Will Rogers and Warren Buffett and perhaps others have been quoted as saying "It takes a lifetime to build a good reputation, but only a minute to lose it." Well, Buffett just decided to invest about $600M in its railroad subsidiary, BNSF, to protect Berkshire's (NYSE:BRK.A) stellar reputation.
BNSF confirmed that it intends to buy a fleet of 5,000 tank cars to ship crude oil and ethanol, using specs that exceed the most stringent industry standards approved in October 2011 (see here).
BNSF's voluntary move is a clear step to "get out in front" of likely new specs to be issued by the U.S. Department of Transportation's Pipeline and Hazardous Materials Safety Administration. BNSF's (and Buffett's) reputation is at stake due to the structure of its industry.
Two parts of the industry structure stand out here. First, the U.S. freight railroad industry is highly regulated. The railroads are considered to be "common carriers," which means, among other things, that they cannot discriminate when providing service to customers. Second, the railroad does not normally provide the tank car in which crude oil is shipped.
As "common carriers," a freight railroad must provide a service if a potential customer asks for a service (moving a specific item from point A to point B) that has been approved by the regulator. Thus, if a customer wants BNSF to ship some Bakken crude from North Dakota to Chicago or St. Louis or Seattle and the customer provides a tank car that meets the minimum specification of the regulator, then BNSF must do it, even if BNSF thinks it may be a big risk. Regardless of the risk/reward of taking the business, BNSF must take it.
A series of spectacular and tragic derailments and explosions involving crude oil, notably Bakken crude, since last summer has definitely raised BNSF's risk profile. In any future tragic accident, the railroad will not escape with its reputation unharmed, regardless of where legal liability ends up. I think this reputation risk has risen even more due to a recent move by Canadian National Railway & Canadian Pacific Railway.
Canadian National Railway & Canadian Pacific Railway recently stated that they will begin charging higher rates to ship crude in railcars built before October 2011. Such cars are still allowed for shipping crude oil, even though in 2009 the National Transportation Safety Board called them unsafe for that use. Charging more to ship a more dangerous cargo may seem sensible, and it may be sensible if the extra revenue were spent to make the cargo's trip even safer. (One obvious method to improve safety is to run the train more slowly, which logically would suggest higher costs for the railroad and a premium price.) However, if the risky cargo STILL derailed, exploded, and caused tragedy, this could backfire, assuming it were BNSF shipping the cargo and BNSF charging a premium.
It is not hard to imagine a journalist calling it "profiteering" when a railroad ships a risky cargo and charges more to do it, because the railroad KNOWS the cargo is risky. The railroad is required to ship the cargo. It makes sense to charge more, but if the cargo derails, explodes, and causes tragedy, a journalist may lead with a "BNSF profiteering ..." headline, and trigger the quote "It takes a lifetime to build a good reputation, but only a minute to lose it." Buffett would invest a lot more than $600M to avoid that.
The $600M calculation is simple. A railcar for shipping crude oil generally "costs upwards of $100,000" according to Buffett himself on page 14 of Berkshire's 2012 annual report (find it here).
5,000 tank cars costing $100,000 each will cost $500M, but I add a 20% premium for two reasons. These cars will use premium materials, such as a thicker metal hull. Also, standard design cars spread a variety of fixed manufacturing costs over a great number of cars, but any engineering or tooling or other costs for BNSF's spec will be spread over only 5,000 cars. So, 5,000 tank cars costing $120,000 each will cost $600M.
It is key to remember that the $600M is not a pure cost, but an investment that will generate some return. How much return is surely debatable, since this is a change in industry structure and many large shippers of crude oil have recently been buying their own fleets of crude tank cars. Berkshire's stock reacted badly to this announcement, under-performing the S&P 500 by 0.8% yesterday alone. This was not the only potentially-negative piece of news for BNSF today, but I think at least half of today's under-performance was due to this news. If the $600M were a pure cost, 0.4% under-performance would be about right, given Berkshire's market cap. Since it is not pure cost, I see this as more over-reaction to how much tighter crude-by-rail regulations will hurt Berkshire's profits. It is more "weight" on BRK.A.
Just a few days ago, I wrote on Seeking Alpha that the "Weight Of Crude Oil Explosions May Be Lifting From Berkshire." This move by BNSF adds more uncertainty and more weight. I pointed out that when the executives of refineries spoke on conference calls from January 29 to February 13, BRK.A performed relatively well for the day. One point they made that should be positive for Berkshire is that they, themselves, intend to invest in new, safer cars for shipping crude by rail. My inference was that BNSF would not have to shoulder the burden (though upgrade costs or profits for the Marmon subsidiary remain unclear). It appears that in the market's view, Berkshire proved that wrong and added $600M of weight to the potential pressure tighter regulations could put on its crude-by-rail business. I think the damage that can be done by a variety of tighter regulations cannot justify the many billions of dollars of under-performance Berkshire has seen since last summer.
(Note: BNSF's strategy is somewhat unclear to me, since the makers of tank cars have a backlog of over a year, so the new regulations will probably be approved before BNSF actually receives these cars. That potentially exposes BNSF to the risk of having to re-spec the cars while they are in process of being built. Other questions revolve around Berkshire's ownership of Marmon. Marmon both owns a fleet of railcars that it leases to shippers and also builds tank cars. Will BNSF buy these tank cars from Marmon? If so, Berkshire earns an immediate profit on the $600M investment. If so, how soon could Marmon deliver? And finally, why is Berkshire having BNSF compete with Marmon? Why not have Marmon build the 5,000 tank cars for itself and lease them out?)