Over our career it has been rare for us to be so early to an idea or them to actually have to exercise the patience to sit on the sidelines and not only wait for the sell-off to end, but also for the field to be set up for the rise from the ashes. It is not fun, and actually almost like an out of body experience, having to wait for the bad news to surface in order for us to be comfortable deploying our capital while having to watch readers lose money because they are early to the play. It is the nature of the business, but never pleasant when you can put faces and personalities to that price action. The good news for readers is that we are closer today to the bottom than previously and that is coming from someone who has been unwavering in their short-term bullishness over the past few months.
We expected one to two bankruptcies during this correction, and have already witnessed one victim fall to that fate. That indicates to us that business was indeed as bad as we believed it to be, and no matter what many are saying there still is a strong headwind the group is facing. BMO Capital Markets downgraded both Alpha Natural Resources (ANR) and Arch Coal (ACI) earlier this week, showing that even the pros have been on the wrong side of this trade. This news actually caused new 52-week lows for some in the industry, including Alpha Natural.
So with all of the news over the past few weeks and the data and interviews circulating out there, where do we stand now? Well, we still have not deployed capital into the coal sector, however, we have been buying deep in the money calls of natural gas companies with exposure to the Utica and growing exposure to natural gas liquids and oil production. We believe that the coal recovery is not a simple story and will provide investors with numerous opportunities to make money. Before one will be able to make money in coal, the money will be made in natural gas as coal cannot prosper in this country before natural gas prices rise. So our trade is a two part trade, recognizing that we will lose some of the gains in coal as it follows natural gas's lead, but fully expecting to make it up in the positions established via companies with natural gas exposure. (Editor's Note to Readers: We have chosen natural gas companies with growing production profiles pertaining to natural gas liquids and oil in order to buy ourselves time and hopefully deliver trading gains should this take longer than we expect.
Keeping this in mind, one of the more attractive candidates for early buyers will be CONSOL Energy (CNX) due to the company's dual production portfolio of coal and natural gas. Strangely enough, CONSOL itself is like a hedged trade itself and buying at the bottom offers numerous possibilities and hefty profits should natural gas prices rise. The first headwind shall be when natural gas prices in North America reach the breakeven price where there is no difference in cost of electricity production between using coal or natural gas.
Our charting software is broken, and rather than scan in our chicken scratch handwritten over this chart we figured we would simply include it to give readers a visual of what we have been looking at over the past few months. It is obvious that we are in a downtrend, and have been for some time. Back in April when it appeared that a base was being formed we did not break above the $35/share resistance level in any meaningful way. That was telling, but going along with our thesis this chart will be the first to show how the rest will react later on due to the natural gas exposure. It is our belief that eventually we will get some sideways action to not necessarily carry us higher through the downtrend line, but just "tire" it out. At CONSOL that could be sooner rather than later by the looks of it all, but time will tell and obviously the economy will be a big part of this.
Our other blue chip stock that we would want investors to look at is Peabody Energy (BTU), which has assets outside of North American and quite close to China, giving it a leg up when it comes to transportation costs and diversification of revenue streams and production among geographic regions. It is one of the best run companies in the sector and if coal went through a scenario similar to that which uranium went through years ago, the Peabody would certainly come out as the 800 pound gorilla. This is one of the strongest balance sheets in the industry and one we would feel comfortable buying early due to our faith that it would at least be one of the last, if not the last one, standing.
Alpha Natural Resources and Arch Coal are the two bubble plays we follow. Alpha we think is in worse shape than Arch, and expect that the company will soon have to take charges relating to their assets on the balance sheet. They are required to do it once a year, but with the upheaval in the industry we would not be surprised if this happened due to the changing economics as they pertain to those assets in question. Also keep in mind that this has been one of the few plays consistently setting new 52-week lows. There are serious problems when that develops into a trend, and for investors in Alpha it has become all too normal.
The one year chart tells the story for Alpha Natural, and looking at the tail end of it tells one all they need to know really. It has been a horrible investment. Things change, and trends reverse but this depends on world economic growth and demand for coal moving up. Price increases mean little for a company such as Alpha, especially when you must factor in the fact that they have numerous mines and production shut-in/curtailed. Demand destruction caused the serious problems for coal, and demand growth will be what leads us higher.
Arch Coal has some of the same issues as Alpha Natural, being a mid-sized player facing many of the same headwinds. We think that the write down issue is more of an Alpha Natural issue and not necessarily industry-wide (and thus not a big concern for Arch Coal). What Arch does need to worry about is their asset base which is located in the Appalachia region and proving less and less competitive as other basins have been discovered and opened around the world. BMO Capital Markets said it best in their report, but the bottom line is that this is middle tier player and can do very well in a great market, basically tread water in a market such as this one and underperform in a market which is poor. They are not the lowest cost producer, but their assets are heads and shoulders above those which the speculative plays own.
And The Ugly
So now that one of our two picks to file for bankruptcy protection has indeed filed, we have but one ugly left. James River Coal (JRCC) is now the smallest player with the highest cost assets. Luckily the company secured financing and has already taken its lumps from the credit agencies. More bad news could be on the way from the credit agencies, but we would suspect that to be a bit down the road as we only recently received an update on their views here. This would be one of the last stocks we purchased in the sector due to the bankruptcy risk and need for high coal prices to push profits and the share price considerably higher. This is the play for when the coal story is extremely bullish, not for times like these or to play a recovery…one never knows how long an entity such as this can last and it is never fun to be correct about the turnaround but have a patient too weak to make it through the treatment.
We remain short-term bearish on coal stocks, however for the big picture trade we have already turned bullish and begun accumulating shares in the natural gas plays with growing exposure to natural gas liquids and oil production. That is important as it affords us time to let that portion of the trade play out while also offering us the opportunity to profit from the shift towards higher margin production. At the end of the day that is a bridge trade to get us to the big buying program we hope to do in the coal sector once it becomes apparent that the industry is finally on the upswing and not going to be driven out of business for political gain or by over regulation. We will of course keep investors abreast of our moves and announce when we initiate step two, the deployment of capital into the coal stocks themselves, of the sequence trade.