes. Increased free market competition did away with all that, engendering fierce competition between trucking firms, which of course reduced profit margins.

As the rails become a more profitable form of transportation, railroads are able to allot more money to track maintenance and repair. In 1981, Illinois Central Gulf Railroad put in over a million ties and surfaced in excess of 4,500 miles of track throughout its system.

Since railroads don't usually compete as directly with one another, and since there aren't as many competing railroads for any given route or service, less cutthroat competition has occurred in the rail industry. Deregulation for railroads has instead meant fewer competitors due to mergers and an end to ICC bureaucratic foot-dragging on rail rate requests. Now railroads usually set their own rates in immediate response to market conditions (within reasonable cost-based limits).

"They were deregulated to increase profits, and we were deregulated to lose profits," complains Lana R. Batts, director of energy and economics for the American Trucking Association. Railroaders disagree with such an assessment of congressional intent, but admit Staggers has generally been better for railroads. But the industry is not monolithic; not all railroads are doing well.

"We have 22 operating railroad members," says Gordon E. Longtha, president of the Illinois Railroad Association. "Some railroads are doing well, and others are not. It depends on the market area — coal and grain are doing well, while most other commodities are producing less traffic."

Longtha is the first to claim that rail is asserting an intrinsic superiority for carrying certain commodities. "Railroads are best at carrying trainloads of heavy bulk goods over long distances, the longer the better," he says.

The fact is that since railroads replaced canal traffic as the chief mode of freight traffic, they have always carried most of the nation's freight. Trucks today carry just 23 percent of U.S. intercity freight, barges just 13 percent and pipelines 22.5 percent of U.S. intercity freight, while railroads move an impressive 38 percent of the nation's goods.

Yet rival modes are competitive and often more efficient in carrying some kinds of freight. For instance, trucks are unbeatable at carrying manufactured goods, particularly lightweight, high-tech equipment. Trucks also make sense on short or moderate hauls of commodities not requiring too much space for shipment. Pipelines are incomparably efficient at transporting oil and gas or other liquids in huge amounts. Barges are best at moving heavy, bulky things downstream along rivers. This is all pretty obvious: each mode makes sense for certain things. For railroads it means rival modes may sometimes make marginal inroads in traffic, but railroads retain unique advantages.

The best news for the railroads these days is the way the Staggers Act has been interpreted and enforced by the ICC. Given a new set of laissez-faire directives and a Reagan-appointed leader (commission chairman Reese Taylor Jr., Nevada attorney and former partner to Reagan's close personal friend Sen. Paul Laxalt of Nevada), the formerly hostile ICC has turned markedly pro-rail. It especially favors large corporate combinations, as it implies in its 1982-announced policy on rail mergers which emphasizes that its main concern "is the preservation of essential services, not the survival of particular carriers."

The ICC no longer requires a merged railroad to continue offering rates on newly annexed routes comparable with what had been charged on the same route in "joint-line" (where a single rate is offered for shipments via two railroads) shipments prior to merger. For example, if railroad Blue merged with railroad Gray, they would be free to raise even those rates they had contractually agreed to offer under a single rate for point West to point East shipments when Blue and Gray were separate companies. Suddenly there was a big profit incentive for merging railroads, regardless of their size.

What pushed big railroads together, though, was the ICC's decision to permit railroads under a single corporate umbrella to set their own rates on their own lines. At the same time, the ICC stripped antitrust immunity from competing

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Mergers rule the day, making existence perilous for smaller lines. Here, officials of Norfolk & Western inspect a piece of Illinois Terminal track. N & W later purchased IT.

railroads if they attempted to set joint rates. This immunity, enjoyed since 1948, had actually meant that nearly all railroads participated in collective rate setting for whole regions of the country through five regional boards. Of course, Staggers also made such rate boards obsolete — in fact any shipment via two or more railroads under a single joint rate now requires the companies involved to negotiate apportionment of any revenues derived from the joint-line shipment.

