Much has been written here at Seeking Alpha about the correlation between coal and natural gas and the resulting investment implication. Natural gas has been on a tear since April this year when it bottomed at $1.90 per MMBTU. During the course of 2012 it doubled and pulled back at year end to close at a 76% gain. It has been a great win for those who invested in the commodity.
Along the way there have been numerous articles and comments published here at Seeking Alpha that have advocated buying coal stocks as a smart way to play the rise in natural gas (see here and here, among others). I read those articles and comments and I liked the intuitive appeal of the bullish coal thesis. The thesis goes roughly like this: both natural gas and coal are used primarily for power generation and can be substituted for one another. Therefore, a rise in natural gas prices should lead to a rise in coal prices, because any significant disparity would lead to switching resulting in a reasonable correlation in prices. I liked that logic. Coal stocks had been severely beaten down in the spring and natural gas was taking off. Consequently I invested in a few of the coal names being advocated here at Seeking Alpha. I was at the same time invested in natural gas ETFs (UNG) so I tracked the performance of the two different investments. After several weeks of observing my gas investments rising while my coal stocks stayed flat or fell, I followed Dennis Gartman's often repeated advice of "do more of what is working and less of what is not". I sold my coal stocks and averaged up on natural gas.
I was surprised that those two investments failed to correlate. So I did some further research on the subject. This led me to publish an article here at Seeking Alpha titled Why Natural Gas Has Not Lifted Coal Stocks. That article looked at the price of natural gas and its widely followed ETF The United States Natural Gas Fund as well as the Market vectors-Coal ETF (KOL )and several coal stocks which had received considerable Seeking Alpha discussion: Alpha Natural Resources (ANR); Arch Coal (ACI); James River Coal Company (JRCC); Peabody Resources (BTU). The article found that there was either no correlation or a negative correlation between these coal investments and the price of natural gas. The primary reasons found for this unexpected failure to positively correlate were: 1) most domestic producers having large revenue reliance on metallurgical coal; 2) failure to recognize gas versus coal plant efficiency and its effect on dispatch switching; and 3) the global nature of the market for thermal coal versus a primarily domestic market for natural gas. Subsequent to publishing the article I found that debt levels correlated to coal stock prices; highly levered names like JRCC, ANR and ACI fared the worst while more conservatively capitalized names like Alliance Resource Limited Partners (ARLP) and Natural Resource Partners (NRP) fared much better.
I have received comments on that article as well as replies to comments I have made in other articles stating that my conclusions are not correct because 1) I have not given the thesis enough time to play out and 2) my conclusions refer to "end to end" pricing that ignores tradable rallies in between.
The above two charts that open this article dispel both of those counter-arguments and demonstrate the failure of the "rising natural gas leads to rising coal stock prices" thesis. Specifically note the graphs cover a one year period. During that year, gas is up marginally and the coal stock price index is down by nearly half. One year is ample time for an investment thesis to play out. Second note since the natural gas rally began in early April, gas doubled to its November peak while the coal index declined by roughly a third. Finally, note that there have been four major waves in the natural gas move. The first ran from the mid-April low of $1.90 to the late-May high of $2.75, a move of 45%. During that timeframe, the coal index dropped 24%. The second wave up ran from mid-June to the end of August and saw gas rally 50%. In that same time frame the coal index rose only 7%. While directionally correlated, the under-performance of coal was severe, gaining less than a sixth of what gas gained. The third wave takes us from late August to late November and has seen gas rise 46% while the coal index fell around 5%. From that point, the fourth wave, gas has declined about 20% while the coal index is up about 6%. Of the four moves, there was negative correlation in three of them and weak correlation in the one that was positive.
Coal stocks have not benefited at all from the natural gas rally in 2012. There have been tradable rallies in coal stocks but those rallies have not been correlated with moves in natural gas. There has generally been more negative correlation than positive correlation between the price of natural gas and coal stocks, notwithstanding the strong intuitive appeal of the bullish coal thesis. Natural gas bulls are best off playing the natural gas rally in natural gas and not in coal stocks. There may be a valid bullish coal thesis, particularly at these very low coal stock prices. But the record shows investors should be wary about using natural gas prices as a catalyst for movement in coal stocks.