Playing The Rebound In Coal: 5 Stocks To Lead The Way

by: Matthew Smith

For those who read our daily commodity articles here on Seeking Alpha, then you are fully aware of our outlook for coal and natural gas. For those readers who are new, it is our opinion that the outlook of coal is tied to that of natural gas. The two commodities are substitutes for each other and so long as one is experiencing a glut, so too shall the other. This is the hard reality in the commodity arena, and investors are forced to trade accordingly.

We have discussed natural gas at length over the months, and in short we see no foreseeable let up in the supply glut currently experienced by the North American market. Yes, demand will grow - especially as prices remain low and more industry switches to natural gas as a power source. However, one must also note that with the current drilling taking place in the shale plays across North America that natural gas is still a very large by-product. The economics of the current batch of wells being drilled are dependent upon oil and natural gas liquids remaining high, with little to no credit given to dry natural gas. As we have learned over the past decade of following the commodity space, when something is a by-product of what you are really after it is either a costly nuisance or a gift to be sold for whatever monetary value you can derive from it. Obviously this is what dry natural gas has become, and what is shall remain until it ends up as a transportation fuel or finds some other mass market (potentially LNG for export in the next few years).

So although we are bearish on the short-term prospects for both coal and natural gas, we do see the upside for both commodities moving forward and have stated as much in previous articles. As we promised, here is a summary of some of the research we have done on the coal plays, but keep in mind this is not our endorsement to now enter positions as we still think that there will be better entry points.

Arch Coal (ACI) set a new 52-week low on Tuesday, continuing a trend that anyone following the industry has noticed. All of this is on high volume too, and the Beta of the stock is pretty high registering at 2.2+ right now. The stock currently yields a healthy 5.4%, yet a quick glance at Yahoo Finance indicates that the current payout ratio is a worrisome 98% which leaves little room for raising the dividend and even less for error!

Looking at the company's operations, it does have 20 operating complexes with enough production to qualify as one of the top five producers worldwide. The company is a leader in extracting low sulfur coal from major coal districts in the United States from states such as Wyoming, Utah, Colorado, Illinois, West Virginia, Kentucky, Virginia and Maryland. The company mainly mines thermal coal but does produce some metallurgical coal from their Appalachia region - which is some of the highest quality produced and although a small part of the overall company's business is still large enough to qualify them as a top five producer in that category. The company has 5.6 billion tons of reserves (of both thermal and metallurgical coal) as of 12/31/11.

Alpha Natural Resources (ANR) also hit a new 52-week low on Tuesday, and the company has had a steady stream of bad news to accompany the steady stream of bad results. On Tuesday S&P downgraded the company's debt to BB-, take it for what you will but the outlook for the company is poor according to that rating. We are investors though, always looking for an opportunity so none of this has deterred us, and we still think that Alpha holds some promise because of their status in the industry. The company, even at these low prices, sports a $3 billion market capitalization and is the 2nd largest producer here in the US following their acquisition of Massey Energy. The company is the third largest globally in terms of metallurgical coal production and sixth overall. The company is the largest exporter of coal from the US and has more port capacity than any other producer here, which fits in well with our thinking that those exporting coal will do best as international demand remains strong. It is easier to ship coal than natural gas, and natural gas is still a few years away from being able to be exported via ship from the US - thus coal prices will remain depressed here and remain higher overseas.

Alpha has cut production already in 2012 due to market weakness and lowered their Capex in response as well. Although this delays adding capacity, that is exactly what the market needs right now, but looking ahead the company still has excellent organic growth opportunities - especially in the metallurgical coal category due to their exposure to the Appalachia area.

Peabody Energy (BTU) is the largest US coal company and has production in the US and Australia. In 2011, EBITA was split 50:50 between the two regions and the company's international operations continue to grow. The company's margins are some of the highest for coal companies traded on the New York Stock Exchange, thanks mostly to the impressive returns on their Australian assets - but in all fairness their US assets do outperform the group as well. Peabody is more of a global play than some of the other US-listed companies due to the assets in Australia, but also because they have the sales infrastructure globally to diversify their customer base which should pay dividends moving forward.

The company is trading near its yearly lows, yet still appears to be one of the healthier companies in the industry. The dividend payout seems reasonably safe as it yields 1.2% and the dividend payout ratio is in the high single digits according to Yahoo Finance. This roughly $8 billion market cap company might be the best way to play the industry and any rebound one may expect. The international exposure will only help it avoid some of the pitfalls its US peers face (such as increasing railroad fees and falling demand) and keep cash flow strong moving forward.

Patriot Coal (PCX) held their conference call Tuesday, and we were unfortunately unable to listen in on it. Shares in the company finished up, bucking the trend for most coal stocks which found it a rough day. The entire industry has been volatile recently, but Patriot Coal is one of the most volatile in the industry with a beta to prove it. It is a $500 market capitalization issue and has a low share price, so part of this is due to day traders moving in.

The company has roughly 1.9 billion of proven and probable coal reserves. The company currently has 13 mining complexes in the Appalachia and Illinois Basin. The company derives 76% of its revenues from thermal coal and 24% of its revenues from metallurgical coal.

CONSOL Energy (NYSE:CNX) is an interesting play in regards to this article because it has exposure to both coal and natural gas. It is in the natural gas plays in the eastern United States and in 2012 will target NGLs (Natural Gas Liquids) in roughly 50% of its drilling. CONSOL has 4.5 billion tons of proven and probable coal reserves and based upon revenues is the 3rd largest coal company here in the US with some premier assets. The diversification has helped the company as it ended 2011 with $2.7 billion in liquidity and it has taken steps to remain competitive by shutting in costly coal and natural gas production until the market demand returns along with higher prices. One thing to note is that 84% of sales by tons is thermal and 16% is metallurgical. The company sells to four continents and they expect to be able to realize cost savings once the Panama Canal is widened and can handle larger ships. The stock is trading above its 52-week low and has shown more strength than others in the industry due to the diversification. Not the best way to play a rally in the coal space, but an excellent way to play a rebound in commodities in general for investors looking to take on less risk as the company has liquidity and a 1.5% dividend.

We are not ready to recommend moving into the coal space as we think that natural gas prices can go a bit further to the down side, but right now they are beginning to get into the buying area. It is our belief that one needs to purchase the companies with production overseas and/or the ability to sell a large portion of their production abroad with low transportation costs associated with those transactions. It is only after those shares have been purchased that we would look at the US focused producers with high transportation costs and a dependency on US demand.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.