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My Big Contrarian Bet on Coal

CoalDon’t get me wrong — most of the time, most traders are right about most stocks (even if it’s only on a subconscious level). On occasion, though, investors will collectively lose their minds and overdo something.

Right now, I think the crowd is officially wrong about coal stocks after beating them down for a full year — a lot. The Market Vectors Coal ETF (NYSE:KOL) is down a whopping 38% since this point a year ago, and the United States’ coal names have taken on even more water than that. After such a drubbing, there’s just not much ground left to give up. Ergo, I’ve got a nagging suspicion the pendulum is getting ready to swing back in a bullish direction now that everyone’s certain the industry is on its deathbed.

Reasons to Hate ‘Em

Yes, I get the arguments against coal stocks. They include but are not limited to:

  • Low natural gas prices that aren’t going to rebound anytime soon thanks to a supply glut. (Natural gas can be a substituted for coal by many utility providers.)
  • Tapered U.S. demand as “dirty” coal becomes even more politically and socially incorrect. Domestic demand is off by at least 8% for the year so far.

Fair enough. There’s a flip side to that coin, though.

Reasons to Love ‘Em

So what can we say that’s good about coal at this point?

  • Natural gas prices may be low at $2/mmBTU, but they aren’t getting lower any longer now that drillers/explorers have turned off the natural gas spigots to crimp the supply. Halliburton (NYSE:HAL) and Schlumberger (NYSE:SLB) are both shutting down a big chunk of their gas exposure rather than sell gas at a loss.
  • While U.S. demand may be falling (though even that’s in question now), overseas demand is still strong, and actually might be picking up. Some forecasters say China’s need for coking, or “met,” coal still is on pace to increase by 10% this year despite worries of stifled economic growth. India’s need for thermal coal used to produce electricity is up 9% for the year. And yes, coal still is the world’s biggest energy source.

Details, Details

It’s those two positives that really poke a hole in the “coal sucks” argument, and verify once again that details matter.

It is true that natural gas is an alternative to coal-powered energy plants. As gas has gotten cheaper, coal allegedly has looked less and less attractive; the EPA’s tighter restriction on coal emissions also is forcing staggered shutdowns of some coal power plants. Problem is, the tapering domestic demand for coal isn’t falling as fast as coal prices are — the market overshot with its assumption. Yes, the perception is killing mining companies in the meantime, but if they can hang on, coal prices will rebound as natural gas prices stop falling. Both commodities simply need to burn off their bearish price momentum, but things like this have a way of self-leveling.

The details also underscore another important detail — coal’s demise is a North American phenomenon, and is affecting thermal (power-generating) coal miners a heck of a lot more than it’s impacting metallurgical/coking coal miners.

Get the point? The market couldn’t dump coal stocks fast enough over the past few months, but some of these names are heavily into coking coal, and a bunch of them don’t rely on U.S. demand for thermal coal. Unfortunately, not many traders have been looking at things with that kind of microscope.

The $64,000 Question

To be clear, I think the whole coal industry is going to benefit at least a little from a sweeping reversal of the downtrend once natural gas confirms a bottom and coal prices stop bleeding. But some of these stocks are better-positioned than others for that bounce.

One of the better-looking stocks is Peabody Energy (NYSE:BTU). The company is looking for a 10% increase in coal demand, by tonnage, for 2012. Part of that demand is going to be fueled by 90 gigawatts of new coal-fired power plants, which will require an additional 300 million tons of thermal coal to operate. They’re all overseas plants, though, which is why we don’t see or hear about them.

Oh, and it just so happens that Peabody Energy is positioned — including geographically — to meet a big chunk of that demand, especially after acquiring Australian mining company MacArthur Coal, which feeds it to China like candy.

If you really wanted a contrarian coal play in front of a completely unexpected coal rebound, though, Arch Coal (NYSE:ACI) is it. The market pretty much hates ACI right now judging from the (no, this isn’t a typo) 75% bloodbath the stock has taken since last April.

Funny thing about the smack-down, though: Arch Coal never booked a loss in any of those quarters, and revenue actually grew during that time.

That’s not to imply the company is bulletproof, because it isn’t. Indeed, Arch Coal explicitly made a point of noting a mild winter and a (likely temporary) slowdown in Asia meant generator stockpiles were getting uncomfortably high. It’s even aiming to sell $600 million worth of its thermal coal mines.

Yet, if you read the fine print, the company also is looking to expand its metallurgical coal mining operation to meet — you got it — growing overseas demand of 5%+ for coking coal this year. Shedding the lower-margin thermal coal mines might actually improve overall margins. It also will keep it away from the heart of the thermal coal rat-race in the United States, which seems to be where the glut is forming.

The 4.5% yield on Arch Coal isn’t bad either, especially at a P/E of 13.1.

No matter how you play it, though, the worst-case scenario seems to be fully baked in for all these names, leaving them nowhere to go but back up — right when it’s the last thing the masses expect.

Welcome to trading.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media, https://investorplace.com/2012/04/my-big-contrarian-bet-on-coal/.

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