How To Play The Major Price Breakout In The Energy Sector

by: Jeb Handwerger

It is amazing to me that investors believe there is no inflation or risk of energy price spikes as the Middle East deals with geopolitical turmoil and Civil War. That complacent mindset may be changing rapidly. Oil is breaking through the $100 a barrel mark, a key psychological price level.

Energy prices look like they are on the verge of a major price breakout on geopolitical tensions in the Middle East combined with a U.S. economy that many say is improving slowly.

I have recently written about a potential rebound in coal as well. It is dirt cheap and is a hated sector by fellow analysts and the investment community as the consensus believes that coal is dead. New regulations from the Federal Government and Obama Administration have made coal very unpopular. Hardly anyone covers this sector right now, which provides astute investors with discounted situations.

A recent Barron's article highlighted the insider buying in the coal sector at a time of extreme negative pessimism. This could indicate a bottom for the coal sector.

Coal giant Walter Energy (NYSE:WLT) had 11 insider buys of over 2 million shares most notably over $150k from CEO Walter Scheller. Natural Resources Partners (NYSE:NRP) had two insider buys. Another CEO of a junior U.S. coal producer in Alabama bought 149,000 shares at the end of May. As the old saying goes, insiders may sell for many reasons but they buy for only one ... potential profit.

I have learned to tread against popular opinion and that great wealth is found during times like these when the consensus is bearish and follow the insiders or the smart money. As Mark Twain said wisely, "Whenever you find yourself on the side of the majority, it is time to pause and reflect."

I see comments all across the media that natural gas is the future as it is abundant and cheap. Do they not realize that natural gas over the past year is up over 70%, outpacing the Nikkei and S&P 500?

When natural gas was cheaper some plants may have converted from coal to natural gas, but now the price rise above $4 may mean this fuel source is becoming just too expensive. Oil's price rise above $100 could put more pressure to use cheap and abundant coal.

Do not forget that coal is still the most used source of energy in North America and around the world. Natural gas is up 120% over the past 12 months, while the rare earths (NYSEARCA:REMX) and coal (NYSEARCA:KOL) are down approximately 30% and oil (NYSE:DBO) and uranium (NYSEARCA:URA) are down 10%.

To those who believe that natural gas will replace coal and oil remember that it would cost hundreds of billions of dollars to replace coal with natural gas and decades for U.S. utilities to make such a transition if they choose to do so, which is doubtful. The historical price of natural gas is much more volatile than coal.

Although the U.S. has abundant shale oil reserves the rest of the world does not and pays much higher prices. Major coal companies such as Peabody Energy (NYSE:BTU) is seeing increased demand from Asian nations who do not have large reserves of natural gas.

Many are saying China is slowing in the short term. However I believe over the long term China's expanding economy will need increasing amounts of cleaner and higher quality coal both for thermal and metallurgical applications to produce steel. The U.S. is blessed with abundant, high quality and cleaner coal. In addition, Japan and Germany have been boosting their imports of coal to record levels. They must make up for the power that was lost from nuclear reactors that have been shut down after Fukushima.

Remember Japan was the largest importer of coal in the world before Fukushima, even with all of its nuclear plants operating. Japan has been dealing with a declining yen and rising natural gas prices. They may be forced to import increasing amounts of cheaper coal and restart its nuclear reactors this month.

There are many emerging nations where people have no access to the electric grid. Countries are looking to modernize their infrastructure. Coal is economically viable for many of these nations.

Countries like India, which had a major power outage recently, need to import cleaner coal from the U.S. as their domestic coal has high ash and sulfur, which contributes to dangerously high air pollution levels. I know that the natural gas boom in the U.S. is remarkable, but the infrastructure in many parts of the country is not suitable for the utilization of the energy source. When natural gas (NYSEARCA:UNG) hit record lows more than a year ago at $2, natural gas plants were running at full speed and still coal needed to be used.

Do not forget the increasing violence and geopolitical turmoil in the Middle East and North Africa. A turn for the worse in this region may be driving oil prices above $100 a barrel. The U.S. may cut back on oil imports and look to turn to safer coal, which is abundant domestically. The coal sector is a major employer throughout the United States.

Fundamentally, coal is certainly not dead, but the coal equities are certainly priced for the graveyard. Large coal miners like Peabody, Alpha Natural Resources (ANR) and Arch Coal (ACI) trade for less than their liquidation value. The large players have challenges. Underground coal mining is unionized and many companies can't pay the costs of the benefits and pensions. The large companies also have some lower quality coals that must be washed or stockpiled due to increasing EPA standards.

Times are certainly tough for coal miners, but I believe in the long-term viability of coal as a fuel source and that demand will grow going forward. Asian demand is still very strong with coal growing almost 20% over the next few years in this region. Despite these difficult times for the sector and increasing regulations there are coal companies with strong fundamentals and cash flow.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.