Update: Our Outlook For Coal

by: Matthew Smith

We have continued to take our hits over the past few weeks from many readers as the entire coal sector rallied and even more so after it caught fire following the news out of the European summit. The data we were looking at did not warrant allocating capital to these plays except on a trading basis - which we attempted a few times. There was this elephant in the room (the Patriot Coal search for financing), which many disregarded out of overconfidence resulting from the fact that this is a real business that requires real assets and the fact that more bad news did not follow the initial bad news. Many have also been here and seen the industry bounce back, but we are lucky enough not to have that past experience to cloud our current and future judgment and instead can focus on what the charts and data are indicating.

Across the spectrum of coal stocks we remain above the lows set earlier, although there are a few areas where there are some serious questions that need to be asked. We have been waiting to make our entry and now we are closer than previously. Have others purchased shares lower than current prices? Of course, however we are focused on getting shares as they recover and catch this on the upswing. We have previously gone on record in our morning commentary and other coal articles to say that we expect a prolonged downturn in the stock prices of coal companies and would expect a 'U' shaped recovery rather than a 'V'. We will supply readers with an in-depth article in the next few days, but with the news and extreme volatility we wanted to do a quick run through of the industry with our views on the various companies we have covered to keep you abreast of the situation. Our record is not perfect here, but we have been one of the few who has been steadfast in our opinion that the sector was heading lower and that a bankruptcy would occur.

Patriot Coal (PCX) had rallied strongly off of the $1/share level as a short squeeze must have been initiated and possibly even news leaking that it had secured financing - although just not the rest of the news regarding that financing. Shares were down early yesterday around the $2/share level before the news in the afternoon that the company was filing for bankruptcy protection. Shares fell $1.58 (72.10%) to close at $0.61/share in yesterday's trading. After hours we saw shares fall a further $0.26 (42.72%) to close at $0.35/share. Volume for the day was 38.4 million shares. This company was over leveraged and had production that was high cost. A portfolio of assets that produces a commodity at high cost can be richly rewarding for investors as the underlying commodity's price rises to the point where an inflection point is reached for a company and supercharges results. As great as these assets can be when prices are sky high, they can be detrimental to the health of a company, and investors' capital, when the price of the underlying commodity falls. We have seen it far too often in our career and that is what happened here.

With Patriot now out of the picture for investors, here is what we are looking for with some of its peers:

James River Coal (JRCC) is next on our list for being at risk of bankruptcy. This is not an earth shattering revelation, as the assets and balance sheet here are closer to Patriot Coal's than anyone else's in the industry but it is a reality investors need to face. These assets are not low cost producers and James River could come under pressure financially if coal prices remain depressed at current levels. One important point investors need to keep in mind is that even if we see prices level out or even move up a few dollars from current levels, that does not necessarily solve any problems. Production has been cut and we have seen serious curtailments by some of the players, so the industry would have to see enough increased demand to not only push prices upward but also support all of that production shifting back onto the market. That is one of the things that JRCC shareholders need to pay attention to the most as they are vulnerable to the same fate as Patriot during a prolonged downturn in the industry.

Investors acted accordingly as shares in James River Coal fell $0.67 (18.93%) to close at $2.87/share in regular trading. During the after-hours trading in shares we saw shares fall another $0.37 (12.89%) to close at $2.50/share.

Alpha Natural Resources (ANR) closed down $0.65 (7.50%) to finish the day at $8.02/share on volume of 19.1 million shares yesterday. This one is getting closer to its 52-week low, and during intraday trading yesterday it got within about 5% of it. This one will be interesting to watch as earnings will be out at the end of the month and the company should have a lot to discuss regarding its business and the sector in general. We viewed this one as the third riskiest in the group that we follow due to inflated asset prices on its balance sheet resulting from acquisitions. Now that the Patriot news has occurred, this moves to number two on the watch list (as Patriot filed bankruptcy) for bad news behind only James River Coal now. We think that there will be a write-off at some point to adjust the balance sheet to reflect the realities of the current market, and that news could knock the shares down to fresh lows. This would not be one of the first shares we will purchase when making the move into the industry but rather one of the last as we wait for confirmation that the company will survive.

Arch Coal (ACI) we like marginally better than Alpha and it got within roughly $1 of its 52-week low in trading yesterday. During trading yesterday shares closed down $0.48 (6.71%) at $6.67/share on volume of 14 million shares. After hours the shares fell another $0.18 (2.70%) and shares appear likely to open at this level this morning. We would expect Arch to test the $6/share level at the very least and would not be adding this to the portfolio until it was time to add the risky players.

Peabody Energy (BTU) is one of the blue-chip players in the industry and this may be the pullback we have been waiting for. Shares are still above the level where we want to purchase our initial position, but we are patient and will wait for that level to present itself. If it does not we shall simply wait until this can be caught on the upswing. The Patriot bankruptcy pushed shares down $1.55 (6.23%) to close at $23.31/share on volume of 12.1 million shares. We need shares to fall roughly another 15% to reach the point we have alluded to and force us to pull the trigger, assuming no changes in the general economic story. This has been one of our more controversial calls, but when you look at the data we were within $0.67/share from the $20 level when shares were under pressure only a few weeks ago. The dividend is not great here, but this will be one of the first coal plays we add to the portfolio when we do make the move, that is one fact we are sure of.

It has been a rough time for coal investors and the news of Patriot Coal filing for bankruptcy protection only made matters worse for many, especially those who thought that the train had left the station in the past week or two. One can usually trade these bounces as industries bottom out and we think that this is the process we are currently watching play out. It is our opinion that one should allocate capital judiciously and keep out of the riskiest plays until the charts and data dictate that we catch these plays on the way up, however buying initial positions in the blue-chip plays at attractive entry points is never a bad idea, and one we shall embrace.

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