Get Out Of Coal Stocks

by: Kofi Bofah

Coal is going bust. After coal stocks peaked in Q2 2008, bulls have come out of the woodwork with every leg down to beat the drum in support of this segment of the energy complex. Over the past four years, felled contrarian coal investors lay ruthlessly bloodied by this falling knife. All energy investors recognize that commodities follow a boom and bust pattern that parallels the global economy.

Amid boom times, investors pour money into coal mining infrastructure to produce at peak level, meet demand, and cash out. Over time, high prices will weaken demand. To sell off high supplies of coal, the producers must slash prices. Low profit margins repel investment capital, which consequently degrades supply. The marketplace will then bid prices higher as consumers compete against each other over limited supply. From that point, another boom begins anew.

Patriot Coal's July 9, 2012 bankruptcy filing was the proverbial canary in the coalmine. King Coal, by many accounts, is largely becoming obsolete as an energy source. Coal is going the way of wood as a power generator. With alarming speed, coal is becoming a relic that is only useful for locomotives and steelmaking. Hydraulic fracturing, or fracking, is flooding the market with natural gas. Gas is now a cheaper, cleaner fuel, and utilities are happily making the switch at the expense of coal.

It is high time to get out of dodge. The coal industry must consolidate and re-engineer itself with fewer players. Stubborn investors and Appalachians who refuse to get with the times will bear the brunt of the damage. Right now, a few stragglers remain on this road to Centralia, Pennsylvania, population 10.

Coal and the Energy Complex

To cope with coal stock volatility, novice investors have been forced to quickly transform themselves into seasoned commodities experts. Coal and heavy industry historically go hand in hand. Coke is a byproduct of coal and is essential for steel making. For electricity generation, coal is pulverized and set ablaze to produce steam through a boiler and spin power plant turbines. Traditionally, coal has been the cheapest and leading power source for worldwide electricity generation.

Coal, of course, is associated with environmental damage as a fossil fuel. Coal has been linked to lung cancer, toxic sludge, acid rain, contaminated groundwater, and catastrophic mining accidents. According to Tim Worstall and Forbes Magazine, natural gas is the much better alternative in terms of both energy efficiency and environmental impact. Compared to coal-fired plants, the report indicates that natural gas plants emit half the carbon dioxide, less than one-third nitrogen oxides, and one-percent of the sulfur dioxides. To appease environmentalists, Washington legislation will always favor natural gas production at the expense of coal. Expensive regulatory costs further discourage utilization of coal-fired plants.

Historically, the use of coal was justified due to its steep spot price advantage relative to natural gas. As recently as December 2005, natural gas futures traded at $14 per million BTU compared to $2 for coal per million BTU. Fracking, however, has sparked a U.S. natural gas production boom between the interior Rockies, Texas, and Central Appalachian Mountains. Today, natural gas and coal prices have both converged at equilibrium near the $2 per million BTU price point. In real terms, natural gas is the significantly cheaper fuel, due to regulatory and transportation cost savings above coal's spot price. U.S. power plants are making the switch to natural gas.

The Energy Information Administration [EIA] reports that coal powered utilities are now responsible for less than half of all U.S. electricity generation. In 1990, coal-fired plants generated more than 80 percent of our electricity.

Coal Exports to China

Coal bulls look towards China for salvation. China, population 1.3 billion, always looms as the world's fastest growing large economy. China's demand for raw materials will remain voracious as it industrializes rapidly. China is the world's largest consumer of coal, as its economy demands more than 3 billion metric tons of this fuel per year. As a coal producer, China is only behind Russia and the United States on the list for proven reserves. Productive Chinese coal fields, however, are located in the north and west of the country, and far removed from booming coastal cities. In many cases, total costs for imported coal into China will be cheaper than raw materials transported overland from Inner Mongolia.

As exporters of coal, Australia and Indonesia are poised to benefit most from a booming China. United States coal, however, will remain largely shut in due to both geographic distance and government regimes hostile towards fossil fuel transportation. The Environmental Protection Agency alongside its liberal allies on the West Coast have proven their mettle in blockading major proposals for new coal ports and terminal expansions on the Pacific.

Critics, such as Carol Holding, continue to rail against a $600 million Longview, Oregon port proposal for the terminal to export 44 million tons of coal a year. This ambitious proposal would designate Longview as the largest coal port on the West Coast. After completion, the Longview, Oregon terminal would be twice as large as the then second-place Metro Vancouver, British Columbia coal port.

The backlash against Longview and the jobs it would create highlight America's animosity towards coal. The Left Coast is a bottleneck, and we can expect tons of subbituminous coal from Wyoming's prolific Powder River Basin to remain shut in domestically and off the international marketplace.

Coal investors are left with nowhere to hide.

The Bottom Line

Throughout the past year, diligent investors have been scouring annual reports and balance sheets in search of the ultimate Silver Bullet coal stock. This perfect stock would be loaded with reserves of cleaner burning anthracite coal, while also exploiting a direct trade link of metallurgical coal to China through Australia. Coal cheerleaders will highlight Peabody Energy (BTU) and even integrated miner BHP Billiton (NYSE:BHP) as best of breed, due to their relatively stable cash flow levels and manageable debt service. In nominal terms, Peabody Energy financials compare quite favorably to rivals Alpha Natural Resources (ANR), James River Coal (JRCC), Walter Energy (NYSE:WLT), and Arch Coal (ACI).

At $19 per share, Peabody trades for five times earnings. With this superficial information alone, bulls could easily make the case that this stock is cheap. This logic, of course, would assume static earnings power for Peabody and the coal industrial complex. I, however, would argue that further collapse in coal prices and the consequent deterioration in profits are not yet priced into shares.

Firstly, the sustained China growth story is getting long in the tooth. The Daily Mail and its satellite images reveal eerie ghost towns behind the Great Wall. Whereas former Centralia, Pennsylvania residents abandoned the city in response to coal fires raging underground, the Chinese appear hellbent upon building roads and bridges to Nowhere. The centrally planned versions of Chinese Nowhere are made complete with gleaming skyscrapers, towering monuments, and ornate city squares that are indeed, desolate. These ghost towns cannot be described as "abandoned," because nobody has ever lived there in the first place.

China is overdue for a slow down, if not an outright bust. A slowdown in China would destroy the turnaround story for the coal complex. If anything, I would foreshadow more bankruptcies and steep investor losses for coal. Consolidation is the order of the day and a smaller list of nimble players will survive.

In the intermediate term, an Ice Age winter and spike in natural gas prices is your only hope for profit deliverance as a coal investor.

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