Jonathan Liss

Burlington Northern: Hauling Freight or Price Gouging Consumers?

The situation is actually worse than what I thought with my first erroneous reading. Patrick’s (General Director Corporate Communications) figures are correct. I glanced at this one too quickly. Total fuel costs for Q3 2006 was $792 M.

Let’s start with Q3 2005:
Total fuel costs = 500 M
Customers portion / “Surcharges” = 300 M
BNI out of pocket fuel bill = 200 M or 40% (less after tax profits from hedging).

As of Q3 2005, BNI assumes that oil is coming down 60% as 60% of its fuel cost is being passed on as a “surcharge” and is not regarded as a normal business expense. <strong>60% of the fuel bill was passed onto customers while 57% of BNI’s total (2005) consumption was hedged at less than a dollar a gallon!</strong>

I read the 10Q carefully this time. In other words when there is a profit from hedging then BNI gets to keep it and still pass on increased fuel prices to the consumer. In 2006 BNI decided to hedge less, a lot less. So when BNI has a loss from higher fuel prices due to lack of hedging, BNI gets to pass this on to the consumer as well. If that is the case then what is the point of hedging. Oh, I forgot; if BNI has a profit from hedging they get to keep that as well – uhm, I’m definitely in the wrong business.

Now take the Q3 2006 figures;
Total fuel costs = 792 M
Customers portion / “Surcharges” = 500 M
BNI out of pocket fuel bill = 292 M or 37% (less after tax profits from hedging, see Note 1).

As of Q3 2006, BNI is assuming that oil prices will come down 63% and therefore must regard the additional fuel expense as a temporary spike which should be recouped via the surcharge mechanism. In other words, BNI is viewing current circumstances akin to the oil embargo of 1973. According to BNI, oil should be at 28 to 30 today as well as for the foreseeable future.

As a side note, there have been numerous articles posted on Seeking Alpha pointing out that new oil projects, currently under development by major heavyweights in the oil industry, will be profitable only if oil remains above $40. Some of these projects are scheduled to come online in 2009/10 and some of the figures have been confirmed by company representatives (Shell, Canada tar sands).

Back to the present;

Reading the current 10Q, there are two paragraphs that got my attention.




<blockquote class="quote"><e... expenses of $2,031 million for the first nine months of 2006 were $679 million, or 50 percent, higher than the first nine months of 2005. The increase in fuel expense was due to an increase in the average all-in cost per gallon of diesel fuel, as well as an increase in consumption driven by higher volumes. The average all-in cost per gallon of diesel fuel increased by 54 cents to $1.84, resulting in a $597 million increase in expense. The increase in the average all-in cost was comprised of an increase in the average purchase price of 46 cents, or $510 million increase in fuel expenses, and a decrease in the hedge benefit of approximately 8 cents, or $87 million (first nine months 2006 benefit of $303 million less first nine months of 2005 benefit of $390 million). Consumption in the first nine months of 2006 was 1,100 million gallons compared with 1,043 million gallons in the same 2005 period, resulting in an $82 million increase in fuel expenses.



Based on fuel consumption during the twelve-month period ending September 30, 2006, of 1,459 million gallons and fuel prices during that same period, excluding the impact of the Company’s hedging activities, a ten percent increase or decrease in the commodity price per gallon would result in an approximate $272 million increase or decrease, respectively, in fuel expense (pre-tax) on an annual basis.</em></...



Based on the above, fuel costs increased at the very least 33%. Using BNI disclosed figures, 272 x 3.3 = 897. On a quarterly basis (897/4) this is $224 M. I am being very conservative here. One could surmise that the issue is where does hedging begin and end and when does a surcharge come into play.

Investors have a right to know what the company is actually making from the primary transport business. If we were to remove ALL hedging activities and ALL surcharges and ALL fuel price fluctuations (for arguments sake using the 2005 average cost), BNI would have posted at least $200 M less profits for Q3. To conclude that the additional 200 M is a cleverly disguised form of price gouging is one way of looking at it. Others may consider this to be good business.

This also explains why the transport sector has been doing better than usual in spite of higher oil prices (excluding some airlines). As oil comes down, these non operational profits are going to disappear. Eventually oil may settle in the mid 50’s and the surcharges will have to disappear as well. New freight rates will have to be set. Once this happens we will have a clearer picture of the real profits and of course the higher freight rates will add to the official inflation, but that is a whole different story.

If I got my figures wrong again, I would be more than willing to go over them with the CFO. By the way, the second paragraph quoted from the 10Q above is slightly misleading because a 10% fluctuation would NOT “lead to a 272 million” decrease on an annual basis – it would be passed along to the consumer as a surcharge! I said “slightly” because the potential does exist. BNI should have stated “could result” instead of “would result” and then we could/would all be happy!

<small>Note 1: Excerpt from latest 10Q (quarter ending 9/30/06)


<blockquote class="quote">“For derivative instruments that are designated and qualify as cash flow hedges, the effective portion of the gain or loss on the derivative instrument is recorded in accumulated other comprehensive loss (AOCL) as a separate component of stockholders’ equity and reclassified into earnings in the period during which the hedge transaction affects earnings.”</blockqu...



Note 2: All figures are approximations.</sm...