Seeking Alpha
Gold & precious metals, macro, research analyst, deep value
Profile| Send Message|
( followers)  

Introduction

Energy is an excellent hedge against inflation. Yet too often "energy" is conflated with oil. While oil may be a good investment it is by far the most expensive energy commodity. Oil prices have never been higher with the exception of their brief climb to $140+ per barrel during the middle of 2008. As of now Brent Crude trades at over $115 per barrel, just over 20% off of its all time high. West Texas Crude has underperformed Brent as of late, yet it is still only slightly more than a third off of its all time high. In this article I look at other opportunities: coal, uranium and natural gas.

The prices of these commodities are all considerably more than 50% below their respective all-time highs hit in 2008 (2007 for uranium). There are reasons for coal, uranium and natural gas underperforming oil. Yet these reasons have been known for years, and the price depreciations that have occurred appear to have played out. Furthermore, coal and uranium prices are still in long-term uptrends, while natural gas bottomed at $2.00 per MMBtu's (million British Thermal Units), which is a long-term support price going back to 2000.

The shares of their producers have generally fared far worse as their profits have plummeted or turned negative, while their counterparts in the oil industry have seen record profits and record share prices in many cases. This has created enormous opportunities for patient, contrarian investors.

The Price of Energy

The following table illustrates the fact that oil is overvalued relative to coal, uranium and natural gas:

Assumed PriceMMBtu/unitCost per MMBtu
Oil$100/bbl5.8 MMBtu/bbl$17.25
Coal$65/ton17.6 MMBtu/ton$3.70
Uranium Oxide$45/lb.180 MMBtu/lb.$0.25
Natural Gas$3.30/MMBtuNA

$3.30

(Note #1: of course this ignores the cost of extracting energy from these energy commodities once they have been mined and refined. Yet as a long-term investor I have to assume that the low prices of coal, uranium, and natural gas relative to oil will spur innovation that minimizes these costs, particularly for uranium.)

(Note #2: For coal I am using the more expensive Powder River Basin Coal (see data source). Northern Appalachia Coal is far less expensive at $2.50/MMBtu.)

The disparity in price between these four commodities relative to the energy that can be extracted from them is unsustainable, and over the next decade or two I suspect that businesses and governments will gravitate towards the cheaper energy sources I outline in this article.

In what follows I look at coal, uranium and natural gas separately and suggest a couple of investment ideas that will likely benefit from their respective price increases.

Coal

The coal industry has been a target of the Obama administration. Consequently, over the past couple of years coal prices have languished. Furthermore shares of coal producers have plummeted in value with many companies showing steep losses, or in some cases, bankruptcy. From the chart above we see that coal prices are just 20% of oil prices. So while environmental fears are bandied about in the United States, nations that view energy security as a top priority such as China will gravitate toward coal.

Unfortunately individual investors will have a difficult time buying coal directly. There is no ETF that provides direct exposure to coal prices and the futures market for coal is relatively illiquid. Thus the best way to get coal exposure is by buying coal producers. KOL is an ETF that holds several companies, including many Chinese companies. However coal companies vary greatly in terms of the value and consistency they provide, and given that the industry is having trouble turning profits I prefer to focus on individual companies that have strong balance sheets that will be able to withstand the storm should it last.

My favorite coal investment is Alliance Resource Partners, L.P. (NASDAQ:ARLP). The company has several operations, primarily in the Illinois Basin in Illinois, Indiana, and Kentucky. It also has operations in Pennsylvania, Western Virginia, and Ohio. Over the next four years it plans to increase production to nearly 50 million tons, which is a 40% or so increase from current levels. While the United States may continue to reject coal as an energy source the countries of Southeast Asia will be more than happy to take it off our hands at these depressed prices, and there are plenty of rail lines near ARLPs operations that can ship the coal to the west coast so that it can reach China, Korea, Singapore…etc. by boat.

Alliance Resource Partners, L.P. has remained profitable while other American coal companies have seen enormous losses. It also pays a large dividend that currently stands at more than 7%, and has managed to increase the payout every quarter throughout the bear market in coal. The third quarter of 2012 was the only quarter that the company's dividend payout exceeded profits.

Uranium

Nuclear power is by far the cheapest form of energy I discuss here, and uranium is among the cheapest assets in the world. At current uranium prices nuclear power costs less than 10% of coal and natural gas, and less than 2% of oil. Furthermore it is also the most environmentally friendly source of energy provided there are no accidents. But as we have seen, most recently with the Fukushima debacle, a single mistake can have incalculable consequences. However, unless you accept an "Armageddon" scenario, disasters such as those at Fukushima or Chernobyl provide essential learning experiences that strengthen and stabilize the industry long term.

