The North American railroad business is in a state of transition. That’s because its long-time economic mainstay—coal—is declining in use as power utilities switch to cheaper natural gas.

Speeding that changeover along are tighter environmental regulations, which are placing strict limits on carbon emissions from power plants. At the same time, economic weakness in Europe and elsewhere is weighing on demand for metallurgical coal, which is used in steelmaking.

According to a recent outlook on railroad stocks from Zacks.com, railways currently account for two-thirds of U.S. coal shipments. Meanwhile, only one-third of power plants relied on coal in 2012, down from about 50% in 2008.

Unparalleled Efficiency Gives Railroad Stocks an Edge

In the past, such declines would have spelled big trouble for railroad stocks. However, the best railroad stocks are more nimble and diversified than ever before. They’re also taking advantage of a number of favorable trends that should support their growth for years to come.

Intermodal shipments (containers that can be loaded onto ships, trucks or trains), for example, continue to rise due to the cost effectiveness of shipping goods by train. As the Zacks report points out, railroads are estimated to be around 300% more fuel efficient than trucks. That’s helping railroad companies pull more freight off the roads and onto trains. Intermodal now accounts for 20% of all railroad revenue, second only to coal.

A continued economic recovery should keep boosting demand for intermodal shipments. “In the long term, we see the total addressable opportunity to convert highway freight to rail in the eastern U.S. at more than 9 million loads per year,” said CSX Corp. (NYSE: CSX) chief executive Michael Ward in Railway Age’s 2013 freight rail outlook.

As Benjamin Shepherd pointed out in the October 5 issue of our Personal Finance newsletter, Norfolk Southern Corp. (NYSE: NSC) is one of the railway stocks that has made a significant effort to attract more intermodal traffic:

“One of [Norfolk Southern’s] most interesting projects,” wrote Shepherd, “was a recent upgrade to its Heart­land Corridor, a 379-mile stretch of track running from seaports in Vir­ginia to Chicago, to accommodate double-stacked intermodal freight trains. Hauling two intermodal con­tainers on a single car not only lowers costs for shippers, it also adds nearly a third to the revenues generated by each train.”

CN and CP: Two Railroad Stocks That Are Tapping Into the Canadian Oil Sands

The Department of Transportation sees demand for railroad freight shipping rising 88% by 2035. A big part of that gain will likely come from oil and gas as production continues to rise in the U.S. and Canada, both of which are currently dealing with a shortage of pipeline capacity.

TransCanada Corp. (NYSE: TRP) aims to alleviate this problem with its Keystone XL pipeline, which would pump oil from the Canadian oil sands to refineries on the U.S. Gulf Coast, but the Obama administration blocked Keystone in 2012 because the projected route passed through the Ogallala aquifer in Nebraska. The company has since submitted a revised route, and a decision is expected early this year. Meanwhile, Enbridge’s (NYSE: ENB) Northern Gateway pipeline, which would carry oil from the oil sands to the Canadian west coast, has encountered similar resistance from Native groups and environmentalists.

To deal with the lack of pipeline capacity, many producers are turning to railways. And railroad operators are rapidly boosting capacity in response: in November, Canadian National Railway (NYSE: CNR) projected that it would ship 30,000 carloads of crude in 2012, up from zero in 2011. Through the first nine months, petroleum and chemicals supplied 16% of Canadian National’s $7.4 billion (Canadian) of revenue.

Meanwhile, rival Canadian Pacific Railway (NYSE: CP) is predicting that its crude volumes could rise to 70,000 carloads by 2014, up from just 500 in 2009.

Shale Production Takes to the Rails

Both Canadian giants are also benefiting from rising production from shale rock in the U.S., mainly by hauling in sand and equipment for hydraulic fracturing and taking out the oil and gas. Canadian Pacific has been particularly aggressive on this front. Last summer, it inked two shale-related agreements: one was a deal with Smart Sand to ship drilling sand to unconventional oil and gas operations, including those in the Bakken region and the Marcellus shale. The other was an agreement with Silica Holdings to be the exclusive shipper for that company’s new sand-processing facility in Wisconsin.

Canadian National, for its part, recently signed a deal with Tundra Energy Marketing Ltd. to build a facility near Cromer, Manitoba, to load 30,000 barrels per day—or about 50 cars’ worth—onto trains. The facility, which will start up in the second quarter of 2013, will serve producers on the part of the Bakken shale that extends into Canada.

Of course, the risk here is that this new business will disappear once the pipelines start up. That concern is being fueled by railways’ higher costs compared to pipelines that are already built—about $5 to $10 more per barrel, according to a recent article in Canada’s Globe and Mail newspaper.

Working in the railways’ favor is the fact that the heavy bitumen from the oil sands must be thinned with diluent to be shipped by pipeline—a step that’s not necessary for rail shipments. Railways also allow for greater scalability to meet fluctuating demand and offer the ability to ship to places where no pipelines exist—or are planned.

Both Canadian National and Canadian Pacific stand to gain from a continued rise in demand for petroleum shipments by rail. Norfolk Southern’s recent track upgrades will also help it benefit from this trend, as well as rising intermodal shipments.

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