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By Joseph Hogue, CFA

The production cuts at its Kentucky mines by Alpha Natural Resources (ANR) on the 8th sent stocks of coal companies down further after heavy losses over the last year. CEO Kevin Crutchfield said the industry faced a 'new normal,' as record low prices in natural gas and new regulatory pressures lead to switching by utility providers and lower demand for coal.

While the longer-term pressures on coal may mean consolidation in the sector, there is more than enough evidence to suggest a relief rally is in order, especially within its strongest player Peabody Energy (BTU).

The United States just experienced its hottest spring on record, a full two degrees above the record and that could mean increased electricity use throughout the summer. This increase in electricity usage helps to push coal prices and company shares up in the second half of the year. The table below shows the return for the first and second half of the year for Peabody through 2004. While the average second half performance for all years is only slightly above that of the first half, removing those years outside of a normal volatility has the second half outperforming with an average gain of 18% against that of 4% in the first half.

(click to enlarge)

Record low natural gas prices have prompted some switching but more than a third of the country's electricity is still generated from coal. Growth of 2% in the world's largest economy and increased demand for electricity could contribute to a second half surprise in demand.

The credit crisis in the E.U. has brought coal prices down almost 27% from last year's high. While a surge in natural gas supply in the United States is driving down gas prices, the dynamic has not played out that way across the ocean. Coal consumption in Europe is increasing against other sources, up 20.2% over the last quarter in the UK versus a 25% decline in natural gas usage.

Further evidence of increased demand may come from Asia. Japan has yet to restart any of their 50 nuclear power plants and will need to find other sources of electricity generation or face widespread blackouts this summer. Chinese power consumption growth slowed to 3.7% in April versus the year prior, the slowest pace in 16 months. Demand may increase throughout the rest of the year as the government approves infrastructure projects in an attempt to reignite economic growth.

Peabody has held up fairly well relative to its U.S. competitors. The company is geographically diversified with significant revenues from Australian mines as well as across the United States. Earnings per share for the first quarter were flat against the same period last year while Alpha Natural and Arch Coal (ACI) both booked losses. Operating margins and return on equity at Peabody are still close to 20% while metrics for both competitors have fallen dramatically.

Peabody's production in the United States is already fully contracted for 2012 meaning they have some leeway to ride out this year's selloff in commodities. Production cuts as weaker companies struggle with higher costs will help to put a floor under the price of coal. Significant stimulus measures in China and the developed world should support energy and commodity prices in the second half of the year. The company continues to be the leading producer in low-cost regions in the United States and benefits from exposure to higher-margin operations in Australia.

Further weakness in the industry could be hedged with a short position in the Market Vectors Coal ETF (KOL) with its exposure to weaker names. An increase in exportation of natural gas products from the United States may eventually drive up the price of gas and make coal more competitive. Until then, the industry will face considerable long-term pressures. Investors should look for oversold entry points and manage profits over short term horizons.

Source: The Market Is Saying Buy This Stock Now