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It's hard to believe it, what with the large plunge in the aftermath of Obama's re-election, but there are reasons to believe the worst is behind for coal in the present cycle. Sure, over time added regulations might lead to a slow erosion of coal's market share, mainly due to less new coal-fired generation coming online, but with coal reestablishing its place as the cheapest fossil fuel for electricity production, there's little reason to think coal will go away.

Why is the worst behind?

Coal in the US is used overwhelmingly to produce electricity. For this purpose, coal's main competitor is natural gas (NYSEARCA:UNG). Natural gas-fired generators generally have several advantages over coal-fired power plants. Natural gas makes for cleaner power production, it is cheaper in terms of the necessary investment, and natural gas-fired generators are more flexible, able to ramp up production faster than coal-fired power plants, which is particularly important when the grid is relying more and more in intermittent generators, such as wind energy.

This host of natural gas advantages is usually compensated in coal's side by a single factor: cost. Yet, with the shale boom natural gas saw such an increase of supply versus rather stagnated demand, that natural gas prices collapsed, and in doing so natural gas actually became competitive with coal in the single place where coal usually won. This led to massive "dispatch switching", in which natural gas-fired generators got scheduled to produce ahead of coal-fired power plants for the simple reason that it was cheaper to do so. All throughout 2012 this happened, leading to a substantial drop in coal demand and pricing, and at the same time an increase in natural gas demand, which managed to compensate the excessive natural gas supply.

With so much natural gas being burned to produce electricity, demand for natural gas finally kept pace with its supply. The end result was that natural gas stopped crashing. Indeed, natural gas has bottomed several months ago, back in April. Ever since, natural gas has been slowly working its way up, and recently even got past the levels ($2.70 - $3.00) where one starts observing a switch towards coal. However, natural gas remains below the levels ($4.00-$4.50) where one usually sees increased drilling for it, so rigs exploring for natural gas continue to be on a downward trend. Since natural gas wells deplete rapidly, this decreased drilling will over time lead to decreased natural gas production even with the increased efficiencies brought about by horizontal drilling, fracking and re-fracking.

What this means is that even if there can be hills and valleys in natural gas, the trend is now mostly up for natural gas prices. And as a consequence, it's also mostly up for coal prices as well.

As an added benefit, since 2012 saw so much dispatch switching, 2013 will compare favorably in terms of coal volumes. So the coal companies have both a volume and pricing increase to look forward to. It's entirely possible that these increases won't make these companies incredibly attractive; however the market usually overreacts to any improvement in a cyclical sector whose shares have been deeply punished, with the homebuilders being a prime example of this.

In this context of fundamental improvement, the re-election of Obama - seen as a speculative negative for coal - should end up being a temporary setback on a trend that's already positive for coal, since increased pricing and volume should trump speculative fears. Hence, we have a good motive to say that the worst is behind for coal.

The main threat

More than regulations which affect new coal-fired capacity, the main threat for coal would come from any kind of carbon tax would be a real killer. A carbon tax would hit coal in its most important advantage, cost. If such tax is enacted, then that would constitute a valid reason to abandon the coal sector. This is where Obama could go from being a speculative fear to being a concrete - and deeply negative - reality. Barring this, the thesis remains that the worst is behind for coal.

Conclusion

If one is betting on the market recognizing that the worst is behind for the coal sector, and that the market will be playing the sector for a continued rebound, then the most attractive stocks will be the ones that took the most damage. My personal favorites are James River Coal (JRCC), Arch Coal (NYSE:ACI) and Alpha Natural Resources (NYSE:ANR) and I have re-entered these names on November 13, but more conservative investors might approach the sector through stocks such as Peabody Energy Corp (NYSE:BTU) or a sector ETF such as Market Vectors Coal ETF (NYSEARCA:KOL).

An eye will have to be kept on natural gas, and another on Obama's moves regarding any carbon tax, though.

Source: For Coal, The Worst Is Behind