Not All Commodities Are As Cyclical As Copper Or Lumber, Thermal Coal Demand Is Sticky

by: Peter Epstein

Thermal (or steam) coal, natural gas and nuclear energy are the primary sources of fuel used to generate electricity in the U.S. According to the EIA, 45% of the electricity generated in 2010 came from coal-fired power plants. A common definition of a commodity is that it's easily substitutable. Over the past few years, natural gas has made serious inroads at the expense of coal in the country's generation mix. However, in order for a meaningful amount of switching from to continue, our country needs more natural gas and nuclear power plants to be built. This is happening and of course renewable energy sources are gaining share. The key takeaway is that it will take years for coal's percentage of electricity generation to fall to even 40% from 45%.

I argue that not all commodities are as volatile or cyclical as say, copper or lumber. Steam coal demand is relatively sticky. A good indication of this stickiness can be found by looking at coal prices this year. While several U.S. coal stocks are down more than 50%, coal prices have barely moved. An index of Powder River Basin coal is down 2% from its mid-July high, but up 16% from its mid-May low. Central Appalachia coal prices were stuck at $80.15 per ton for 10 weeks in a row until Friday's reading of $81.75 per ton. $81.75 is the highest price of the year. By comparison, spot copper is down 27% from its high.

Clearly, coal prices have not moved all that much. That's because demand for steam coal does not rise or fall significantly from year to year. Yet stocks like Alpha Natural Resources, (ANR), Patriot Coal, (PCX) and Peabody Energy, (BTU) are down 73%, 69% and 53% from their respective highs. A big concern among investors is that the demand for coking coal used to make steel is far more variable than that of steam coal. While this is true, coking coal prices have not fallen off a cliff either. A benchmark quarterly coking coal price index is down 14% from $330 per metric tonne to $285. This decline is greater than the declines witnessed lately in steam coal, but it's noteworthy that the most recent $285 per tonne figure is still up 27% from the $225 per tonne price at the beginning of the year.

There's plenty more to the story, nuances that get left out of the big picture. For example, coking coal comes in a range of qualities. The benchmark price I referenced above is for very high quality coking coals from the Bowen Basin of Australia. Importantly, there's been a greater weakening in the prices of lower quality coking coals. ANR and PCX sell a mix of steam and coking coals, but neither sells the top quality Bowen Basin quality stuff. This factor explains a meaningful part of the massive stock price declines. Another concern is that since U.S exports of coking coal have been so strong in 2010-11, there's room for export volumes to fall. ANR and PCX are beneficiaries of strong exports, will they get stuck with unwanted coal and be forced to fire sale it domestically? I don't think so.

Offsetting possibly lower demand for U.S. exports is supply challenges around the world. Five U.S. coal producers have warned that their 3rd quarter production levels will be below expectations. Three of the earnings misses, from PCX, ANR and Walter Energy, (NYSE:WLT), were big ones. The two largest coking coal producers in the world, BHP (NYSE:BHP) and Teck Resources (TCK) have also had supply disruptions this year from severe flooding and unusually harsh winter weather to labor strikes.

So, there are valid and legitimate reasons for coal stocks to have sold off. High cost inflation, company specific earnings misses and a global slowdown. But, steam coal demand is not as cyclical as that of many other commodities. A big portion of U.S. coal producer's sales tonnage is steam coal. In terms of exports and coking coal demand fears, coking coal prices have held in quite well, while exports of coking coal are running at close to all-time highs. All of this can change for the worse, but the stocks appear to be pricing in a lot more fundamental damage than has occurred to date.

I've been selling Put options on WLT and buying call options on PCX, ANR, BTU and Consol Energy, (NYSE:CNX). To investors that have not been exposed to the coal sector this year, good for you! But, if the global economy is not headed into a free fall, then it makes sense for coal stocks to be on one's list of high risk / high return investment opportunities. Some readers have asked about or recommended the coal ETF, KOL. KOL is a great way to go, but I prefer ANR, PCX & BTU at these levels. I'm comfortable with the higher risk of these names compared to buying the ETF because I'm aiming for higher returns.

If we get a 4th quarter melt-up in risk assets like we did in 2009 and 2010, then these coal stocks could be among the best performers by year-end.

Disclosure: I am long ANR, PCX, CNX, BTU, WLT.