(FORTUNE Magazine) – Since 8:30 in the morning, two 3,000 horsepower locomotives pulling 65 freight cars have been barreling west from Beaumont, Texas, through Houston on their way to Mexico. I'm on the train, riding comfortably and legitimately--unlike the time 25 years ago when I hopped a boxcar from Oregon to California with my dog Rufus and huddled with him all night to stay warm. Now, as always, bystanders view our passing freight train as a stirring sight. Guys in pickups stare. Kids wave. At one stop young cowboys and cowgirls en route to a rodeo in Houston ride their horses up an embankment to call out greetings to the crew. Pat McGuire, the engineer, climbs out of the cab to chat engagingly with them.

But inside the locomotive, Pat's concerned. Although our train has made good progress, we see signs of trouble as we near Houston. Half a dozen mile-long trains bearing the Union Pacific logo sit idle on an adjoining track--without an engineer or conductor in the locomotive. A crewless train on a siding, McGuire knows all too well, means serious congestion at UP's freight yards a few miles ahead. The crews had waited so long to get to the yard that they'd given up and gone home. A yellow signal light appears ahead, and McGuire slows down. A mile later, when a red light shows, he stops. And waits. And waits. And waits. For four hours. By the time he can move again, it's too late to pick up a half-dozen cars waiting for him at factories in Houston. The customers will be angry, but McGuire has no choice if he wants his train to make a timely arrival in Mexico. He throttles up and tells dispatchers to route him toward the border crossing at Laredo.

McGuire's Houston customers may be angry, but like so many others dependent on the Union Pacific, they aren't surprised. For nearly a year, freight train service west of the Mississippi River has been all but derailed by the merger of the Union Pacific and Southern Pacific railroads. Billions of dollars worth of freight shipments, supposed to arrive in three or four days, have been taking 30 days, 45 days. Sometimes they get lost. For months, UP has been losing dozens of tank cars belonging to Olin Corp. How does a railroad lose tank cars? Who knows? Robert Goodell, an Olin sales manager, describes them as being "in orbit somewhere around Houston."

For customers like Olin, there's nothing romantic about railroads. Although more than 75% of the $300 billion spent annually on freight shipments goes to the trucking business, railroads are still an absolute necessity for thousands of companies. Measured in ton-miles, trains carry 40% of all the freight moved in the country. When the trains don't run on time, there's trouble all down the line. As a result of Union Pacific's delays, electric utilities in the South have been low on coal. Oregon lumber mills have resorted to stacking finished products in employee parking lots. Rice bound for Midwest food processors has spoiled on rail sidings. Retailers canceled Christmas orders for an El Paso company's beauty products because UP's computers lost track of 48 freight containers sitting in a local switchyard. Perhaps most serious, petrochemical plants along the Gulf Coast have had to shut down or slow down because they've had no place to store billions of pounds of plastic resin.

A pair of University of North Texas economists estimate that UP-SP snafus have already cost U.S. companies $2 billion. The merger could hurt in other ways too. Now that UP has eliminated a competitor, many customers worry that it will jack up prices. Interesting case in point: A UP representative arrived at Olin's headquarters in Connecticut last month and had the gall to announce a rate increase. Maybe he thought the railroad had to charge more to keep those tank cars in orbit around Houston.

As with all mergers, the UP-SP combination was supposed to produce fabulous efficiencies. On a map (see page 100) it looked brilliant. Instead of taking a long, circular route through Wyoming, Union Pacific trains bound from Texas to Southern California could now short-cut through El Paso on Southern Pacific tracks. And on important routes where UP tracks run parallel to SP tracks a few miles away, the merged company could speed northbound trains on one set of rail and southbound trains on the other. The merger, which UP said would save $800 million a year, was finalized in September 1996.

Someday, maybe; but first it has to stop costing money. Operating problems ate up $353 million at UP last year and reduced earnings to $432 million, 35% less than in 1996. The company recently announced that it would slash its dividend in half. Its stock price has fallen to 50 3/4 a share, from 71 11/16 in July. UP lost $152 million last quarter, and the railroad is predicting another loss for the quarter that ends in March. There is no easy fix in sight. Last month, before a roomful of furious customers, Dick Davidson, a former brakeman who worked his way up to chairman after college, conceded that UP's problems with Southern Pacific are proving "much harder to fix than I ever imagined."

