Are Conditions In Place For A Coal Stock Rally?

| About: Walter Energy, (WLT)

Coal stocks have fallen and they can't get up. The week just ended was especially bad. Early last week, Patriot Coal (PCX) alarmed coal investors by announcing that a customer was backing out of a contract for 1 million tons of PCX's lower quality coking coal. Patriot commented that the price of that coal was down $25-$30 per ton from when the contract was signed. This raised fears that Patriot's problem was the tip of the iceberg of industry-wide contract defaults.

However, prolific SA contributor Paulo Santos put out a BUY on selected coal names on May 17th and 18th. While I agree with his reasoning, I decided to wait until this weekend before publishing my latest thoughts. In addition to Paulo's thesis that rising natural gas prices should be a catalyst for thermal coal producers, I think developments in the met (coking coal) space are equally important for overall sentiment.

A string of potentially positive events are unfolding that suggest most of the bad news is likely priced into the coal stocks. I'm not pounding the table and saying it's time to go ALL-IN, but if ever there were to be a sharp rally of say 20%-30%, the conditions for such a move look to be in place. Supporting the thesis of a robust rebound, no doubt sparked initially by short covering, is the following:

1) Benchmark global coking coal prices appear to have bottomed at $210. Yes, I realize this is not new news, but I was skeptical until just a few days ago. Importantly, on May 18th, we learned that striking BHP (NYSE:BHP) workers in Australia did NOT accept a labor contract proposal, and in fact have announced a week-long strike next week. BHP is the largest coking coal producer in the world.

2) Natural gas prices have rebounded to $2.74 per MCF from under $2.0 in just the past few weeks.

3) Announced production cuts of thermal and met coals will help rebalance supply and demand. James River's (JRCC) long-time CEO Peter Socha believes that U.S. coal production could be down 140 million tons in 2012 vs 2011.

4) Thermal coal inventories, currently estimated at 200 million tons or more, may have peaked, especially if coal to gas switching slows or reverses due to higher gas prices.

5) The outlook sections of recently filed quarterly 10-q reports of U.S. coal producers contain some decidedly upbeat / optimistic comments. [I will write more on this.]

6) There's increasing talk of a hot summer -- does anyone really know? Probably not, but this perception can only help investor sentiment.

These potentially positive catalysts, be they real or perceived, combined with a substantial sell-off in the coal stocks that accelerated last week, could provide a good entry point. I've said all year long that I don't see a sustainable rally in the coal stocks. After this week's bloodbath, further sustained downside may be limited.

I think an investment in Walter Energy (NYSE:WLT), Alpha Natural Resources (ANR), Consol Energy (NYSE:CNX), Peabody Energy (BTU), or Arch Coal (ACI) offers a compelling risk/reward proposition. Note, Arch and Alpha are significantly more risky than the other three. Cloud Peak (NYSE:CLD) has proven to be a relatively safe haven, but I think it has less dramatic upside.

An observation that has not received a lot of air-time is that dozens of global coal companies, listed in Australia, on London's AIM and in Canada, are having great difficulty raising capital to bring planned new projects online. Therefore, with financing having dried up in late 2008 through most of 2009 AND for what will likely be all of 2012, new coal supply may be a lot less than expected. The U.S. producers that hunker down and make prudent decisions will be well positioned to thrive.

My single favorite stock given the above analysis is Walter Energy. WLT is making slow but steady progress in bringing costs down, is ramping up production and exports 6-7 million tons of the best coking coal in the world from its Alabama mining complex. I am writing a separate article on WLT.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in WLT, ANR, BTU, CNX, ACI over the next 72 hours.