Rail Stocks Continue Multi-Year Rally, What Next?

For the past six or seven years, large rail stocks have been on a tear. With an abundance of catalysts in the industry, the stocks have rallied in nearly a straight line. However, the future of the industry is in question as these catalysts play out.

Since 2006, Union Pacific UNP shares have rallied a whopping 260.8 percent; Norfolk Southern NSC shares are up 71.3 percent; CSX CSX shares have rallied the most at +280.79 percent.

Not to mention Burlington-Northern Santa Fe was purchased by Warren Buffett's Berkshire Hathaway BRK BRK. What financial crisis?

There have been several catalysts in the market that have driven stock prices higher. Mainly, the rail companies have adopted new technologies over the past decade making operations much more efficient. Also, there has been lots of consolidation in the industry allowing the big rail companies to dominate the market.

Lastly, the shale oil boom has created a huge opportunity for rail companies to transport this newly found crude around the country.

Analyzing each of these catalysts shows that these reasons for out-sized growth have nearly played out. Efficiency of the businesses is near an all-time high and it is unlikely that efficiencies can come from new technologies.

However, one key catalyst that has yet to play out in technology is the adoption of natural gas as a fuel source: should the rail companies adopt natural gas at these depressed prices to power trains, it could lead to continued cost savings.

Also, the industry has already become fairly consolidated. No longer can the large rail companies see further consolidation benefits from economies of scale. The consolidation of the industry has allowed the big rail companies to benefit from lower overhead costs and thus have lower costs as a percentage of revenue.

Lastly, the rail companies have benefited from the massive boom in U.S. energy production. The IAEA expects the U.S. to become a net exporter of energy by 2020 and the rail companies will benefit because, as of the end of 2012, they transported nearly 75 percent of all shale energy extracted from the Baaken shale. Thus, they have a huge market share in the space.

However, new pipelines, such as the Keystone Pipeline, will continue to come on line and hurt market share. Nevertheless, the entire market is growing as the shale boom continues across the country and thus the rail stocks will have a smaller piece of a much larger pie.

Analysts surveyed by Bloomberg are bullish on all three companies, with buy/strong buy ratings on all three. Union Pacific analysts see approximately 4.8 percent upside from the current price over the next 52-weeks while analysts covering CSX Corp. see about 4 percent upside. Analysts on Norfolk Southern are slightly less bullish.

As the U.S. economy continues to grow and recover from the Great Recession, rail stocks could continue to move higher. However, they have been a nice run recently and could see some short-term weakness before continuing higher. After all, stocks don't normally move in straight lines.