Since 70 percent of all rail shipments were joint-line at the time Staggers was enacted, phase-out of regional collective rate-making (to be complete by 1984) prompted rail giants to lengthen their routes in "end-to-end," as opposed to parallel line mergers. (For instance, Union Pacific, a giant in the West, had its easternmost terminus in Kansas City; it merged with Missouri Pacific, a Midwestern giant with lines centered around Kansas City, lying mainly north-south between Chicago and the Gulf of Mexico.) In so doing, the giants avoided the need to negotiate a collective rate with each smaller, hungrier competitor whose lines reach a strong, untapped shipper or market, and everyone avoided getting slapped with a fat, inky antitrust suit for rate-fixing every time they turned around a joint shipment of freight.

"The structure of deregulation virtually forces railroads to merge," explains Robert D. Long, transportation analyst with the First Boston Corporation. "Why should railroads have a thousand meetings to set rates when they could have one?"

The ICC encouraged mergers also by speeding its consideration of proposed combinations. The merger forming CSX (Chessie and Seaboard) railroad, for instance, was approved in just a year in 1980, whereas most previous mergers took anywhere from four to six years to worm their way through ICC red tape. (The 1970 Burlington Northern merger — which combined the Southern; the Central of Georgia; the Great Northern; the Northern Pacific; the Chicago, Burlington and Quincy; the Spokane; and the Portland and Seattle railroads — took 10 years.)

Thus recent mega-mergers have formed freight-hauling behemoths to the east and west of Illinois — all with major lines reaching into the state, and into Chicago in particular. The first mammoth system was assembled in 1976 from the ruins of six bankrupt eastern railroads. The principal corpse belonged to the notorious Penn Central, itself formed in the 1960s from what had been the nation's two largest railroads, the Pennsylvania Railroad and the New York Central. A federal bicentennial bailout created Conrail, which was to become the industry's phoenix, but only after Washington poured nearly $3.3 billion of public funds into the flame, losing $1.3 billion in the first five years. Yet even Conrail showed a profit in 1981 — $39.2 million worth, and though even that seemed small and shaky in the shadow of $4.2 billion worth of operating revenues, it was a welcome harbinger of the industry's turnaround. Conrail has not needed any added federal funding since June 1981, despite an 8 percent decline in freight car loadings in 1981. In fact, the first half of 1982 saw the quasi-public Conrail Corporation produce a $30.6 million profit.

In the fully private sector, deregulation also induced the colossal merger of Burlington Northern with several smaller western roads in April 1980 which created the nation's biggest railroad in terms of route miles — 29,000. The September 1980 merger of the east coast Chessie System with Seaboard Industries formed CSX, the nation's second biggest railroad at 27,000 route miles. In June 1982 two highly profitable southern railroads merged to create Norfolk Southern — clearly the nation's healthiest megasystem in its return on equity (mainly because it hauls a very high percentage of coal traffic).

But the largest merger of all in terms of total yearly profits was announced in September 1982 when Pac Rail was formed from the merger of the Union Pacific, the Western Pacific and the Missouri Pacific.

It is especially ironic that mergers, which are now reviving the industry, were once seen as destructive. A flurry of mergers and takeovers occurred between 1893 and 1904, after an 1893 depression that shoved one-third of America's railroad mileage into bankrupt status. That period culminated in formation of a key rail monopoly by J. P. Morgan and other "robber barons." The Northern Securities Company in the Pacific Northwest soon became populist President Teddy Roosevelt's test case for application of the Sherman antitrust law, and the U.S. Supreme Court ruled to break up a major U.S. corporation for the first time ever. While this case didn't really hurt the rail owners' stock ownership in and control over the separated railroads, it made a lasting difference to management's willingness to merge.

Haunting J. P. Morgan's fondest dreams, the Northern Securities decision prevented major rail mergers until "well after World War II," according to one rail historian. Stephen Salsbury in a 1982 book, No Way to Run a Railroad, says "this is certainly one of the factors preventing America from following the Canadian example, which by the 1920s saw the emergence of two nationwide railroad systems, the Canadian Pacific and the Canadian National. It was not until. . .the 1960s that mergers were again seen as a method of solving railroad ills the way they had been in the 1890s."

Since 1955 there have been more than 70 U.S. rail merger proposals, or proposals for one railroad to purchase controlling interest in another. Mergers are a key factor in the reduction of U.S. railroad companies from 6,000 in 1955 to about 300 now, but bankruptcies are a much larger factor. Eleven major railroads went belly up in the 13 years preceding the 1980 Staggers deregulation, and countless smaller lines failed. By 1973, 13 percent of the nation's rail mileage was owned by a bankrupt line.

