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Back in October, I wrote about how coal stocks could explode higher. Within a couple of weeks, several coal stocks were up 50%. Since that time, though, they have fallen on hard times once again. However, it appears that this is just a healthy pullback in the context of a recovering industry that bottomed out several months ago.

It's all about Natural Gas (NYSEARCA:UNG)

In 2009, there was a massive switchover from coal to nat gas when the price of natural gas dropped below the price of coal, relatively speaking. During this time, the EPA cracked down on coal fired plants, forcing them to be upgraded or retrofitted or else risk being retired. These two forces combined to create massive downward pressure on coal. At the same time, though, overseas demand from China and India sparked enough investor enthusiasm for coal to cause the coal stocks to rally hard.

Over the past 2 years, recoveries in China and India have been called into question and as a result the thesis behind the "Coal Supercycle" has also been called into question.

However, in case no one has noticed, natural gas has recently risen to as high as $4.0/MMBtu from lows below $1.90 last spring. Weak demand and massive production cuts have sharply lowered the price of coal to the point where most utilities will be piling back into coal at around $3.50/MMBtu natural gas.

In addition to this, I have laid out my own thesis on why there may be a Natural Gas Ponzi Scheme going on in the shale gas formations. That is, I believe natural gas companies have artificially inflated their estimates for total reserves and the estimated lives of reserves so that they can sell off land that they spent billions of dollars acquiring. If this is the case, then the bull market in natural gas that started in the spring of 2012 could run far higher than anyone is estimating. Most estimates are that Natural Gas will run into a brick wall at $3.5/MMBtu because that is the price at which most power plants will be forced to convert back to coal. Well, we're now well above $3.8 and if my theory about the Shale Ponzi scheme holds true, then the excessive negative sentiment that surrounds natural gas prices should lift and create even further tailwinds to the price.

About 1 year ago, as people kept trying to catch the bottom in natural gas, many investors figured the safe way to invest in the rebound was to invest in coal stocks. Coal, as the immediate alternative energy source, would benefit greatly if natural gas were to rise…or so the thinking went. A good deal of corporate insiders at Walter Energy (WLT), Arch Coal (ACI) and others were buying up stock in the fall of 2011. Investors were piling in as well. Unfortunately, though, their stock prices continued to plummet.

Alpha Natural Resources (NYSE:ANR) is down about 60% since fall 2011, Walter Energy is down 55%, Arch Coal is down 55% and Peabody (NYSE:BTU) is "ONLY" down 30%.

So what is the catalyst?

First and foremost, higher natural gas prices will increase demand for coal. Natural gas is up 100% since its lows.

Second, coal production has dropped dramatically, which will eventually cause coal prices to rise and make it more profitable for coal companies to operate.

Third, emerging economies should continue to grow and therefore imports of coal should continue to grow.

Fourth, a recent proposal is underway in China's economic agency to scrap annual thermal coal contracts, which has caused domestic coal prices to be subdued to the point where it was uneconomical to import coal. As a result, this could cause a big jump in imports as domestic prices rise.

Which stocks are the best ones to invest in?

I still believe the best way to look at Coal Stocks is through price to book values. Many have written down their assets significantly over the past year, so a lot of the risk to book values is gone. Based on this alone, the following are the lowest priced relative to book values:

  • ANR - 0.30
  • James River Coal (JRCC) - 0.32
  • ACI - 0.43
  • BTU - 1.12
  • WLT - 1.56

ANR and JRCC appear to be the cheapest. ANR has legacy issues with its purchase of Massey Energy back in 2011, which may continue to be a headwind for it, but that is most likely priced into the stock. JRCC is a very risky company operating at huge operating losses, but its cash flows are still OK and could warrant a look.

The safest pick would be BTU, which has managed to increase book value and maintain profitability throughout this downturn. However, a risk taker should look closely at ANR.

Most sectors / industries that go through bottoming processes tend to have sharp pullbacks in a series of higher lows. This one appears to be no different. It has recently gone through a pullback and appears poised to make another run. Keep your support levels in mind when taking a position, but right now the risk reward looks excellent.

Source: Coal Stocks Look Ready To Run