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Friday, May 10, 2013 - 10:00
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Friday, May 10, 2013 - 10:00

Forget Oil And Gas -- This Commodity Is Poised To Rally

Friday, May 10, 2013 - 10:00am

All across Europe, power companies are being forced to mothball natural-gas power plants. In just the past few weeks, renewable-energy companies such as Germany's E.ON and Norway's Statkraft have done so as well, as a key dynamic taking place in the United States starts to have a global effect.

That dynamic: abundant production of natural gas. As U.S. power producers have shifted their multi-fuel plants from coal-burning to gas-burning (known as coal-to-gas, or C2G), demand and pricing for coal have collapsed.

Coal is now so cheap that European electricity producers now realize it's far cheaper to switch back to imported coal rather than continue burning pricier gas. Call it the gas-to-coal movement.

In fact, the C2G trend, a key theme in the United States over the past few years, has run its course. And a switch back to coal has been the new response from some U.S. power producers as well. There is a multi-month lag time regarding power-plant usage, but UBS's analysts noted in a May 1 report that "Coal once again appears to have continued to regain market share in February as it outpaced electric generation while natural gas underperformed electric generation for the third straight month."

This marks a very strong open to the year after coal lost roughly 94 million tons of demand compared with 2011. UBS's analysts added, "Lower production, falling stockpiles, increasing exports, and fuel switching reversals are all finally pointing in a positive direction for coal, especially thermal coal."

That's also a view shared by analysts at Morgan Stanley, who recently wrote, "We think coal burn will surprise to the upside in 2013, resulting in a faster-than-expected inventory drawdown. Thermal coal prices could rally, benefiting shares of thermal-heavy producers."

Specifically, these analysts expect natural-gas prices to average around $4.38 per thousand cubic feet, which, as I noted a few weeks ago, should be quite beneficial for a wide range of gas producers. Yet these analysts think gas prices in that range should also help stimulate demand for coal, predicting that U.S. power-plant consumption of coal will rise this year by 70 million tons, compared with 2012, and another 45 million tons in 2014.

The U.S. export picture is also looking better. Coal exports had fallen sharply in the past few years but have risen roughly 5% this year. The European power plant issue is a likely factor in the upswing.

"We find the sudden strength in export volumes surprising as export prices have not materially improved since the summer decline," UBS's analysts said. "We believe there may be more hope for the export market despite tepid pricing."

As a quick primer, thermal coal has lower energy density, is low-cost, and favored by power producers. Metallurgical coal (commonly known as met coal) packs a lot more heat and is primarily used in the production of coke, which is an important part of the integrated steel-mill process. In effect, these analysts don't yet see a spike in met coal demand, though that trend is certainly worth monitoring when steel production begins to rebound. For now, this is all about the power-plant consumption.

Here's a quick look at a pair of appealing thermal coal producers.

1. CONSOL Energy
Five years ago, shares of this coal producer were trading above $100, though the decimation in coal pricing and demand has pushed shares of CONSOL Energy (NYSE: CNX) down below $35.

Operating conditions grew bleak in 2012 as sales fell 11%, to $5.4 billion, and operating profits fell a sharper 37%, to $497 million. And coal pricing got off to such a rough start in 2012 that CONSOL will likely post further full-year drops in sales and profits. But year-over-year comparisons should turn positive this summer as third-quarter sales and profits are expected to rebound at a double-digit pace compared with a year ago.

Morgan Stanley, which carries a $44 price target, considers CONSOL its top pick, due to the company's low production costs. As an added kicker, CONSOL owns a variety of shale-gas acreage and is benefiting from the rebound in that commodity as well.

Most importantly, management appears to be committed to maximizing shareholder value by selling underperforming assets, which should help the company free up cash to support a boost in the dividend. CONSOL's dividend had been stuck at 40 cents a share from 2008 through 2011. It now stands at 50 cents a share -- and could approach 60 cents a share once those asset sales are complete.

2. Arch Coal
Analysts at UBS rate this thermal coal producer a "buy" as industry conditions finally stabilize. They argue that Arch Coal's (NYSE: ACI) considerable collection of coal-mining assets is undervalued by many investors and that shares have roughly 80% upside to their $9 price target.

Thanks in large part to the rebound in pricing and demand that is now underway, analysts expect Arch Coal to also post much better results into the second half of this year and into 2014. Revenues are expected to rebound more than 15% next year (to around $4.25 billion) and though high levels of depreciation will trigger net losses, operating profits should also grow in excess of 15%, according to analysts.

Risks to Consider: Morgan Stanley's analysts clearly note the upside limit to the coal trade. "By late 2014, thermal markets should break down again as new environmental rules destroy demand and supply grows in low-cost basins."

Action to Take --> That risk factor implies that this is a timely trade and not a long-term investment, which means you should be prepared to book profits in coming quarters if the coal trade works out as planned. Still, industry values are quite appealing at the moment.

P.S. -- If you've been looking to add resource stocks to your portfolio, now may be the time. The global trend for commodities is rising demand coupled with shrinking supplies. That's why we've seen soaring prices for years... and it means short-term sell-offs can be rare buying opportunities. To learn more about Scarcity & Real Wealth, which focuses solely on the market's best resource investments, visit this link.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.