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Bankruptcy and the rush toward consolidation in the rail industry has helped reduce the number of Class I railroads — those with yearly operating revenues of $50 million or more — from 52 in 1977 to fewer than 40 now. These Class I railroads dominate the industry, moving 98 percent of total traffic, employing 92 percent of rail workers and operating 94 percent of the track mileage, according to the Association of American Railroads.

The major improvement in the industry's profits have come primarily in the Class I category, of course. But Class II — those with yearly operating revenues between $10 million and $50 million — and Class III — those with yearly operating revenues below $10 million, plus all terminal and switching railroads — called "short lines," are still rather numerous, though many are struggling.

The American Short Line Railroad Association is comprised of 255 member railroads, many of which own less than 100 miles of track. One, the Crab Orchard and Egyptian in Marion, owns eight track miles, employs five people and, like a lot of short lines, provides a service essential to the local economy (in this case, connecting 24 Marion shippers to the Illinois Central Gulf main line at Carbondale) without making a profit. Many short lines serve also as tax shelters for investors, with their losses passed through to wealthy individuals who can legally deduct a percentage of such loss from federal income taxes.

Short lines are troubled by undercapitalization, old equipment, drying up of state and federal subsidies and, sometimes, lack of management experience. The federal Department of Transportation ceased making grants for operating subsidies to such railroads in September 1982. In 1983 grants for track acquisition and repair will be cut in half, to about $20 million. Consequently, many states, including Illinois, have tightened railroad assistance programs. "There's going to be a shakeout," admits Fred Wengenroth, of the Illinois Department of Transportation. Previously the state was federally mandated to offer operating subsidies to short lines, he says, but in the future the state will only favor grants for track repair.

Photo by Roger McCredie Steel, coal and agricultural processing rely heavily on low-cost rail transport to distribute products nationwide. Should Chicago be replaced as the nation's rail hub, these industries will suffer.

Under the Staggers Act short lines are at a big disadvantage since no line may adjust rates on joint-line shipments without negotiating a new rate with the other railroads involved. This inevitably takes time, meaning short lines generally can't react fast enough to market conditions on the potentially most profitable long distance shipments. For example, if a short line entirely located in Illinois wanted to competitively bid for movement of grain to the Gulf, the short line would first need to negotiate a joint rate with a larger southern rail line, to underprice the ICG; meanwhile, ICG could directly lower its price, as it owns track all the way to the Gulf. (Big railroads can rapidly adjust rates for long hauls confined to their own track.)

All railroads are now able to enter into short- or long-term contracts with shippers. This may work as a saving grace for short lines able to negotiate an innovative contract. For example, Prairie Central Railroad, one of the shortest of the short lines, recently negotiated contracts with Conrail and two food product shippers. Conrail was interested in shipping the products of two vegetable oil refiners located in Decatur, but Conrail had no spur to Decatur. Prairie Central offered Conrail a shuttle from Decatur east to Paris, Ill. — where the two railroads interchange. Prior to the contract Conrail hauled the goods only a short distance on the eastern leg of the trip. In those days Prairie Central got little of the Decatur area oil traffic. Now Prairie Central has this traffic, and certain mid-size regional railroads are squeezed out.

Although some short lines, like Prairie Central, can survive in a realm of giants, it is deceptive to think of the rail industry as a coequal mix of companies of every size and description. In terms of overall market share the industry is utterly dominated by nine major railroads, which grab nearly 90 percent of the profits. The consolidation milieu is like that in the American auto industry half a century ago: The big fish are swallowing their rivals. As the New York Times noted after formation of Pac Rail, "yesterday's ICC decision was expected to put particular pressure on smaller independent railroads such as the Chicago and North Western, the Kansas City Southern and the Illinois Central Gulf." And a railroad analyst for Oppenheimer & Company told the Times, "I wouldn't want to be the last independent railroad. . . .[The big ones] would just go around you; you would be isolated."

Many such ominous threats are around, yet Illinois railroads are in a beautiful spot to negotiate for mergers both geographically and in terms of existing track network. The state ranks second in the nation in track mileage, with 10,672, and first in its number of rail employees, with 38,004; both areas, however, had fallen off markedly in the last decade, due largely to decisions by management to concentrate on the most profitable routes and to maximize profits with layoffs and labor-saving technology.

But these conditions are products of the past and do not insure Chicago's continued role as the hub of the nation's rail system. It would seem a likely mid-continent gateway to any approaching transcontinental corporation,

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of course, and precedent favors it, but other more practical factors may work against it.

One very knowledgeable insider, Railway Age senior editor Gus Welty, speculates that any future gateway might more easily be placed in Kansas City or Memphis, "with possible diminution in the importance of Chicago and St. Louis — in part because of changing traffic patterns and in part because Chicago has no particular plans for relieving congestion and speeding up interchange procedures, while physical improvements talked about for St. Louis/East St. Louis carry a horrendous pricetag."

Welty's scenario could land an unsettling gut punch to the rail industry in Illinois. The industry's annual payroll in the state totals almost $1 billion. Also, Illinois has many low-tech heavy industries like steel, coal and agricultural processing which would have to shoulder enormous additional costs if they were forced to send their products hundreds of miles south or southwest for rerouting to other parts of the nation.

Deregulation does not affect only railroads. The ripple effects of rail deregulation on regional economies have been substantial. A 1981 Massachusetts Institute of Technology (MIT) study, Freight Transportation Regulation, by Ann Friedlander and Richard H. Spady, concluded that, prior to rail and truck deregulation, an indirect subsidy was essentially provided to surface freight transport in the industrial Northeast and Midwest through artificially low freight rates. This "official region" of the ICC, the trusty old industrial belt of the nation, includes Illinois.

Prior to the Staggers Act the official territory received an annual indirect subsidy of over $1 billion in the manufacturing sector alone. The study projected that rail and truck deregulation, producing a more competitive rate structure, would cause the "loss of some 35,000 manufacturing jobs in the official territory and a gain of some 2,500 manufacturing jobs in the southwest region. . .a reduction of some $590 million in manufacturing income in the official territory and an increase of some $23 million in the south-west region." (The toll on other industries was not determined but was acknowledged as substantial.)

The study added that "the Northeast and Central States would doubtless lose. In view of the rather precarious situation of these urban and state economies, it is certainly legitimate to question whether such a change makes social or political sense, or, alternatively, whether we can make these changes without developing some new and innovative means of establishing transitional subsidies. . . ." No replacement subsidy was, of course, provided. Throughout the industrial Northeast, those hit first and hardest by the recession might have a legitimate complaint about the "social or political sense" which the Staggers Act has made.

Such regional differences aside, it is legitimate to ask what the country — as opposed to the railroads — actually gained from partial deregulation or rail rates. Again the MIT study offered an intriguing prospect: that this would remove the railroads from the political realm of the ICC's rate-making and make clear the real political problem, namely, the viability of older manufacturing industries of the Northeast, rather than the viability of northeast railroads. The railroads have, indeed, proven quite viable.

Thus, the big winners of deregulation, as already suggested, were the big Class I railroads. Proof? Between April 1980 and April 1981 the nation's 10 largest railroads more than doubled their value on the stock market. Meanwhile a good many trusty old industrial concerns from the industrial Northeast flirted with bankruptcy (like International Harvester) or moved to the Sunbelt (like Schwinn bicycle). As MIT's study reasoned, "if producers really are cost minimizers, then changes in freight rates should affect relative production costs and hence locational decisions." Thus moves the market's unseen hand once the handcuffs are removed — striking down some and blessing others.□

Gary Adkins is a research associate with the Illinois Legislative Council. A former intern for Illinois Issues, Gary graduated from Sangamon State University's Public Affairs Reporting Program. The author wishes to acknowledge the extensive collaboration of Karen Adkins in researching and writing this article. Karen is a former technical editor for the Engineering Division of DuPont Corporation.

