Inflation running off the rails

The core inflation enthusiasts, which ignore the price of energy, complacently keep buying up stocks, especially those stocks with momentum. And transport stocks have had that kind of momentum.

The question is whether transports are sowing the seeds, like those genetically modified suicide seeds, of their own destruction.

There comes a point when their customers cannot afford to pay the price increases, especially if they cannot recoup the costs from their customers. And so, while prices are fabulous, the volume of trade (and industry) dries up. And that is the evil of inflation which the CenBanks have grown so wary of.

So rejoicing in the rising prices of things can be a bit shortsighted, even if you own those things. Thus, those cheering the rising price of copper and other metals and buying "commodity" stocks need to be careful they are not getting too much of a good thing, however good it may seem, because when prices are too high for the end users to afford, the bubble bursts.

And the same goes for the transport stocks. The railroads are absolutely on fire with the revenues they've been getting, but it is burning out their customer base, as these two Reuters stories illustrate: Railroads, utilities square off over coal

Utilities say poor coal deliveries by the railroads affect their ability to do business and provide service to customers.

The railroads admit to delivery problems. But they complain in turn that after decades of relying heavily on natural gas, electric utilities are raising coal inventories as fast as they can which is making the supply crunch far worse.

"For 20 years the utilities relied heavily on natural gas on the premise that it was cheap and in plentiful supply," said Wick Moorman, chief executive officer of railroad Norfolk Southern Corp. (NSC.N: Quote, Profile, Research). "During that time they kept coal stockpiles low and now that natural gas is no longer cheap they want as much coal as we are capable of providing."

KING COAL

Texas power producer TXU Corp. (TXU.N: Quote, Profile, Research) said in April it would spend $10 billion on new coal-fired power plants, then said on Tuesday that it was looking to expand coal power outside Texas. Both times the company's stock jumped in response.

Utilities have been particularly keen to get coal from the thick, rich seams of the Powder River Basin in Wyoming. Closer to the surface than other U.S. coal veins and cheaper to mine, its low sulfur content makes it easier for utilities to meet smokestack emission standards.

But boosting coal demand has come at a cost.

The Laramie River Station near Wheatland, Wyoming, is within the Powder River Basin itself and burns 24,000 tons of coal daily. In March the plant's coal stockpile dipped to 125,000 tons, well below the 700,000 tons the company plans on for emergencies and enough for just five days' power generation.

Although the plant's stockpile is now at 416,000 tons, Floyd Robb, spokesman for the Basin Electric Cooperative which runs the plant, said the future is still uncertain.

"We are cautiously optimistic," he said. "But if supplies fall, we may be forced to curtail production and buy energy on the market, which would not make us happy."

Tensions between the utilities and the railroads have spilled over into the courts.

Two utilities, Wisconsin Energy Corp. (WEC.N: Quote, Profile, Research) and Entergy Corp. (ETR.N: Quote, Profile, Research), launched lawsuits recently against railroad Union Pacific Corp. (UNP.N: Quote, Profile, Research). Both suits focus on insufficient coal deliveries.

PUBLIC FORUM

Last week trade groups from both sides called on the Federal Energy Regulatory Commission (FERC) to hold a public forum on the problem.

FERC spokesman Bryan Lee said the regulator is "giving serious consideration to holding" public talks on coal deliveries, but said any such talks would have to include the U.S. Surface Transportation Board, the federal regulator overseeing rail rate and service disputes. The STB is already due to examine complaints from customers over fuel surcharges levied by the railroads in hearings in Washington May 11.

Today is the day those STB hearings take place. In advance of the hearing, Reuters reported, Railroad customers bristle at fuel surcharges

The resurgence of the U.S. railroads has investors laughing all the way to the bank, but rail customers are far from happy about steep energy surcharges they claim are fueling railroad profits.

"I don't like using the term, but it feels like price gouging," said Bob Zelenka, executive director of the Minnesota Grain & Feed Association.

Over the past three years, railroads have benefited from rising U.S. imports and growing demand for coal from utilities. Higher fuel costs and a driver shortage in the U.S. trucking industry have pushed more freight onto rails.