The Fukushima incident has led to a collapse in uranium prices, and the shares of uranium companies followed suit with many falling well over 80%-90%. Many nations abandoned or postponed their nuclear reactor projects. However China, Russia, India, and Saudi Arabia all have plans to build several more nuclear power plants as they recognize the benefits that nuclear power will bring to their developing economies.

This being the case uranium is not only the cheapest source of energy, but demand exceeds supply. Currently new mine supply is roughly 145 million lbs. while demand is 175 million lbs. Furthermore, the largest uranium miner, Cameco Corporation (NYSE:CCJ) projects here that demand will be 225 million lbs. by 2021.

Investors interested in uranium who wish to avoid mining risk should consider Uranium Participation Corp. (OTCPK:URPTF), a holding company managed by Dennison Mines Corp (NYSEMKT:DNN) that simply holds uranium oxide and uranium fluoride. The company has management fees of less than 1% of its assets, and it currently trades at slightly less than its book value.

URA, the Global X Uranium Miners ETF, should provide far more upside than the metal itself, although it is subject to mining risk. The fund has fallen by more than 2/3 since the Fukushima incident and provides excellent value at current prices. If it didn't hold a large position in Cameco, which is highly profitable and pays a small dividend, then this decline would have been far steeper. While I hold some URA shares, I should note that the fund holds several small companies that are not in production yet, and I believe that, in general, such companies should be evaluated on a company by company basis.

For those interested in a speculative uranium company one of my favorites is Virginia Energy Resources Inc. (OTCPK:VEGYF). Virginia Energy has a flagship property in Virginia called Coles Hill that has more than 150 million lbs. of estimated uranium resources. It also has the Otish Basin property in Quebec, which is an exploration property, although uranium mines take 10-12 years to bring to production once deposits are discovered, so investors should not expect any cash flow from this property until well into the next decade.

Virginia Energy is a long-term investment with high risk, as the company currently has no cash flow and there is a moratorium on uranium mining in Virginia, although the company anticipates that this will be lifted by the end of the year. The reward can be substantial given that you pay less than $0.20 per pound of uranium and get the Otish Basin property for free. If the gap between the price of nuclear power and other forms of energy narrows, as I expect it will, and if Virginia Energy is able to get its Coles Hill mine into production, then this company can make fortunes for its early investors. I should note that the shares traded as high as $0.90 each just a few weeks ago, and they now trade under $0.35, so this may be an excellent buying opportunity.

Natural Gas

Of the commodities I discuss in this article natural gas is my least favorite, and I currently hold no natural gas position. While the price declines in coal and uranium are due to political issues, natural gas has seen an enormous supply glut. Nevertheless natural gas is still much cheaper than oil on a cost per MMBtu basis, and it is cheap relative to production costs in many instances, which will provide enormous leverage to shares of producers should natural gas prices rise. We may see prices rise (normalize) given that natural gas can be liquefied (condensed) and shipped to places where the price is higher than it is in the United States. Natural gas has one advantage over coal and uranium that I should note, namely that it is perceived to be the most environmentally friendly by many (although there is speculation hydraulic fracturing [i.e. "fracking"], the new method of extracting natural gas, causes earthquakes).

Investing purely in natural gas is difficult because often oil and natural gas are found together. The First Trust ISE Revere Natural Gas ETF, FCG, invests in companies that have significant exposure to natural gas. So does the Van Eck Global Unconventional Oil and Gas ETF: FRAK. There are also ETFs and ETNs that track the commodity--UNG and GAZ--however they have failed to track the price of natural gas due to the fact that they must roll over their futures contracts, which trade in contango. DCNG is an ETN that attempts to overcome this issue, although it has only been minimally successful.

Conclusion

Every portfolio should include some exposure to energy. Yet, as I hope I have made clear, not all energy investments are created equal, and the difference can be one of several hundreds or even thousands of percentage points in returns. Thus while it may be simple to just buy Exxon Mobil (NYSE:XOM) or the Select Sector Spiders Energy ETF: XLE, investors who dig a little deeper and who are willing to withstand potential short-term pain will be mightily rewarded.

Source: Beyond Oil: Playing The Downtrodden Energy Commodities

Additional disclosure: I am long VEGYF.PK, which is currently not in Seeking Alpha's system.