March 29, 2021
It was hard to miss news of the ship blocking the Suez Canal last week. It is a significant event in global trade—and an unexpected topic for an internet meme. There was another story in transportation last week that got much less coverage, and the two stories may converge in less meme-worthy but equally interesting ways. Last Sunday, Canadian Pacific railroad announced plans to acquire Kansas City Southern for $29 billion in what would be the first merger of Class I railroads since the 1990s.  According to some, the events are connected.  The rail merger would create the first North American railroad connecting Canada, the U.S., and Mexico as companies grapple with widespread disruptions of global supply chains, a new North American free-trade agreement, and cancellation of the Keystone XL pipeline.
The first transcontinental railway in the U.S. was established on May 10, 1869 with the Golden Spike Ceremony in Promontory, Utah. The industry expanded rapidly in the 19th and early 20th centuries to a peak of over 250,000 miles of rail by 1916. This peak coincided with the start of construction of the U.S. highway system that would eventually link roads, airports, ports, and other key transportation facilities in a way railways never could. Before the 1920s, highways were primitive and primarily served as road capillaries to rail arteries. In the years after World War II, railroads steadily lost their most lucrative business to trucks, which could offer more flexible, door-to-door service. By 1969, trucks hauled 21 percent of intercity freight in the U.S. and took 75 percent of intercity revenue. 
For most of the 20th century, the U.S. rail industry was regulated by the Interstate Commerce Commission (ICC). This changed in 1980 with the Staggers Rail Act, which allowed rail carriers to set prices more freely and manage their rail network. Before the Staggers Act, rail carriers could be forced to continue operating unprofitable routes if it was determined to be in the public interest. The Staggers Act allowed carriers to petition the ICC to abandon underperforming rail. Some of these abandoned lines were sold to smaller rail operators or converted to recreational paths by the Rails to Trails Conservancy. The ICC was dissolved in 1996, and the industry is now regulated by the U.S. Department of Transportation’s Surface Transportation Board (STB).
Despite the loss of high-value traffic to trucks, the U.S. still has one of the most efficient and cost-effective freight rail networks in the world. Railroads continue to move bulk commodities—coal, ore, grain, and timber—and now offer intermodal services that integrate highway and oceangoing transportation networks. Today, trucks move approximately 60 percent of total freight by weight in the U.S., while railroads move over 40 percent of long-distance freight (ton-miles) and one-third of the country’s exports. 
As with ocean shipping and the economics that led to the construction of the massive ship stuck in the Suez Canal, rail transportation is governed by economies of scale. It requires significant investments in infrastructure to own and operate a railroad company. By some estimates, it can cost as much as $1 million per mile to build a rail line, and $300,000 per mile per year to maintain. According to the Association of American Railroads (AAR), railroads invest $25 billion per year—$175,000 per mile of rail—on locomotives, boxcars, rail yards, and the thousands of miles of rail lines needed to provide railroad services. 
Today, there are over 140,000 miles of track in North America. No one carrier provides coast-to-coast service. Instead, there are eastern and western alliances of large (Class I) rail carriers—the so-called era of the “Big Four” with Norfolk Southern and CSX in the east, and Union Pacific and BNSF in the west. Following the Staggers Act, the industry consolidated into seven Class I freight railroads—defined by the STB as having 2019 revenue of at least $504 million—and hundreds of smaller regional (Class II) and local (Class III) carriers. Class II and III carriers operate feeder lines often abandoned by Class I carriers or specialize as switching and terminal railroads.
The seven Class I carriers in North America operate 92,000 miles of track across 46 states, Canada and Mexico. Canadian Pacific (CP) and Kansas City Southern (KCS) are the smallest Class I railroads. CP was incorporated in 1881 and by 1885 linked the eastern and western provinces of Canada with the transcontinental network it continues to operate today. In the U.S., CP’s network extends as far south as New York in the Northeast and Kansas City in the Midwest. CP shares a rail yard with KCS in Kansas City, Missouri, which serves as a key link between CP’s northern transcontinental network and the Gulf Coast and Mexico. 
KCS began operations in Kansas City in 1890. Today, the company’s rail network links Missouri with Gulf Coast states including Texas, Louisiana, Mississippi, and Alabama. It began cross-border service to Mexico in 2006 and serves as a key link between the two countries with service that extends south to Mexico City, Veracruz on the Gulf, and Lázaro Cárdenas on the Pacific.
The merger between CP and KCS would create a single Class I railroad—still smaller than the other five U.S. Class I carriers—with 20,000 miles of rail, 20,000 employees, and total revenues of approximately $8.7 billion. The merger, however, must first be approved by the Surface Transportation Board (STB), which is no easy task and could drag on for years. The STB imposed more stringent rules in 2001 to prevent over-consolidation and maintain competition in the industry. Since then, the only Class I deal that has been approved was Berkshire Hathaway’s acquisition of Burlington Northern Santa Fe (BNSF) for more than $35 billion in 2010. It’s also not the first time CP has tried to merge with a U.S. railroad. Previous deals with CSX Corp. and Norfolk Southern faced opposition from shippers and never made it to the STB. 
The deal with KCS announced last Sunday is expected to face fewer market and regulatory hurdles. KCS was exempt from the STB’s more strident 2001 rules because it’s the smallest of the major railroads and the combined CP-KCS railroad would still be the smallest Class I railroad. KCS also operates a north-to-south network, so there is less risk of displacing competitors’ east-to-west service. CP expects the STB’s review to be complete by mid-2022. If approved, the new company would be in a stronger position to compete for market share with the trucking industry and could change the calculus of companies contemplating moving parts of their supply chain to North America. 
