2013 was a strong year for railroad stocks: the iShares Transportation ETF (NYSE: IYT), about the closest you can get to a gauge for the industry (roughly 30% of the fund’s portfolio is devoted to railway operators) gained 39% during the year.

That’s miles ahead of the Dow Jones Industrials (up 26%) and the S&P 500 (up 29%).

Railroad Stocks in a Downhill Pull

Railroads currently carry the largest portion of the nation’s freight—about 43%—ahead of trucks, at 31%. According to a recent report from RBC Capital Markets, the industry has another year of full railcars ahead.

RBC’s 2014 Railroad Shipper Survey queried 53 customers of the six North American Class 1 railroads (or those with operating revenues of $433.2 million or more) to gauge their expectations for the year ahead. The picture that emerged is one of an industry enjoying a period of sustained growth.

The investment bank found that a strong majority of respondents (71%) expect rail-shipping rates to rise in 2014, though the largest group (42%) expect moderate increases of between 1% and 3%. Notably, just 28% expect rates to rise 4% or more, down sharply from 65% two years ago, but very few (3%) expected rates to fall.

Overall, most customers expect to ship the same amount as last year or slightly more—68% expect a 1% to 5% rise in volumes. That’s about the same as last year, but crucially, RBC found that 26% expected shipments to rise 5% or more, up from 15% in 2013.

“A distinct element of our conversations with respondents this year is that economic concerns did not permeate discussions on volume expectations for 2014. Accordingly, we believe shippers have greater conviction in their near-term volume forecasts compared to prior years,” wrote RBC’s analysts. 

Oil Trains Keep Getting Longer …

One area primed for continued growth is shipments of crude oil by rail, as producers grapple with a shortage of pipelines in Canada’s oil sands and U.S. shale regions.

According to a recent estimate from the Railway Association of Canada, about 140,000 carloads of oil sands crude and bitumen were shipped by train in 2013, up from just 500 in 2009.

In the U.S., shipments will likely total around 400,000 carloads in 2013. Railways are also benefiting by hauling in supplies, such as sand for hydraulic fracturing, as shale production rises.

By the end of 2014, about 2 million barrels of crude per day will be riding the rails around North America, according to pipeline operator TransCanada Corp. (NYSE: TRP). That will continue to help railways offset declining shipments of coal, a long-time mainstay.

Shipping oil by rail costs about $5 to $10 more per barrel compared to pipelines that are already built, but the oil trains are helped by the spread between crude prices. If that spread narrows too much, rail becomes less viable compared to pipelines.

Right now, for example, the differential between international Brent crude and West Texas Intermediate (WTI) stands at around $12, while Western Canada Select is sitting at a roughly $21 discount to WTI.

However, the safety of shipping oil by rail has been called into question in the wake of the July 6 tragedy at Lac-Mégantic, Quebec, in which an oil train operated by the Montreal, Maine and Atlantic Railway rolled away after it was left unattended for the night. It then sped downhill, derailed and exploded in Lac-Mégantic, killing 47 people.

Governments on both sides of the border are now re-examining safety regulations. In Canada, new rules have already been introduced with regard to parked trains and the labeling of volatile cargo. Additional changes would further increase the cost of shipping crude.

… But Intermodal Is an Underappreciated Growth Area

According to the 2013 U.S. Freight Transportation Forecast, prepared by the American Trucking Association, intermodal shipping—or moving freight in containers that can be loaded onto ships, trucks and trains—will continue to be the fastest-growing freight mode, increasing by an average of 5.1% a year until 2018. Intermodal is about 300% more fuel efficient than shipping by truck, according to a January 2013 report from Zacks.com.

As we wrote in a December 18 Investing Daily article, one way to play intermodal’s growth is through trucking stocks: J.B. Hunt Transport Services (NasdaqGS: JBHT) was one of the first to enter the intermodal game and has developed considerable expertise. In 2012, intermodal freight supplied 61% of J.B. Hunt’s revenue.

Railroad stocks are the other angle: Norfolk Southern (NYSE: NSC), for example, has been focusing on boosting its intermodal traffic. In 2012, it generated $2.24 billion, or about 20% of its revenue, by shipping the versatile containers, up 5% from 2011.

It’s a similar story at Canadian National Railway (NYSE: CNI), the largest operator north of the border, where intermodal revenue totaled C$1.99 billion in 2012, up 11% from 2011 and accounting for 22% of the total.

Union Pacific: All Aboard!

One railway with exposure to both rising intermodal and crude shipments is Union Pacific (NYSE: UNP), a stock we cover in our Personal Finance newsletter.

The company is America’s largest freight railroad, with a track network spanning 32,000 route miles across 23 states. Its revenue is well diversified across six different categories of freight: intermodal (20.1% of 2012 revenue), coal (19.9%), industrial (17.7%), agricultural (16.7%), chemicals, including oil (16.4%) and automotive (9.2%).

Revenue from each of the above sectors can fluctuate greatly due to their cyclical nature. To help mitigate some of this risk, Union Pacific tries to lock in long-term freight contracts.

Focus on Costs Keeps Earnings Rising

A key metric of a railroad’s health is its operating ratio, which measures operating costs against revenue. In the third quarter, Union Pacific once again showed that it’s among the most efficient railroads in the U.S., posting a best-ever quarterly operating ratio of 64.8%, down 1.8 points from a year ago and 0.9 from the record it set in the second quarter.

In the third quarter, Union Pacific’s earnings rose 10% from a year earlier, to $1.15 billion, or $2.48 a share. Revenue gained 4%, to $5.57 billion. That fell just short of the consensus forecast of $5.58 billion, but earnings beat the Street’s expectation by a penny. Union Pacific saw higher revenues across all its segments except intermodal, which was flat.

The stock gained 32% in 2013. It also pays a $3.16 dividend (1.9% yield). It trades at 15.4 times its forecast 2014 earnings, which puts it roughly in the middle of the railway pack: Canadian National, for example, boasts a forward p/e ratio of 16.1, while Norfolk Southern stands at 14.4.