After the shellacking that coal stocks have experienced over the last few years, Morgan Stanley’s recent upgrade of coal kingpin Peabody (BTU) is a very welcome sign. Its beleaguered and downtrodden investors managed to send shares of BTU up around 5% on the news. Likewise, shares of coal stock rivals — Alpha Natural (ANR) and Arch Coal (ACI) — also rallied.
But the recent upgrade is only the latest piece of bullish news for the coal sector.
After falling around 20% in both 2012 and 2013, the broad-based sector measure — the Market Vectors Coal ETF (KOL) — has gained almost 8% since early February. That move has prompted several investors and analysts to believe that bottom for the sector is finally in and more gains could be in store.
I’m not so sure.
While the medium term is certainly singing coals praises, the longer term is just as rocky. So is the rise in coal stocks actually for real? It just depends on your timeline.
A Bullish Set of Factors for Coal Stocks
James River Coal’s (JRCCQ) bankruptcy filing aside, it has actually been a good couple of months for coal stocks. The vast majority have moved upwards from their lows. The bulk of those gains could be tied to rising natural gas prices.
As the cold and snowy winter gripped the United States during the first quarter, the country began to seriously deplete natural gas inventories. As such, prices for the fuel began to rise and recently touched the $6 per MMBtu mark. While still substantially less than records, that high price for natural gas does clip some of its appeal from utility standpoint. Many utilities have been making the switch to natural gas from coal as prices for the fuel remain low.
With coal prices now trading for less than natural gas, there’s less incentive for an electricity provider to make the switch. Add in the steadily rising growth in the U.S. economy, and coal miners look like they’re in the driving seat when it comes to providing some big returns in the months ahead.
Morgan Stanley’s upgrade of BTU highlights these points. Analyst Evan Kurtz predicts that the U.S. will burn around 63 megatons this year, while inventories of the fuel — due to mine closures since 2012 — will fall to “near historic lows” and see a modest price recovery throughout the year.
The Rub for Coal Stocks
So with the potential for higher coal prices and earnings on the horizon, the time to bet heavily on the coal stocks could be at hand, right?
Well … it’s not that easy.
First, the main reason for coal’s place in the sun has been rising natural gas prices — something that appears to be changing. Already, demand for natural gas a fallen, and E&P firms are once again producing an abundance of the fuel. While inventories are still below 5-year averages — due to the prolonged drawdown during the winter — the trend for new gas entering our storage facilities is upward.
Last week, the Energy Information Administration (EIA) reported that inventories of natural gas increased by 74 Bcf (billions of cubic feet). That brought current supplies up to 1055 Bcf, whichwas more than what analysts had been predicting. Following several weeks of rising inventories, Henry Hub natural gas prices are now trading for around $4.57 per MMBtu — right around a good place for utilities to start switching over again.
And more importantly, when they do switch, they aren’t going back. Retrofitting and building new gas fired plants cost billions of dollars to do. Once a utility puts in the capex, they aren’t going spend more to go back to coal. Nor do they have an incentive on the regulation front. The Obama Administration and the EPA have essentially made coal enemy number one. The costs for using coal as your fuel source are growing — even when the price of it has fallen.
Aside from those factors, pressure on coal stocks could be coming from another front — pension funds and institutional investors.
Stanford University’s recent decision to sell nearly $18 billion worth of coal shares from its endowment is just the latest bid by various large institutional investors to use activism to their advantage. Both CalPERs & CalSTERs — two of the largest pension funds with well more than $300 billion in assets — have both flexed their combined muscle when it comes to green and social responsible investing. So has the State Retirement System of New York.
As institutional investors continue to dump coal from their portfolios, the downward pressures could be great.
Leave Coal Stocks Alone
In the longer term, it still looks like coal’s days are numbered here in the U.S. The pressures are still there and the recent rally may be short lived. The coal sector shake-out is still only in the third inning or so.
As far as BTU’s recent upgrade of coal stocks, Peabody is probably the best investment. Its size, scale and scope makes it perfect to weather the continued storm. It’ll still producing far into the future and most likely exporting the bulk of that production. If you’re going to bet on the sector, BTU is the one to choose.
As for the rest of sector — ANR, ACI etc. — coal still remains a possibly profitable trade for this year. But the longer-term pressures are just too great to make coal a good investment.
As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.