Warren Buffett is lauded as one of the greatest investors of all time, if not the greatest. He’s the second-richest person in the world, and known as the “Oracle of Omaha” for his seemingly prescient investments. For example, in the wake of the collapse of Bear Stearns and during the height of the market panic that followed it, Buffett stepped in and negotiated a deal with Goldman Sachs. He acquired $5 billion worth of preferred shares, which pay a 10% dividend, as well as warrants with the rights to sell those shares in the next 5 years.  As of September this year, those warrants were “in the money” to the tune of $3.1 billion, and that doesn’t include the $500 million in premium payments that Goldman pays every year. Those lucrative terms (punitive for Goldman Sachs) left others wondering why the Treasury Department could only negotiate a 5% dividend, but that only added to the mystique and legend of Warren Buffett. At the time, Buffett was quoted as saying “If I didn’t think the government was going to act, I would not be doing anything this week,” referring to the massive bailout bill which was indeed enacted by the government.

It’s deals like that that enabled Buffett to become one of the richest people in the world. But it’s also that background that has some on Wall Street scratching their heads at the news that he was purchasing Burlington Northern railroad. The Wall Street Journal discussed how the acquisition seemingly broke two of Buffett’s cardinal rules on investments: 1) buy undervalued stocks or companies, for obvious reasons and 2) don’t split your own stocks, as it dilutes the equity of the existing shareholders. Bloomberg quoted a hedge fund principal as saying, “It could be five years before the logic of [Buffett’s purchase of] Burlington Northern becomes clear.” Even Buffett admits that the purchase was “not cheap” and that it represents an “all-in wager”on the future of the American economy. And there can be no doubt that it is a significant investment– he’s liquidating other rail investments totaling $691.3 million while the Burlington Northern purchase will cost some $26 billion– an increase in his railroad holdings of some 3,600%.  And this bears repeating, he’s splitting stock to get it done.  This is the first time ever that Berkshire Hathaway (Buffett’s investment company) has split shares.  He’s so reluctant to split shares, the class A shares regularly trade over $100,000 per share, an unheard-of valuation.

So knowing all that, why would Buffett apparently overpay for the railroad?  The answer is the same as it always has been– he’s not overpaying at all. Some other big news from last week provides the key: remaining oil supplies appear to be overstated.   Buffett’s purchase makes perfect sense if we assume that peak oil theory is true. First, it represents a bet that coal will become more important in the near future. Marketwatch reports:

Unlike petroleum, the United States sits on some of the world’s biggest proven coal reserves, with a powerful lobbying group in Washington making sure it stays relevant despite some nasty emissions issues. For a traditionalist like Buffett, coal is still king.

Or say, if oil were to become suddenly a great deal more expensive, coal would become increasingly important, environment be damned. That would make him less of a traditionalist, and more of a visionary. And he has been diversifying in the last few years into other power generators and utilities. Analyst and investor Whitney Tilson said of Buffett, “he has demonstrated over 40 years an uncanny ability to identify value long before others.” Tilson wrote that praise in 2000, speaking about Berkshire Hathaway’s acquisition of a majority stake in Mid-American Energy, a energy and utility conglomerate. Mid-American energy has recently received regulatory approval to add wind farms in Iowa totaling 1,001 megawatts of generating capacity, an increase which the company claims makes them the industry leaders in wind-power generation capability. Mid-American last year announced the acquisition of troubled Constellation Energy, which adds nuclear energy to the Buffett portfolio. Bloomberg reported at the time (emphasis mine):

U.S. nuclear plants like the three owned by Constellation have become more profitable in the past year as power prices rise and costs of competing generation fuels increase.

“Warren was looking to buy nuclear plants at dirt-cheap prices and now he has them,” Phelps said. “They deliver positive cash flow from the first moment you own them.”

Secondly, not only does the purchase reflect the potential importance of coal, it also makes sense from a transportation and logistics standpoint. Burlington Northern’s website indicates that one of their trains can transport more freight than 280 over-the-road trucks, while being three times more fuel-efficient than those trucks. They also boast that they train all their employees to “think fuel” (as a part of their “every drop counts” initiative), that they are in the process of testing locomotives powered by liquified natural gas, and that they are “an industry leader in the use of alternative power sources, including wind-powered generators and solar-powered switches.” If diesel fuel were to cost $10 per gallon (only to go up from there), railroads will look increasingly like the best way to move freight around the country, and Burlington Northern looks especially good due to the inroads being made into weaning themselves off of oil.

So in looking at Buffett’s strategy over the last decade or so, the latest acquisition is not as far out of line as some others have been implying. Rather, it’s the continuation of a series of purchases which will leave Berkshire Hathaway well placed to profit from a coming transition away from oil as a primary fuel source. And know this, Warren Buffett does not overpay. Ever. So when he breaks two of his own sacrosanct cardinal rules to get a deal done, and classifies it as an “all-in” bet, it’s a very big bet indeed.

I think Michael Hampton summed up the situation nicely last week:

That is the real bet that Warren Buffet has made. He has bet against the Soccer Moms. The suburban car users had better see that they and their families are losing the bet on cheap oil. The sooner they begin to examine their lives, where they live, and how dependent they are on a scarce global resource, and begin to make the dramatic adjustments that are needed, the greater the chance they and their children will survive the inevitable changes that Warren Buffett has so clearly signaled by his largest ever investment.