We have been leery of coal for some time now, waiting for it to fall and bottom out before we moved into it in order to position ourselves for large gains. Over that time we have gone under serious scrutiny by peers and readers alike but have maintained an unwavering opinion regarding the need to stay out of coal. Our comments which were considered by some as outlandish or blasphemous now look to be prescient, so we should be feeling great at this point, right? Wrong.
Since our big calls, for instance Alpha Natural Resources (ANR) headed below $10/share, we have had a bounce in the general market which has enabled the coal stocks to bounce. Everything we said about the smaller coal stocks seems to have happened for the most part, but what we find troubling is the fact that the big boys still came out of this with minimum damage if one believes what we just witnessed was capitulation. We expected a big sell-off in the big names to indicate a bottom for the sector and that never happened. What did take place was a sell-off in the smaller names with the lows hit intraday and shares rallying. They have continued their upwards movement since then, which has us a bit worried to be totally honest.
There is a bit of fear that we have missed the bottom, but everything in our experience tells us that we have not seen the bottom just yet. Resource markets hardly ever bottom out with a 'V' but rather grind lower until hit a range where they then are range-bound for a period of time. Always the little fish get hit first followed by the bigger players as money is taken out of the industry as a whole. Every mining cycle we have been a part of across an array of resources has appeared this way. Now we could have a special situation with the European issue constantly in the news and natural gas paired with a presidential election year here in the US, but either way we feel that this is a relief rally which will shortly end and we will head lower.
A few important points which remain obvious to us. First, we have had very few mine closings or production curtailments. That will be needed to keep some of these plays afloat and coal prices from falling further. Second is the fact we have had zero companies go bankrupt or get taken over or forced to do some sort of asset sale. This always happens when an industry comes under attack like coal has. The leveraged players are forced out leaving the better capitalized firms to duke it out. Third, where are the write-offs? Coal demand has collapsed, prices are down and if certain production is now deemed uneconomical, well then what can one say about that asset? With the acquisitions which have taken place and the large investments there have to be some around the corner and sooner rather than later. Lastly, we see little reason for demand to go up dramatically in the next 12-18 months from current levels and in fact we could see further demand destruction in the US due to low natural gas prices. If demand is not going up then the next round of contracted coal purchases will be at lower prices and then the one saving grace that the companies had on their side is less of a factor.
We still believe that we are correct in or original and follow up predictions regarding coal and the relative bleak outlook in the short-term with a better outlook long-term once natural gas prices have rebounded and we see a turnaround in the world economy. Here is our latest on a few selected coal companies which we are watching because we feel they will make ideal investment candidates once the industry has bottomed:
Alpha Natural Resources
We said this would go below $10/share and everyone laughed. It did seem hard to believe at the time, but here we are. We saw shares hit all-time lows recently and they almost reached exactly $8/share before this recent rally. We do not trust this rally here, especially as the company has already taken some drastic steps by closing mines and curtailing production. For those wondering why the shares trade at such a discount to book value, it is because the company needs to write-off some of their assets. It is obvious that this needs to happen and only a matter of time before the company's accountants make them do it. That will give this one a jolt as ordinary investors jump ship worried about the potential for the company to go under. We are NOT trying to imply that is what is going to happen, simply that a write-off needs to occur and most likely will and that will create fear among the rank and file shareholders. These moves are always amplified by the computers moving in and playing the penny game to turn profits and we suspect that this news will be met with volume in the 30-40 million share range. For those still not convinced, simply look up the book value, look at the share price and then research what the stock price action looked like on the day the company announced the mine closings and production curtailments. That will paint the best picture.
Arch Coal (ACI)
Just like the rest of the industry this one has hit new 52-week low day after day. Currently the shares are trading above those levels, but the rally has not presented itself as a breakout. Looking at the chart it simply appears that this is a bounce and we will eventually describe this move as a lower high which was followed by a lower low. Arch has more wiggle room than others in the industry and would be in the mid-tier group for us, so plenty of volatility. We will get a better idea of what the company is doing on July 22 as the company announces their earnings, according to the calendar we are using for earnings. The last earnings announcement was not pleasant as the company had to cut its dividend on top of the drop in earnings. It is hard to imagine they will have better news to report this quarter, and that is why we are not long at these levels.
Patriot Coal (PCX)
This is one of the two riskiest plays in the sector, and by our estimation the one with the highest probability of going under. The company we are describing is of course Patriot Coal , a company which we are constantly updating readers about due to its large intraday swings and the interest it garners due to the volatility. This is one of those companies investors must own on upswings in the market, and be far away from when the sector heads lower based on the assets they own. Remember these are the assets which Peabody (BTU) did not want and thus could be considered castaway assets. When you are marginal there is little room for error, and to describe Patriot as marginal here would be very kind. Investors would be wise to buy this after the rally is underway as it will still rise at a greater rate than its peers and you minimize the risk of mistiming the buy and getting trapped in it (not due to liquidity but due to one's inability or unwillingness to take a loss and want to hold until they are back to even).
The next two plays we are going to discuss are the reason we are a bit confused at this point because rightfully or wrongfully they have not traded in tandem with their peers on more than a few occasions recently. It is a zig and a zag game, but the price action has had us perplexed on more than once. We are awaiting a sell-off in these blue chip names to indicate to us a bottom is being set, and truthfully we have not seen that.
We have said this one needs to break down to the $20/share level and we think that it goes below that. Maybe not for a prolonged period of time or very much further down than that level, but we do think that shares need to get down there to indicate some sort of capitulation here. This is one of the better run companies here, and it trades for a premium because of this - as it should. The company does have a more diversified production base than the rest of the companies mentioned here as they have exposure to Australia and easy transporting to Asian markets. With the new structure being put in place in Indonesia, their exports become a bit more competitive, but like their North American counterparts the China market is key to a turnaround.
CONSOL Energy (CNX)
This has been one of the bigger surprises to us as the stock has held up much better than we had anticipated. We are still waiting for it to have that day when investors sell-off shares and with the market the way it is in coal and natural gas we think that day could be on the horizon. This and Peabody are really the two reasons we worry about still staying on the sideline, but we have stuck to our guns and been correct thus far, so we shall continue this.
We still have a few months to see whether natural gas production will outstrip demand enough to fill what storage space is available and that will be key going into the winter months. This will affect coal prices one way or the other and they will move in tandem with natural gas prices, make no mistake.
When investing it is always important to remember that the trend is your friend, and across the board the coal stocks have bounced back, but not enough to break the current trend of lower highs and lower lows. Until that is broken and a base is built, investors have plenty of time to sit on the sideline and/or slowly build positions. We realize that we have seen dramatic price drops and valuations appear compelling here, but moving forward they may yet still get more attractive thus our reason for remaining on the sideline and not turning bullish ... yet.