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The Contrarian Case for Coal Stocks

The sudden abundance of natural gas and tightening of coal-emission standards by the EPA has pushed U.S. coal prices down sharply over the past five years as generation plants shifted their energy preference to the cleaner and cheaper resource:

^DJUSCL Chart

^DJUSCL data by YCharts

While no one is suggesting we’re at the dawn of a new coal age, a research note from Westwood investment management makes an interesting case for why we may be at an important inflection point. With natural gas losing some of its pricing edge relative to coal and coal inventories already at lows, we could be at the turn for an incremental shift in demand for coal. “…(W)e believe that 2014 could mark a new profitable stage for the coal sector as headwinds have turned into potential tailwinds,” wrote Westwood’s energy research team.

In fact, over the past six months, coal prices have indeed shown a bit of recovery.

^DJUSCL Chart

^DJUSCL data by YCharts

For the same period last year, the index was down more than 10%, suggesting the recent uptick is not some seasonal norm.

Westwood didn’t name stocks in the report, but checking recent portfolios, Cloud Peak Energy (CLD) and Consol Energy (CNX) both show up in the Westwood SMidcap Institutional mutual fund.

With a $1.1 billion market cap, chances are Cloud Peak Energy isn’t on your radar. That said, it’s the largest public pure-play for coal produced in the Powder River Basin (PRB) that bleeds across Montana and Wyoming. As this chart shows, falling demand/prices has been a serious hit:

CLD EBITDA (Annual) Chart

CLD EBITDA (Annual) data by YCharts

In its 2013 annual report, management suggested 2014 could be a moderate turning point: “Current coal burns appear to be recovering from the low levels in 2011 and 2012, which should lead to an improved supply-demand balance this year. If it does, we hope to see prices increase to levels that allow profitability to return to previous levels.”

Goosed by the polar vortex and rising natural gas prices, coal-fired power at electric plants rose 15% this past winter and coal consumption rose 10%, according to Energy Information Administration data.

At the same time, those plants still using coal as a complementary energy source to natural gas are staring at lower inventories. While demand grew during the frigid winter as utilities augmented natural gas (and its steep price climb) with coal, the same frigid winter slowed coal rail deliveries to the power plants. In its first quarter earnings release Cloud Peak management suggested all those moving pieces provide a potential support for coal going forward: “The recent increases in PRB coal prices should be maintained due to low natural gas storage levels and coal inventories going into the summer cooling season. It is possible that, if there is a normal summer cooling demand, it will be difficult to rebuild coal and natural gas inventories ready for next winter.”

Morningstar (MORN) has a fair value estimate of $26 per share for Cloud Peak, which puts the stock at a steep discount for investors with a bit of a contrarian bent.

Consol Energy is a natural gas and coal producer based near Pittsburgh with coal mines in Pennsylvania, Virginia and West Virginia. The $10 billion market cap energy producer is also telegraphing increased coal demand. Management guidance is for 30.1 to 32.1 million tons of coal sales this year. At the low end that’s a near 6% increase over last year’s haul and at the high end it would represent a 9% sales gain. In the first quarter of this year the turnaround seems to be playing out, as sales were sales were 6.7% higher than Q1 2013.

Given its natural gas complement, Consol Energy has a more diversified portfolio to navigate increased coal emission regulation. In late April the U.S. Supreme Court backed an EPA initiative to tighten emission standards. Here’s how the two stocks have fared since:

CNX Chart

CNX data by YCharts

But that belies the fact that about 40% of our nation’s electricity is still generated with coal. That isn’t going to change overnight. Moreover, coal-heavy utilities including Southern (SO) and American Electric Power (AEP) are in the midst of retooling existing coal plants (and shutting down some as well) to meet tighter environmental standards.

From a valuation standpoint, using EV to EBITDA, Cloud Peak is trading at a lower entry point:

CNX EV to EBITDA (TTM) Chart

CNX EV to EBITDA (TTM) data by YCharts

And Cloud Peak is even cheaper than Peabody Energy (BTU) a $4 billion coal producer with operation in the U.S. and Australia:

CNX EV to EBITDA (TTM) Chart

CNX EV to EBITDA (TTM) data by YCharts

Carla Fried, a senior contributing editor at ycharts.com, has covered investing for more than 25 years. Her work appears in The New York Times, Bloomberg.com and Money Magazine. She can be reached at editor@ycharts.com. Read the RIABiz profile of YCharts. You can also request a demonstration of YCharts Platinum.

Read more articles about: Company Analysis  coal   natural gas   energy stocks   stocks that look cheap   

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