By combining CP’s transcontinental network covering Canada and the U.S. Midwest with KCS’s north-to-south network linking Mexico, the merged company would be well-positioned to serve North American supply chains. KCS was a leading proponent of the new United States-Mexico-Canada Agreement (USMCA) and co-chaired the U.S.-Mexico CEO Dialogue.  Compared to Union Pacific and BNSF—U.S. railroads which also do a considerable amount of business in Mexico—a significant percentage of KCS’s operations and infrastructure are in Mexico. KCS’s network in the Gulf States and its northern connection to Kansas City also serve as a key link to Canadian oil.
Last Sunday’s announcement comes two months after U.S. President Joe Biden revoked a key permit for the Keystone XL pipeline. The existing Keystone pipeline travels east through Manitoba before crossing the border and traveling south to Texas. The XL pipeline would have provided a more direct route from Alberta to Kansas and the Gulf Coast, but the pipeline is a “deflated political football” and construction has been stopped.  Rail is poised to pick up some of the volume that would have moved through the XL pipeline. CP and KCS announced earlier this month they were working together on the construction of a new unit train that would transport heavy crude oil from Alberta's oil sands to the U.S. Gulf Coast. The new diluent recovery unit (DRU) train will move a form of crude oil designed for rail transport that’s more cost-competitive with pipelines. 
Moving oil by train, however, highlights a paradox with the rail merger on its environmental credentials. Trains are over three times more fuel-efficient than trucks. Freight moved on the least efficient trains emit less CO2 per tonne-kilometer than the most efficient diesel trucks on the road today.  CP and KCS highlight this fact in their comments about the merger.  However, the merger would also serve the oil market—something notably missing from the railroad’s announcement —and trains emit more greenhouse gases (GHG) and have more spills and accidents than pipelines. According to one economic study, the costs of air pollution and GHG emissions from trains are twice that of pipelines, and eight times as high for damages from spills and accidents. 
This does not mean the XL pipeline is better on environmental grounds. The combustion of oil—after it has been delivered by a train or pipeline—is one of the leading global sources of GHG emissions and there were other environmental and social concerns with the proposed pipeline. However, it does mean that framing the merger around its environmental benefits warrants closer inspection. If a stronger, more efficient rail network connecting Canada, the U.S., and Mexico can take market share from trucks there very well may be environmental benefits. If, on the other hand, the merger purely serves to make rail more cost-competitive for Alberta’s oil, the merger may find more pushback from regulators and other groups than anticipated—the XL pipeline is a good lesson. (Either way, it would be prudent to hold off on repainting locomotives for the time being. )
The real answer lies somewhere in between. While it may be a simple oversight—or strategy—to not highlight oil trains in the merger’s marketing materials, CP and KCS do serve grain, intermodal, automotive, and other markets in North America.  And as shippers come to grips with backlogs at ports, global container imbalances, and the Suez “walling” — instead of “grounding” the Ever Given technically impaled the wall of the canal  — a stronger, more efficient rail network uniting Canada, the U.S., and Mexico may be a compelling offer for post-pandemic supply chain strategy.
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 Brooke Sutherland at Bloomberg explores the connection between the rail merger and the Ever Given in last week’s Industrial Strength newsletter. https://www.bloomberg.com/opinion/articles/2021-03-26/suez-canal-ship-blockage-and-railroad-merger-linked-by-supply-chains
 Solomon, Brian (2007). Intermodal Railroading. St. Paul, MN: Voyageur Press.
 https://data.bts.gov/stories/s/Moving-Goods-in-the-United-States/bcyt-rqmu; https://www.aar.org/railroad-101/
 Sims R., R. Schaeffer, F. Creutzig, X. Cruz-Núñez, M. D’Agosto, D. Dimitriu, M.J. Figueroa Meza, L. Fulton, S. Kobayashi, O. Lah, A. McKinnon, P. Newman, M. Ouyang, J.J. Schauer, D. Sperling, and G. Tiwari, 2014: Transport. In: Climate Change 2014: Mitigation of Climate Change. Contribution of Working Group III to the Fifth Assessment Report of the Intergovernmental Panel on Climate Change [Edenhofer, O., R. Pichs-Madruga, Y. Sokona, E. Farahani, S. Kadner, K. Seyboth, A. Adler, I. Baum, S. Brunner, P. Eickemeier, B. Kriemann, J. Savolainen, S. Schlömer, C. von Stechow, T. Zwickel and J.C. Minx (eds.)]. Cambridge University Press, Cambridge, United Kingdom and New York, NY, USA. https://www.ipcc.ch/report/ar5/wg3/transport/
Supply chains are complex and dynamic. This past year delivered that message in container-ship-sized portions.To accelerate out of the pandemic and excel in the coming decade, we need better tools and processes than MRP systems developed in the 1960's.
With the climate crisis, coronavirus pandemic, trade tensions and the rising power of China... uncertainty may be the one certainty. Join us at #reConnect2021 for a fireside chat with Sam Kaplan, author of the new book "Challenging China: Smart Strategies for Dealing with China in the Xi Jinping Era," and moderator Kellen Betts. They will discuss challenges and opportunities in the international business environment, and what this shifting landscape means for global supply chains, trade and world economies.