If anybody could have pulled off the biggest railroad merger in history, it should have been Union Pacific: wealthy and powerful, with the best managers, track, locomotives, and computers in the business. In part because of its heroic origins--UP laid the track from Omaha to Promontory, Utah, that completed the transcontinental railroad 129 years ago--Union Pacific was accustomed to operating on a grand scale. It wasted less time and money than most railroads schlepping a few cars at a time to and from factories. Instead it picked up big trains already assembled by East and West coast railroads and whisked them halfway across the country. If UP had to collect railcars in one region, it assembled them at a superefficient regional yard and created enormous trains that traveled long distances.

By comparison, poor Southern Pacific came from, well, the other side of the tracks. It was a weary, money-losing mess, long weakened by vigorous competition from truckers in its home state of California. It had few big, profitable trains like the ones UP ran bulging with coal from Wyoming strip mines. Since 1988 it had been owned by Philip Anschutz, a Denver oilman who sold off much of SP's California real estate but invested very little in new train equipment or facilities. By last year SP's all-important Englewood switching yard in Houston was in sorry shape, with sagging, misaligned track too short to handle most trains; a lack of locomotives; and an outmoded computer system.

Southern Pacific should have benefited enormously from a union with UP. Blame for why the merger went so badly has been laid on everything but plague and swarming locusts: Computer problems. Bizarre labor rules. Inept federal regulators. Weather. Mexico. An intimidating CEO with subordinates reluctant to deliver bad news. Surging grain traffic. A booming petrochemical industry. But mostly the problem was arrogance. Union Pacific refused to accept suggestions from Southern Pacific employees who knew how to run their ailing railroad with chewing gum and baling wire. When UP tried to impose its way of doing things on the very fragile Southern Pacific, service went haywire.

If you had to put a finger on the spot where the train wreck began, it was in Southern Pacific's Englewood switching yard. That, concedes Davidson, was ground zero. Typically, a small switch-engine locomotive delivers empty cars to a manufacturing plant and lugs full cars to a switching yard such as Englewood to be sorted according to destination. Big switching yards have 30 or more 8,000-foot-long tracks arrayed side by side and process 2,000 to 3,000 cars a day. (UP's main yard in Nebraska has 260 miles of track.) The switch engine pushes the train cars to the top of a small hill, or "hump," and as they roll down the other side, they are switched onto the track that holds cars bound for switching yards in St. Louis, Chicago, or Los Angeles. It is a complex and surprisingly delicate process. A minor problem anywhere in the system can trigger a cascade of trouble.

Despite its many shortcomings, one of SP's strengths was a corps of managers who knew how to compensate for Englewood's deficiencies. When the yard was about to overflow, they routed cars to yards hundreds of miles away. To relieve the strain on Englewood, they routinely sorted a few hundred cars a day in small satellite yards in Houston, sent 150 or so on to their destinations, and ordered the rest back to Englewood to be sorted again. Often, SP managers in Houston would assemble a half-dozen cars bound for, say, New Orleans in a satellite yard, then order a high-speed train to collect them. That might slow down the big train for a while, but it kept Englewood from getting too crowded. To make sure SP's aging computers had the right information, managers would actually drive out to a customer's factory before dawn to make sure his railcars were ready to be picked up.

All this "inefficiency" was anathema to Union Pacific managers. Early last year they ordered that more and more of SP's cars be sorted at Englewood instead of the satellite yards. They figured they could cope with the additional cars by sending in more locomotives to haul them away. That might have been fine, except that SP had a shortage of both locomotives and the crews needed to run them. Imperceptibly at first, then alarmingly, Englewood began to fill up. UP's other yards in Houston got crowded, too, because of the booming petrochemical business and growing NAFTA-related trade with Mexico.

One problem led to another. A hurricane washed out some of the CSX railroad's tracks near New Orleans, backing up trains eastbound from there. An old SP line east of Houston had to be shut down eight hours a day for repairs. Delays at the border clogged the lines leading to Mexico. After a series of derailments and fatal collisions on the UP in Texas brought traffic to a crawl, the freight yards in Houston became so crowded that no one could sort the cars toward their proper destination.

Nor was there room for trains coming into Houston. They were told to pull into sidings along the nine UP lines heading into the city. When those sidings filled up, trains had to stop on the main lines. But since a single track usually serves trains running in both directions--and because the sidings normally used to pass were hopelessly full--no trains could get in or out of town. Soon, miles and miles of railcars were backed up all over Texas.

