Photo credit: Flickr/Roy Luck

Transporting crude oil by rail is an explosive risk, the magnitude of which few truly grasp. Sure, we see the warning signs that lighter crude oil like those produced in the Bakken Shale and Eagle Ford Shale are more flammable than conventional oil. But that risk only compounds the greater risk, which is the fact that the railroad industry isn't adequately equipped to handle the financial aftermath that grows each and every day.

To put it simply, the railroad industry doesn't have enough insurance to cover an explosive derailment in a highly populated area.

When tragedy strikes
We need to look no farther than the tragic train derailment in Canada last year. More than 40 people lost their lives after a train carrying Bakken Shale oil derailed, which caused an explosive chain reaction that destroyed the town. The cost of clean-up alone from that disaster is estimated to be at least $200 million. That's just scratching the surface as it doesn't include compensation for the deaths, injuries, or property damage.

One of the issues is the fact that the train's operator, Montreal, Maine & Atlantic, only carried $25 million in liability insurance, which was actually a typical number for a railroad of its size. It's no wonder why the company was forced to file for bankruptcy protection shortly after the disaster.

Wise move by Warren Buffett?
Overall, the railroad industry is woefully underinsured against a mass-casualty event. So, this begs the question, is Warren Buffett wise to own a railway subsidiary as part of the portfolio of Berkshire Hathaway? Or is Berkshire Hathaway one of the few companies that could survive a railway disaster?

Last quarter BNSF contributed $5.65 billion in revenue, or 12% of total operating revenue, and $989 million, or about 20% of net operating earnings. Clearly, it's a big enough piece of the Berkshire puzzle to matter. Most analysts pointed to the growth in earnings from the subsidiary as being a key to the company's success last quarter, with the growth in oil shipments having a noticeable impact on profits.

While Berkshire Hathaway doesn't detail the amount of disaster insurance that BNSF carries, few companies have the balance sheet strength of Berkshire Hathaway. As of its last quarterly report, Berkshire Hathaway had more than $4.7 billion in cash sitting on its balance sheet, just in its railroad, utilities, and energy segment. That's on top of the more than $35 billion in cash sitting in its insurance segment. It would have to take a disaster exceeding the Macando oil spill in the Gulf of Mexico to breach Berkshire's fortress like balance sheet.

Wholly inadequate
Unfortunately, the same can't be said for Berkshire Hathaway's other oil-carrying rivals such as Canadian railway companies Canadian National (NYSE:CNI) and Canadian Pacific (NYSE:CP). Both companies have warned that insurance is inadequate to cover a disaster. Canadian Pacific, for example, said, "[I]insurance should be recognized for what it is: an inadequate secondary layer of protection." That doesn't bode well for the company's investors should one of its trains carrying crude oil or any other toxic material ever spill in a highly populated area.

One of the issues is that the maximum insurance coverage available to a major railroad is typically between $1 billion and $1.5 billion. Norfolk Southern (NYSE:NSC), for example, is self-insured for the first $50 million in losses from a single incident. The company carries insurance coverage of up to a billion dollars after that, but it again self-insures against amounts over that limit. That still leaves it at risk for a catastrophic event.

Investor takeaway
The recent oil-by-rail accidents highlight the fact that railway companies face a real risk that the next disaster could have a disastrous effect on an operator's finances. We can debate into the night as to the odds of that disaster happening. But one thing isn't debatable and that's the fact that Warren Buffett's Berkshire Hathaway is one of the few companies with the financial resources and insurance know-how to survive a mass casualty train derailment. Buffett's wisdom and years of experience in the insurance industry positions BNSF above all its peers should disaster strike. 

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This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.