(The following story by Christopher Dinsmore appeared on The Virginian-Pilot website on June 1.)
NORFOLK, Va. — Talk about lousy gas mileage.
This vehicle burns an average of 2.62 gallons per mile. It’s not the latest giant SUV, but a vehicle with even more utility — a railroad locomotive.
When it comes to fuel consumption, few companies in Hampton Roads come close to Norfolk Southern Corp. The Norfolk-based railroad burns about 40 million gallons of diesel a month to operate trains along its 21,500-mile eastern rail system.
But even as fuel prices have soared, Norfolk Southern’s cost of fuel has remained relatively stable. In 2004’s first quarter, the railroad paid 83 cents per gallon, not including taxes and delivery charges, down from 86 cents in 2003’s first quarter.
Huh?
It’s true. The railroad actually paid less in the first quarter even as the market price averaged $1.01 a gallon. In 2001, as diesel fuel prices started to fluctuate more and more, Norfolk Southern abandoned its longtime practice of buying fuel on the market. Instead, it began buying in advance through a financial technique called hedging to lock in prices for much of its diesel fuel.
In the process, it has saved tens of millions of dollars in the past year. If Norfolk Southern used its monthly average, it saved about $22 million through hedging in the first quarter, when it earned $158 million.
“The market’s gone up and we look like we’re smart …,” said Henry C. Wolf, Norfolk Southern’s vice chairman and chief financial officer. “But we happened to make a decision that we wanted to reduce our exposure to the volatility of fuel prices.”
In the early 1990s, diesel fuel costs were very stable. With the exception of a spike related to the first Persian Gulf War, prices stayed between 55 cents and 65 cents a gallon, excluding taxes and delivery costs.
Prices did blip up over 75 cents in late 1996, but promptly started falling again to as low as 35 cents by the end of 1998. But in the first quarter of 1999, diesel prices began rising and didn’t stop until they hit $1.06 per gallon in early 2001.
“In two years, the price of our fuel literally tripled,” Wolf said.
As fuel prices became more volatile during the past decade, Norfolk Southern itself became more risk averse.
In the early 1990s, the company had a little debt, but that changed in 1999 when it split Conrail and its northeastern rail network with longtime rival CSX Corp. In the process, Norfolk Southern took on billions in debt.
Coupled with the debt load, fluctuations in fuel prices represented a big risk to Norfolk Southern’s earnings potential.
“Wide swings in fuel prices have a significant effect on the bottom line,” Wolf said. “For every 10 cents of fuel increase or decrease, it literally shifted our expenses by a full percentage point.”
According to an analysis by the brokerage Legg Mason, a penny increase in the cost of fuel boosts Norfolk Southern’s annual expenses by $5 million.
Wolf began examining hedging as an option to reduce the volatility of fuel prices. He drew up a policy and the railroad’s management brought it to the board of directors for approval.
The policy called for Norfolk Southern to phase in a fuel hedging program over the next 24 months whereby 80 percent of its next month’s projected consumption would be hedged. With the board’s approval, the railroad began implementing the plan in May 2001.
Once a month, Norfolk Southern requests bids from three or four financial institutions for what’s known as a swap.
The institutions submit their bids based on what they think the cost of diesel will be in each of the next 24 months. Norfolk Southern then buys the swaps from the low bidder.
A swap is essentially an agreement on a price for diesel at certain time in the future. If the price is higher than the agreed-upon price at that time, the institution pays Norfolk Southern the difference. If it’s lower, Norfolk Southern pays the institution.
Norfolk Southern is not the only major railroad that hedges its fuel costs. It has been a longtime practice at Union Pacific. Burlington Northern Santa Fe saved 17 cents per gallon in the first quarter by hedging fuel, said Patrick Hiatte, a spokesman for the Fort Worth, Texas-based railroad. CSX recently resumed hedging and is benchmarking its program against Norfolk Southern’s, said Misty Skipper, a spokeswoman for the Jacksonville, Fla.-based rail holding company.
Trading in such derivatives has drawn a lot of attention in the past few years because it exposes the buyers and sellers to potentially significant costs down the road. In short, it’s very risky.
“People who are buying and selling derivatives, or trading, are trying to beat the market,” Wolf said. “It’s like going to Las Vegas. That’s not what our program does. It’s about trying to reduce the volatility of fuel prices.”
In other words, Norfolk Southern is only buying the swaps for a commodity that it uses. The effect is more fuel price stability.
“If prices fell sharply, they wouldn’t impact us immediately, but be phased in over time; but if prices rose sharply, they also wouldn’t impact us immediately, but rise slowly,” Wolf said. “Initially our swaps were costing us money.”
After peaking in 2001, diesel fuel prices fell back under 65 cents per gallon by early 2002.
But the dip was short-lived. In the run-up to the second Iraq war, prices rose again and they remain high.
“The savings last year were very substantial,” Wolf said.
Right now, the market price for diesel is as high as $1.15 per gallon, excluding taxes and delivery. Norfolk Southern’s cost will likely rise some from the 83 cents a gallon it paid in the first quarter, but it will be nowhere near the actual cost.
With prices even higher now than last year, the savings should be even greater.
“Mmm-hmmm,” Wolf agreed.