Is the Coal Industry Nearing a Bottom?

Source: Thinkstock

Source: Thinkstock

Coal and related equities have been among the worst performing stocks over the past several years. Not only has demand for energy been weak, but the Obama administration has been notoriously anti-coal. In fact, the sensationalist mantra created by the media is that Obama set out to kill the coal industry.

While this sounds like it is over the top, the weakness in the coal market and in related equities make it believable. In 2012, the EPA limited the amount of carbon emissions that a coal plant can produce. We have since seen the bankruptcy of Patriot Coal (OTCMKTS:PCXCQ), the collapse in shares of James River Coal (NASDAQ:JRCC), and incredible losses coming from even the largest and most efficient players in the industry such as “best in breed” Peabody Energy Corporation (NYSE:BTU).

But, while coal seems like a dangerous investment given the harsh regulatory environment, it is during these periods of extreme weakness that the best contrarian ideas can generate life-changing returns. Of course, I am not going to advocate a contrarian bet simply because it is a contrarian bet. But there do seem to be signs that the industry is turning around. Furthermore, we are seeing a strong rebound in coal prices by nearly 20 percent in the past 6 months from $50/ton to $60/ton.

There are at least three bullish factors that should drive coal prices higher in the coming years. First, we are seeing demand outpace supply. According to the U.S. Energy Information Administration, we are seeing about 10 million more tons of demand than supply this year in the United States. Indian coal demand is rising dramatically, too, despite the fact that the India produces less coal than it consumes. While it can import much of this from China and Australia, these two countries are also seeing some supply constraints due to environmental regulation. Furthermore, while global coal supply is rising somewhat, we are seeing that lower prices make some coal uneconomical to produce, and this means less supply down the road.

Second, geopolitical tensions in the Ukraine and the Middle East make it less desirable to use oil, and it also increases the tail-risk possibility that we will see a spike in oil prices. Such a spike would be bullish not just for oil futures, ETFs, and related equities, but for energy more generally as reduced oil demand will leak into natural gas, uranium, coal, solar, and so on.

Third, for many producers the price of coal is at or below the cost of production. As I have already mentioned several companies are having trouble turning a profit at $60/ton. If the price doesn’t rise, then these companies will be forced to shut down their operations. This will make coal mines that are producing more valuable. It also means that they will be beneficiaries if low prices create a shortage and a price spike.

While there is regulatory risk, I think these reasons are sufficient to justify taking at least a small contrarian position in the coal mining sector. Investors who are interested in coal mining companies will be pleased to learn that a lot of these stocks are close to forming double bottoms with their June or July lows, and so there is a good reference point for those who want to get involved while using stop options in case the trade doesn’t work out.

While there are several individual companies investors should first consider, the Market Vectors Coal ETF (NYSEARCA:KOL) fund used to be a lot bigger and more liquid than it is today, but due to lack of interest, this is no longer the case. This is a good way for investors to get diversification among coal miners. However, keep in mind that several of these companies are Chinese companies. We know that China’s economy is decelerating and this could put pressure on Chinese stocks even if the coal price rises. KOL shares are trading at just under $18/share and are within reaching distance of their 52 week low of $17.16/share. This could be a good buy point for traders interested in this ETF.

Another option that I like is a company called Alliance Resource Partners (NASDAQ:ARLP). Alliance Resource Partners has remained highly profitable throughout the downtrend in coal and the shares are in striking distance of an all time high. The company has very low production costs, and it eschews many of the environmental issues as it sells its coal to power plants that have pollution control devices installed. This is also a great stock for dividend investors. The company pays a dividend of over 5 percent and it has been able to raise this dividend on a quarterly basis going back several years. While investors may make more money owning the higher beta stocks that are found in the Market Vectors Coal ETF, value investors who are risk averse will find the company’s 11 P/E, double digit return on equity, and rising dividends very appealing.

Disclosure: Ben Kramer-Miller is long shares of Alliance Resource Partners.

More From Wall St. Cheat Sheet: