Investing In A Coal Rebound: 5 Stocks To Watch

by: Matthew Smith

For some time we have been bearish of fuels used to generate power, namely coal and natural gas. The logic behind this is simple, pure economics really, and as natural gas has fallen precipitously over the past few months so too have coal prices. The two commodities are substitutes for each other, even capable of being used in the same power plants to power the turbines. At every point in a downward trend a company looks like a buy, and it seems each time we discuss the ugliness of the coal market and its impact upon individual stocks we get comments and emails detailing how great a buy each company is based on a P/E ratio or some other metric that usually looks back at the previous 12 months.

At some point it will be time to jump back into coal stocks, but we do feel the need to once again stress the fact that investors should stay out of them. There are few good reasons to invest, and too many good reasons not to. We also envision new news creeping up soon enough that could drive down these stocks even further. Keep in mind we are not bears, but rather long-term bulls who see cheaper prices in the interim time frame - providing good entry points for investors serious about sporting handsome returns.

With natural gas stealing market share from coal in power generating capacity here in the United States, prices have been pressured lower. Further complicating matters is the fact that world economic growth has slowed and this requires less steel, another large customer of the coal industry. It is a double whammy of sorts for the industry, but on the horizon we see coal demand falling in China too, something not many are talking about right now.

China has been one of the most aggressive counties when it comes to constructing coal fired power plants, because it was cheap, easy and necessary to provide sufficient power to keep their economy growing. Now it appears that power consumption may have hit an interim high, and if Europe gets any worse, it could very well send Chinese coal demand lower for a period of time. A prolonged recession in Europe could bring China to its knees sporting low single digit growth - assuming that the United States can hold things together. This is not good for overall demand of commodities used in generating energy, such as oil, natural gas or coal, but it will be most damaging to coal and coal equities.

Our logic before was that natural gas could steal market share in the US, but it was not easily exportable so one could bet on coal to languish for a while but bank on it making a comeback due to exposure to international markets. That may no longer be the case.

With that said we would like to highlight some of the companies we are still watching for when we do move into coal at a later date.

Peabody Energy (BTU) is one of the top plays in the industry. It is hard to argue otherwise, and this is one fact we cede in many of the conversations we have with coal bulls. Our main point when having these discussions is that although Peabody has performed better than the rest of the coal focused entities, this is typical of a bear market and only after Peabody gets taken lower would one expect a broad coal market rally. It is hard to imagine in the current economic environment any way that coal recovers before Peabody gets taken below the $20/share level. As we have stated in our daily commodity market commentary, it is quite likely that the stock goes below $20/share before it moves any higher. Should the dividend come under pressure, we could see a real price adjustment on this one, so it is worth staying on the sidelines until the market readjusts Peabody. It is necessary for the market to treat the company on equal terms as the other coal companies and discard them all for this bottom to be put in place, and that is what investors need to watch in order to be able to identify when a buying opportunity is being presented to them.

CONSOL Energy (NYSE:CNX) is another top-shelf brand in the coal industry. Oddly enough, the company is diversified and possesses natural gas assets as well so trying to figure out a bottom on this one may be a bit tricky. Obviously one would hope for a rebound in either coal or natural gas, but a large increase over today's prices in either one looks far-fetched barring a return of speculators to the natural gas market. It is not lost on us, the irony that is, that CONSOL is in part inflicting damage upon itself as it was a player in developing the Marcellus shale and will be a sizeable player in the Utica as well. That is one bright spot for the company as they could derive more revenues from the wet gas areas and further diversify their revenue streams. At the end of the day though CONSOL is a company diversified across two horrible industries right now. For us to say that prices need to go below $30 to indicate a buying opportunity would be an injustice to our readers, as the recent 52-week low was at $29 and change. So we think that shares need to be between 15-25% lower than today's prices, which means that investors should look to purchase in the mid-20s.

Patriot Coal (PCX) has been grabbing headlines lately, and honestly has probably been the target of rumors simply because it is the weakest player in an industry which looks increasingly vulnerable to having a few players go under. The bankruptcy rumors most likely put a low in for these shares in the near-term, but it is easy to imagine shares testing those levels once again if the company cannot arrange financing which the market can be pleased with. When one looks across the industry, Patriot is one of the most likely candidates to bite the dust in a prolonged downturn. The company is one of the riskiest plays, but if timed right it may also prove to be one of the most profitable investments too. The key is to be waiting so as to pounce once it is apparent that the coal market has turned and the bankruptcy risk has been minimized.

One has to shake their head at Alpha Natural Resources (ANR) who acquired Massey Energy not all that long ago based on an optimistic outlook of Chinese steel mills requiring more metallurgical coal and Chinese power plants requiring more thermal coal in order to power those same plants and the structures built with the production from those mills. Well demand appears to have peaked at both the mills and the coal fired power plants, and Alpha appears to have doubled down at precisely the wrong time. We have previously stated that this was going to the single digits, and we were but $0.42 away from that becoming a reality. This is one of the larger and better run companies in the industry but with that said still possesses significant downside risk. The company was able to restructure debt when they did the Massey acquisition and only added $1 billion to their overall debt load, which was the cash portion of the deal. When the market does turn this is one of the first coal stocks we want to buy.

On Friday, Arch Coal (ACI) had an analyst come out and lower their price target on the company's shares from $11/share to $8/share. Credit Suisse was the bank, and they maintained their Neutral rating going forward so it seems that there is a consensus building that one should stay neutral in the near-term and watch as prices fall.

Much of this has sounded bearish, but we are far from bearish on the industry in regards to long-term investing. We do believe in being good stewards to our capital, and feel that readers probably share this view which is why we continue to wait for our entry point. If these shares were thinly traded or listed on a foreign exchange we might be tempted to advise to initiate positions so that one had something once a turnaround occurred, but these are highly liquid issues trading in the U.S. so there is little risk of not being able to get in when one wants to. As a rule of thumb, investors should wait until the top-shelf players are sold-off and then begin their buying programs shortly after that event. This is what our experience tells us is the correct play, and we have a history of calling resource sectors that are down and out on their luck right before they rise (i.e., oil, uranium, potash and rare earths among others).

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