What's Ahead For U.S. Coal Stocks Up 30% From October Lows

Includes: ANRZQ, PCXCQ
by: Peter Epstein

On average, U.S. coal stocks are up ~32% from early October, 2011. Is this move sustainable? Can coal stocks rally further from here? Back in September/October, coal stocks became oversold on fears of a U.S. recession and a marked slowdown in China. However, at that time, thermal and coking coal prices had barely budged to the downside. Today, with the coal stocks ~32% higher, coal fundamentals are substantially worse. As a result, investing in coal stocks after this rally requires a bullish view of equity markets overall and coal fundamentals in particular.

Given the huge employment numbers that came out on Friday, it's difficult to say that coal stocks will not continue to rally. But to reiterate, coal fundamentals were strong 3 months ago, and now they are weak. In my opinion, a bull case for coal stocks is largely predicated on a rebound in coal prices.

But headwinds on domestic coal prices are clear for all to see. A mild winter and very low natural gas prices have crimped demand for thermal coal. Depressed domestic coal prices and weak export demand caused 2 eastern coal producers to cut production last week. After Friday's close, Steve Doyle of Doyle Trading Consultants reported:

Alpha Natural Resources (ANR) announced this afternoon that they will reduce annual Capp production by 4 mm tons (1.5 mm met and 2.5 mm thermal) due to weaker coal demand caused by ten-year low natgas prices. The reduction will be achieved by ANR idling six mines (four immediately and two between now and early 2013), and dialing back production at other operations.

This news comes just a few days after Patriot Coal (PCX) announced similar cuts to thermal and coking coal production. Patriot was very clear on its earnings conference call that they expect domestic thermal coal prices to remain depressed for at least the remainder of the year.

2011 was a year of strong exports of both thermal and coking coal. 2012 is not shaping up the same way. Several domestic and global coal producers have reported that demand is very sluggish. Weak exports are another overhang on domestic coal prices. It seems that there's no easy answer to depressed thermal coal prices over the next several quarters. However, these much needed production cuts signal to some market pundits a possible bottom in coal prices.

Quarterly benchmark coking coal prices, which peaked at $330 per metric tonne last year, have fallen to $235. Some believe that a 2nd quarter price settlement of $200-$225 per tonne will mark the bottom. If true, does reaching a bottom in coal prices mean that it's time to buy coal equities?

Historically when coal prices bottom, it's been a good time to buy coal equities. However, I think that recent buying of the coal names has largely priced in a possible bottoming. If one believes that Europe will not fall into a prolonged recession, that China will hold its own and that the U.S. economy will grow at say 2.5% or more this year and next, then continuing to buy coal stocks might make sense.

But one needs to keep in mind how volatile the coal stocks are. My hurdle rate for investment is 25% +. I'm waiting for a pullback in the sector before deploying incremental capital.

Disclosure: I am long ANR, PCX, CNX, TMCGY.PK, CLNMF.PK, BTU.