As a result, share prices of most big U.S. railroads have soared since 2003 on the back of record profits.

But just as consumers facing $3 a gallon for gasoline complain of price gouging by oil companies, U.S. shippers say railroads are profiting unfairly by adding unnecessarily high surcharges to offset their rising diesel fuel costs.

For the two largest U.S. railroads, Union Pacific Corp. (UNP.N: Quote, Profile, Research) and Burlington Northern Santa Fe Corp. (BNI.N: Quote, Profile, Research), those surcharges amounted to more than $2 billion in 2005, according to regulatory filings.

"This is a concern for us and we would strenuously oppose any effort by the railroads to increase their profits through surcharges," said Jim Owen, a spokesman for the Edison Electric Institute, a trade association for electric utilities.

Railroads contend that they do not profit from the surcharges.

In response to customers' complaints, the Surface Transportation Board (STB), the federal regulator that oversees rail rate and service disputes, will hold a hearing on May 11 to examine the "manner in which fuel surcharges are calculated and charged by railroads."

Representatives for the shippers, their trade associations and the railroads are all scheduled to speak.

RAILROADS SAY NOT PROFITING FROM SURCHARGES

The railroads say they are not fully recovering their costs from the surcharges, let alone making a profit from them, and are confident the STB will reach the same conclusion.

"We are currently recouping only 90 percent of our extra fuel costs," said Jim Young, chief executive of Union Pacific. "We are definitely not profiting from surcharges." [If that is the case, why are investors piling on the company stocks?]

Union Pacific's stock price has nearly doubled since May 2003. Shares of the other big U.S. railroads -- Burlington Northern, Norfolk Southern Corp. (NSC.N: Quote, Profile, Research) and CSX Corp. (CSX.N: Quote, Profile, Research) -- have also more than doubled.

Fund managers say surcharges reflect the railroads' ability to dictate prices amid tight capacity after two decades of stagnating rates. "After lean times in which many railroads went broke or were consolidated, the rail companies are now finally able to raise prices and apply surcharges," said Craig Hodges, portfolio co-manager at Hodges Capital Management.

Hodges' firm manages nearly $1 billion in assets and holds stock in Union Pacific, Burlington Northern, Norfolk Southern and Canadian National Railway (CNR.TO: Quote, Profile, Research).

"The railroads are in business to make a profit one way or another and that's why we own them," he said.

Shippers complain they have been left in the dark about how most surcharges are calculated.

"We don't know for sure, but we think the surcharges are a profit center for the railroads," said Stephen Pocsik, a vice president at Total Petrochemicals USA Inc., a unit of Total SA (TOTF.PA: Quote, Profile, Research), which ships around 24,000 railcars of plastic pellets annually. "What we want is an open and transparent system based on the amount of miles our goods travel." [And I'm sure they'd gladly provide an open and transparent system for showing their profit margins on the pellets.]

Most railroads levy fuel surcharges calculated on top of the base rate charged for moving goods.

Burlington Northern, the second-largest U.S. railroad, has introduced a mileage-based approach, which Chief Executive Officer Matthew Rose said is the "fairest system available."

Steve Strege, executive vice president of the North Dakota Grain Dealers Association, said Burlington Northern's system is an improvement, but still leaves questions unanswered.

"We are glad to see (BNSF) do this but we are not convinced it is based on real fuel costs," he said. His group wants to know why the surcharge is 22 cents a mile for coal, but 33 cents a mile for grain.

Analysts say assessing fuel surcharges is complicated as it is difficult to distinguish between them and revenue.

"The full impact of the surcharges is hard to calculate as the lines between revenue and surcharges are blurred," said Stephen Brown of Fitch Ratings. "As railroads renegotiate contracts with customers, those lines are becoming more blurred as base rates and surcharges are negotiated together."

Of course, the real issue isn't the manner of calculating the surcharge. It's in calculating how to pay or pass on the $2 Billion additional costs. And the issue for the Fed is to make sure those costs don't show up in the "official" inflation figures - to make "core" inflation "cloaked" inflation. And the issue for the folks in Washington hearing these complaints is to pose and scorn and rant and, yes, rail, and get re-elected.