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Photo courtesy of Santa Fe Railway Santa Fe Railway's new lightweight "fuel toiler" container is able to handle bulk materials or packaged goods and can readily be adapted for liquids. These new containers can be double-stacked aboard freight cars when empty or loaded lightly. Preliminary use has shown a 15 percent fuel savings over traditional intermodal equipment. may squeeze out smaller competitors, or try to. The likelihood of such anticompetitive developments makes the threat of successful antitrust action very, very real now. There could be an updated replay of the Northern Securities decision and its aftermath of immense federal intervention. Court actions may block Interstate Commerce Commission formation of Pacific Rail (merging Union Pacific, Missouri Pacific and Western Pacific). Southern Pacific, a key Pac Rail competitor, has in fact brought suit against this merger. One reputable market analyst, Henry Livingston of Kidder, Peabody and Company, says that mega-mergers create "fortress-like companies" with very tight control of regional rail traffic. He believes there is a good possibility the rail giants may soon be dismantled by the courts, or even nationalized. Meanwhile commissioners of the Interstate Commerce Commission (ICC) are openly anticipating just the opposite. They think the big railroads may begin to acquire truck and barge lines to tighten their control over the movement of freight. For this to occur, however, legal questions would first have to be clarified. "The conventional interpretation of law and regulation is that a railroad may not acquire a motor carrier," writes Railway Age senior editor Gus Welty. "Some railroad managers, however, are wondering if this interpretation would withstand a test, or if it would be all that difficult to get the law changed, should that prove necessary." One factor which would lend itself to Welty's intermodal transport ideal is the change currently taking place in rail equipment technology. New all-purpose freight containers have been successfully tested, designed to allow so-called "piggyback" cars to expand their usefulness from packaged freight to liquid and dry bulk commodities as well. One prototype, the "fuel foiler" container, made of fiberglass or of aluminum, has shown a 15 percent fuel savings over traditional intermodal equipment. It can be stacked boxlike six deep for storage and may ride two deep in rail transport. It lends itself to movement by rail, highway and barge without unloading. Such containers are much better aerodynamically than existing rail cars, and their pay load capacity is greater. But "fuel foilers" are just one of the many promising changes now underway with railroads. All seem to relate to saving costs for fuel. Major locomotive builders, for instance, have tinkered with diesels, improving fuel efficiency 22 percent in the past decade — 4.2 percent last year alone. Better operating practices, including speed limits of 40-50 miles per hour, are becoming commonplace. Ironically, the search for alternative fuels turns railroads inexorably back to coal, or derivatives, some already in use. The odds appear good that developmental work will begin soon on an improved coal-fired steam engine, something like the trains of everyone's memory. Burlington Northern is said to be interested in building one if proven effective, and the American Coal Enterprises Company of Akron, Ohio, is reportedly ready to build a prototype. Considering the nation's proven coal reserves, the return to coal seems sensible. A switch by all railroads would boost domestic coal consumption 35 to 50 million tons per year, lowering the price for everyone. But there's another twist to the story. One of the biggest threats to rail profits appears to be from coal producers, who back development of coal slurry pipelines to compete with high rail transport costs. Advocates believe they can transport coal — ground and mixed with water or mixed with oil or methanol — at prices below rail transport rates. One slurry pipeline is proposed to run from southern Illinois to the Gulf of Mexico in Florida. Such pipelines need congressional approval to win status as "common carriers" and to cross rail lines. Opponents say the pipelines wouldn't be able to transport coal cheaper than railroads; they should not be called "common carriers" since they are only for coal and to build them would require that utilities or exporters lock themselves into long-term contracts without knowing actual costs. An Illinois slurry pipeline is advocated by the Illinois Coal Association. Vice president Taylor Pensoneau explains that coal mine companies are presently "highly captive to the railroads" and thus "subject to monopolistic abuses." Pensoneau notes that "about two-thirds of coal mined in the U.S. leaves the mines by rail." Railroaders say that the 30 percent of rail traffic generated by coal provides just 17 percent of railway income. They believe their future is assured, regardless of the outcome of the slurry pipeline threat, yet they admit it is a little worrisome. Deregulation has, meanwhile, returned railroads to profitability. "Railroads are probably one of the better growth industries for the next decade," according to Hays T. Watkins, chairman of CSX Corporation, the nation's second largest railroad company. Most rail experts agree. A proof of this rosy long-term outlook is U.S. Steel Corporation's plan to build a $250 million rail mill in Chicago — the first significant new addition at the South Works plant in a decade. Announcement of the company's intention to go ahead with construction came in September 1982 — at a time when the steel industry was in its worst economic shape in over 40 years. The state agreed to exempt U.S. Steel from sales taxes on rail products it ships out of state when the company said this exemption would be essential for it to make a profit. Still, this was a vote of confidence in railroads' future good health.□

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