The US coal sector has become extremely volatile over the past few years, which is highly unusual for a fossil fuel sector. There are a number of reasons for this volatility some of which are not directly related to the coal companies. The major reasons for these sharp ups and downs being witnessed by the coal sector are
- Sharp drop in Natural Gas prices in the US due to the shale gas revolution
- Clampdown by the EPA on coal mining and power generation due to environmental concerns.
- Sharp upturn in global coal prices due to rising demand from China and India
- Expensive M&A
While the first two factors have resulted in the decline of the coal stocks, the third factor was responsible for the sharp climb in the above mentioned stocks during the 2009-2011 periods. The last factor is responsible for a deep decline in the stock prices of the acquirers.
The Long Argument
- China and India - The biggest reason to be bullish about Coal is the voracious demand for coal by energy hungry India and China. Both these countries rely on coal for more than 50% of their energy needs. China gets almost 80% of its electricity from thermal power plants and consumers almost 50% of the world's total output. India is showing strong secular demand growth of more than 10% a year. Despite huge reserves, India is being forced to import coal due to the inefficiency of its corruption ridden mining sector. India's electricity utilities are constantly on the lookout to buy coal reserves and companies outside.
- Cheapest Source of Power - Coal has many disadvantages such as causing thousands of mining deaths each year and leading to serious environmental pollution. However, the biggest advantage of coal is that it is currently the cheapest source of power. Thermal power plants can provide electricity at 2-4c/KwH which is unmatched by other fuel sources.
- Clean Coal Technologies and CCS promise a greener future of Coal - It is hard to put lipstick on a pig but policymakers realize that Coal will be needed for a long time. So technologies are being developed which would lead to lower harmful emissions and reduce the carbon in the atmosphere. Unfortunately, these technologies have not really matured at the pace they should have.
- Coal will overtake Oil as the Biggest Fuel Source - Coal is set to become the biggest fuel source in the next couple of years overtaking Oil. Not surprising when you consider that Coal is much cheaper and abundant than Oil is. Coal is the biggest source of Energy for Electricity Production in the world and its use is expected to continue to grow to 44% of the Electricity Production by 2030 (IEA).
- Coal to Liquid - It is possible to convert coal into liquid fuel through a process developed by Sasol-Lurgi group. South Africa due to the international embargo developed a large industry to convert coal into petroleum. This process is not widely used globally due to the high investments required. However China and India are testing out this technology.
The Short Argument
- Environmental Problems - Coal is facing a lot of headwinds especially in developed countries because of the manifold pollution and environmental problems it causes. While austerity hit countries are fighting to keep coal (eg. Poland), mining deaths don't make for pretty headlines. Alpha Natural Resources (ANR) got into a load of trouble due to mining accidents. The massive lawsuits and legal expenses can really hurt a coal stock badly.
- Natural Gas - This has been the biggest bane for coal stocks in the last few years in the US. While other countries still buy expensive natural gas, the prices in the US have plummeted. This has led to switching by power plants from coal to natural gas as it was more profitable. Though Natural Gas is up more than 100% from its historical lows, cheap gas still poses problems for coal in the US
- Chinese Hard Landing - The recent decline in Chinese growth has hurt a lot of commodities and coal has been one of them. There have been reports of massive unused inventories of coal lying in China. The economy in China is showing some signs of recovery, however if China economic growth dives then coal prices will fall dramatically
- Democrat Administration and Obama - Democrats are traditionally more environment friendly than Republicans are. This led to a sharp selloff in coal stocks like Arch Coal (ACI), Peabody Energy (BTU), Alliance Resource Partners (ARLP), Cloud Peak Energy (CLD) and Consol Energy (CNX) after Obama got reelected. However, in the last month or so, some of the decline has reversed. Peabody Energy (BTU) gave a negative guidance for Q1 2013, however the stock price remained unchanged. This shows that the current market sentiment towards the coal stocks remains positive
- Global Carbon Tax - Climate change agreements have failed one after another as short sighted leaders really don't care too much about global warming. Like debt, "Kicking the Can" is the unstated policy for climate change and global warming. A carbon tax would dramatically raise the costs for coal producers and consumers. However, we consider this a very remote possibility
The last 5 years have been a roller coaster ride for the coal stocks with a boom cycle giving way to a bust. Some of the US coal stocks like Alpha Natural Resources and Arch Coal made expensive acquisitions and have dearly paid the price for that. Others like Peabody and Alliance Resource Partners have navigated the period intelligently. There are strong arguments to be made for both the long and short side. But considering everything, we remained inclined towards the long side. This is due to the fact that coal stocks have priced in many of the negative factors. However, we think that some coal stocks are attractive buys for the long term (Peabody Energy is up 1526% over the last 10 years). Investors looking for international exposure can also consider the Coal ETF (KOL). In future articles we will try to analyze some of the individual coal names.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.