James River Coal And Patriot Coal Will Likely Retest Lows

Includes: JRCCQ, PCXCQ
by: Adam Gefvert, CFA

This year, coal has felt more pain than it ever has before due to the emergence of an almost unlimited supply of natural gas in the US, and slowing demand in China and the Eurozone. Most of the bigger coal players will get through this downturn, however the fate of the smaller ones are not so certain. The two problem children of the coal stocks are James River Coal (JRCC) and Patriot Coal (PCX).

This situation with coal reminds me of the mortgage insurer crisis last year. I wrote an article here with the same name as this one but replace "coal" with "mortgage insurers". Some of the mortgage insurers went bankrupt, the major one that did was PMI Group (PPMIQ). I remember that it rallied quite a bit right before getting shut down. PPMIQ was like the sacrificial lamb to the other mortgage insurers, as its demise thinned out the industry's competition. Will James River Coal or Patriot Coal become the sacrificial lambs of the coal sector? Will the bigger coal companies shove out these little guys in the fight for a piece of the smaller pie? I'm not sure but one can expect lots of extreme ups and downs and unexpected events to happen before the endgame arrives.

Last week, good news came upon the coal sector and it rallied with a vengeance. Unexpected higher demand for coal came out of Europe and the hot summer in the US demands more coal energy for air conditioning. JRCC and PCX rallied much more than the other coal stocks because they had fallen the most in the sector due to bankruptcy risk. Investor sentiment flipped 180 degrees for these two stocks from extreme fear of a possible bankruptcy to extreme greed for a three to five bagger.

Several events occurred on Friday, June 6th that makes me think JRCC and PCX could soon retest their lows. I was watching the tickers all day on Friday. Volume was very high and there was definitely evidence of heavy support and interest in these two stocks. However, there were also pockets of intense selling pressure and moments of uncertainty and fear. This was illustrated by the beginning of the day. PCX was up about 10% and JRCC was up about 7% in the premarket, despite all the negative sentiment in the stock market and on coal. Then, once the market opened, they both tumbled hard. PCX was actually down 10% at one point, and JRCC down about 6%. Then they both rallied back and stayed green for most of the day until the close when they also turned red along with the other coal stocks.

However, there were several occurrences on Friday that indicates the extreme fear could return:

1. In the US, the jobs report disappointed on Friday. US manufacturing was also down, which means less energy is needed and that includes coal. All commodity prices tumbled, including coal. Natural gas fell by 5% which is bad for coal companies. For coal spot prices to rise, natural gas stop prices have to rise. If natural gas stays low, then electricity generation plants in the US and other countries will continue to switch from coal to natural gas since it's currently cheaper than coal on a BTU basis.

2. Problems flaring up again in the Eurozone. Spanish and Italian government bond yields have approached unsustainable levels and the countries need more financial aid. Finland, one of the healthy EU countries, has threatened to leave the Eurozone if it has to share too much liability with the PIIGS. Although this was an empty threat, it still sends the message that the PIIGS will have to endure harsher austerity measures. Those austerity measures will cause production to contract, which will affect coal demand. Also, the ECB lowered interest rates last week which caused the Euro currency to fall to a two year low versus the dollar. With the Euro weak, that increases foreign exchange losses for US companies to export there.

3. Other bigger coal producers like ANR, BTU, and WLT got hammered much worse than JRCC and PCX on Friday. WLT reached a 52 week low partially because of an S&P downgrade from stable to negative but it retained its BB- credit rating. It also fell because BHP has resolved worker strikes on its coal mines, thereby increasing production and pushing coal prices down further.

JRCC and PCX are at the risk of a further downgrade or other bad news could happen to reignite fear in these stocks. S&P had cut JRCC from B- to the dreaded CCC+ mark on June 25th. Its outlook is negative. Its senior unsecured bonds got further pushed into "junk" territory from CCC to CCC-. On May 23, S&P downgraded PCX from B- to CCC.

If factors don't improve quickly for JRCC and PCX, then the pendulum could swing from extreme greed to back to extreme fear. I'm not saying this will happen, but the risk is not worth the possible reward in my opinion.

Disclosure: I am short JRCC, PCX.