That was bad enough, but the situation got worse when federal safety rules kicked in. Trainmen are allowed to work only 12 hours per shift and must pull over and stop if they can't reach their destination on time. Typically a minibus ferries out a new crew and brings the old crew to a rest stop. But last summer there weren't enough replacements to relieve all the crews caught in traffic when their shifts were over. Eventually some of the guys who were stuck walked away from their trains to the nearest bed. That, of course, didn't do much to ease congestion. In Victoria, Texas, 125 miles southwest of Houston, so many trains were stalled in town that ambulances couldn't get patients to the hospital.

At first Union Pacific denied the severity of the problem. "For a long time UP kept claiming things were getting better," says a manager at a large chemical company. "They accused customers of lying. They were arrogant. When we tried to make suggestions, they said, 'Leave us alone.' "

One former UP executive blames the company's problems on CEO Davidson. "Dick knows the railroad as well or better than anyone," says this executive. "He eats, sleeps, and breathes railroads. But he is a very proud, intimidating guy. He doesn't want to hear bad news. He has stifled what he needs to know." Davidson, 56, the son of a Kansas earthmoving contractor who died when Davidson was 6, appears surprised by the accusations. "I consider myself pretty humble," he says. But he concedes that UP was slow to see how bad things were getting. "Our response was probably inadequate. With 20/20 hindsight, if we'd thrown in more resources in late July, we would have had a much faster resolution."

Not necessarily. Because last fall, when UP finally ordered locomotives from as far away as Oregon and California to go to Texas, they got stuck too. Their crews ran out of time and couldn't be replaced. It wasn't long before the problems in Houston replicated themselves on a smaller scale almost everywhere. At its worst, the company admitted, "we had westbound trains lined up all the way to Phoenix and Tucson waiting to get into Southern California."

Normally a healthy company acquiring a sick one can call on its own workers, managers, and equipment to help out. But the bizarre and ancient work rules of the unionized railroad industry make that nearly impossible. Just because UP now owned the old SP line from Dallas to Amarillo didn't mean it could send UP crews there to relieve congestion. To SP crews, that was still SP territory, with complex rules governing which engineer could drive what train. Even if a line had been part of some now obscure railroad that SP had acquired decades ago, union rules sometimes dictated that only former employees of that tiny line could work on it.

UP's woes in Texas reached far and wide, but no business was hurt more than plastics makers, who have more than half their 60 billion pounds per year of production capacity located along the Gulf Coast. Unlike their cousins the petrochemical makers, who can ship by barge or pipeline, plastics makers are unusually dependent on railroads. Their fragile pellets of polyethylene, polypropylene, and other little polys can't easily be loaded onto barges, and thus must travel by rail or truck. Trucks cost four times as much as trains, per ton-mile, however, and can double the delivered cost of plastic resin.

Plastics makers are quirky in another way: Instead of storing finished resins on their own property, they use railroad cars for long-term storage. They do this so that when an order comes in for 200,000 pounds of light yellow thermoplastic polystyrene, the stuff is all ready to go. A big plastics maker may own $500 million worth of railroad hopper cars. After being filled at the factory, the cars go by locomotive to special storage yards owned by the railroads, where they sit, sometimes for months, until an order comes in. At that point a locomotive pulls the cars to a yard like Englewood, where they can be sorted and sent on their way.

Except that, beginning about a year ago, those plastics barely went anywhere--or if they did, took forever to get there. Harry Ignatowski, transportation manager for Dow Chemical, one of UP's biggest chemicals customers, says the railroad's on-time performance declined from the usual 80% in early 1997 to around 20% last fall. Things weren't much better last month, when only 27% of Dow's cars on the UP arrived on time.

About the only thing as disruptive as full cars that arrive late to customers is empty cars that arrive late back at the factory. Because the resin plants use the railcars as storage facilities, the plants must close when the empties don't show. Ignatowski says Dow or its customers have had to shut down plants dozens of times as a result of the rail crisis. "It's killing us," he says.

It is a virtual certainty that Union Pacific will solve its operating problems--probably within the year. The same pride and arrogance that got it into trouble will eventually get it out. The company has ordered half a billion dollars' worth of new locomotives and is hiring 2,000 new trainmen to run them. UP plans to overhaul SP's Englewood yard in Houston and connect it to UP's giant Settegast yard nearby. And when UP begins to operate northbound trains on one track and southbound trains on another, it will cut travel time (not to mention accidents) between some major cities by 20% or more.

