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Over the past 20 years, the tailwind for North American railway companies has been strong. Most railway companies, like Union Pacific (NYSE:UNP), Burlington Northern and Santa Fe (owned by Berkshire Hathaway (NYSE:BRK.B)), CSX (NYSE:CSX), Norfolk Southern (NYSE:NSC), Canadian National (CNI), Canadian Pacific (CP), and Kansas City Southern (NYSE:KSU), performed well. Several critical factors were responsible for this positive environment.

1. Increase in global trade

This is by far the most important factor. From 1991 to 2011, imports increased from $600 billion to $2.7 trillion, and exports increased from $600 billion to more than $2.1 trillion in the United States, with similar patterns in Canada. The rise of China's economy contributed the most to the increase in trade. Since China became the world's "factory," North America has outsourced labor-intensive industry to China and other low-cost Asian countries. Imports from Asia have exploded. Most ships carrying goods from Asia came to the West Coast because of the short route and limitations of the Panama Canal. West Coast ports are congested and labor costs high. To move the goods from the West Coast to the East, companies mainly rely on railways. NAFTA (the North American Free Trade Agreement) also increased trade among the United States, Canada, and Mexico, and goods have to be moved from borders to inland.

2. The strong demand for commodities from China

China's demand for raw materials has increased dramatically over the past 20 years, and both Canada and the United States have increased their exports of commodities to China. Most of them are coal, grain, fertilizers, base metals, and lumber, and rail is the most efficient way to move these materials from various locations to the West Coast.

3. High oil prices

The price of crude oil has increased from a low of $20/barrel in the 1990s to around $100/barrel currently. High oil prices have made the trucking industry less competitive against railways.

4. Prohibitive barrier to entry

The barrier to building new railways is prohibitive. Environment issues, native land claims, high labor costs, and lack of government funding make it virtually impossible to build new rails.

5. Shale oil transportation

The recent boom in shale oil production and lack of pipeline capacity has forced oil companies to use railways to transport crude oil from North Dakota, Wyoming, and other places to refineries in the Northeast and Gulf regions.

All the above factors have benefited railway companies greatly. However, change comes gradually, and some headwinds may emerge over the next few years. The following are events or trends that may slow down revenue growth for the railway industry:

1. Expansion of the Panama Canal

The expansion of the Panama Canal will have a great impact on the shipping industry. Widening the canal will allow even larger ships leaving Asia to sail directly to the East Coast without stopping in California or British Columbia. While it's too early to know how global trade routes will be affected by the Panama Canal expansion, scheduled for completion by 2014-2015, there is no question that more giant ships will go directly to the East Coast. Currently, 80% of the ships from Asia dock on the West Coast, and 20% go through either the Panama Canal or the Suez Canal to the East Coast. After completion of the Panama Canal expansion, it is possible that 35% of ships from Asia will go directly to the East Coast. This will lessen the need to transport goods from the West Coast to the East.

2. Slowdown of China's economy

China cannot sustain its growth close to 10% any longer. Rising labor costs and severe pollution will force China to slow its infrastructure investments, and the demand for raw materials has already cooled down. The volume for railways will not increase as rapidly as it has in the past 10 years. One bright spot is agriculture commodities (e.g., grains, fertilizers, etc.), which remain strong.

3. Waning of outsourcing

The relatively low energy prices in North America that results from shale gas and ever-increasing labor costs in China and Asia have made outsourcing less compelling. Indeed, we have seen some reverse outsourcing, with GE (NYSE:GE) and Apple (NASDAQ:AAPL) recently announcing that they will move part of their jobs back to the United States. These factors will slow down the growth of international trade.

4. Low price of natural gas

The low price of natural gas has made coal less competitive as an energy source. The volume of coal transports has decreased about 20% over the past year. In addition, interest in natural gas-powered trucks continues to grow. Freightliner has 520 natural gas trucks on order already this year, and it sold 720 units last year. These trucks may pose some competition for railway trains.

5. Buildup of pipelines

Pipelines are a more efficient and safer way to transport oil. Eventually, pipelines will be built to transport oil from both shale and oil sand.

All these trends are happening slowly. There is no immediate risk of a sudden drop of volume for railway companies, but the tailwind is diminishing and a headwind is emerging. Given the high multiples that railway companies are traded at, I would be very cautious in buying their stocks.

Source: The Favorable Environment For Railways Is Close To An End