In the long run, though, customers are still worried, not about whether the trains will run on time, but about what the railroad will charge them. Union Pacific's merger with Southern Pacific is just the latest in a series of railroad combinations that may leave only four major U.S. railroads by the end of the year. Two and a half years ago, the Burlington Northern bought the Santa Fe, creating, at the time, the largest railroad, with 35,000 miles of track. The UP/SP combination, with 36,000 miles, surpassed that. Now, in the Eastern U.S., Norfolk Southern and CSX are getting ready to divide and devour Conrail, itself an amalgamation of formerly bankrupt Northeast railroads. No remaining rail companies are a fifth the size of those four.

To their credit, the railroads have cut prices sharply in the past 20 years. Much of that is due to deregulation, which, beginning in 1980, allowed railroads to abandon government-set rates and enter into elaborate long-term contracts with shippers. Deregulation also enabled railroads to abandon unprofitable track or sell it off to non-unionized short lines. And as railroads merge, they can eliminate managers and reduce oversized train crews. Since World War II, the number of railroad employees has dropped from 1.5 million to 200,000.

Of course, fewer railroads means fewer competitors. More and more factories, mines, and warehouses that once had two railroads serving them now find they are "captive shippers," with only one link. Several plastics executives said captive shippers can expect to pay 15% to 40% more for rail freight than those with alternatives. "Sometimes we have to pay $5,000 to get a railcar from Texas to California," says Patrick Jack, senior vice president for chemicals at Fina, a Belgian petroleum company with plants in Texas. "Then we have to pay a second railroad another $5,000 to take it the last ten miles to the customer." Numerous shippers interviewed for this story declined to criticize UP publicly, for fear the railroad would punish them with higher rates in the future. Some are even reluctant to sue the railroad for damages caused by the recent chaos, figuring that UP would simply get back any awards by increasing prices.

Art Peters, a senior vice president at Union Pacific, concedes that railroads set prices based partly on what alternatives their customers have. If they charged everyone the same rate, he says, many shippers with alternatives would abandon rail altogether, and remaining customers would have to pick up a bigger share of costs. Peters notes that any railroad has to be careful about charging too much. "It's certainly not in our interest to drive a customer out of business," he says.

There's not much chance Washington will put the brakes on rail mergers or prices increases. The railroads are protected in almost everything they do by an obscure but powerful federal agency called the Surface Transportation Board--a remnant of the old Interstate Commerce Commission that was dismantled in 1995. If the STB approves a merger or ignores a rate increase, no state or federal agency, not even the Justice Department or the Federal Trade Commission, can interfere.

The STB has always been a friend of the railroad industry. Hundreds of shippers, and even the Justice Department, objected to the UP-SP merger as anticompetitive, but the STB approved it with only minor changes. Frank Wilner, former chief of staff for one of the STB commissioners, says it is woefully ill-equipped to dissect a proposed merger. "The board is top-heavy with lawyers," says Wilner, who spent 22 years at the Association of American Railroads, a Washington lobbying group, before joining the STB. "There isn't a single person there with operating experience."

The National Industrial Transportation League, an organization of shippers, is lobbying the STB again, hoping the board will order a spinoff of some UP lines to competitors. So far, the STB has refused, saying a spinoff would just create new operational problems. Retorts the STB chairwoman, Linda J. Morgan: "Government is not in the business of running the railroads, and so our job in addressing mergers is not to micromanage every detail of how the railroads should integrate their stystems."

The STB may have an uncertain future. Legislation reauthorizing its existence will come before Congress later this year. Companies angered by the STB's approval of the UP-SP merger say they will oppose its reauthorization. "We will be vocal that the Department of Justice should have a say in railroad operations," says one chemical company executive.

Going back to the old hyper-regulation of railroads--when bureaucrats dictated the shipping price of every vegetable--is hardly the answer. The railroad industry's inability to adjust prices during the rapid inflation of the 1970s caused a quarter of them to go bankrupt. But many of the nation's existing antitrust laws sprang from problems with the railroads a century ago, so it is ironic--and unfair--that so powerful an industry doesn't come under the same kind of scrutiny as everyone else, from Microsoft to American Airlines.

Yes, railroad regulation seems like a quaint subject, and as you watch the freight trains thunder by, it's easy to write off the industry as an anachronism. But as the chaos created by the Union Pacific merger demonstrates, railroads are too important to be left in the hands of an out-of-touch regulatory system.