Play the Coal Rebound With These Stocks

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It's important for investors to understand that there are two types of coal mined. The first is thermal coal which is used by power plants to heat homes. The second is metallurgical coal which is used by steel plants to produce steel. Each one has been affected by different market dynamics that delivered a two-prong hit to the entire coal industry.

Thermal coal has been hit by cheap natural gas. Hydraulic fracturing has expanded supplies of natural gas in the U.S., and the price of natural gas has come down dramatically from almost $15 to under $2 last year. The cheaper natural gas lead to many power plants switching from coal to natural gas. As natural gas prices have rebounded to over $4, coal switching looks likely now. That will not only support coal producers, but the railroads that transport the coal.

In the metallurgical coal market, producers have had to deal with over-supply and a global slowdown. Steel demand has been particularly weak in Europe, and China's economy is not growing as fast as it used to. Couple that with new mines coming online, and you have a classic supply/demand imbalance. Look for the market to balance itself out later in the year as the global economy recovers and improves.

Two coal stocks

CONSOL Energy (NYSE: CNX) is a diversified energy company that produces both coal and natural gas. The company's coal operations mine both thermal coal for power generation and metallurgical coal for use in the production of steel. CONSOL explores and produces natural gas in the Marcellus Shale and the Utica Shale.

CONSOL Energy is one of the companies that has reduced costs as coal prices have come down. According to Chairman & CEO J. Brett Harvey:

Our tier one low-vol assets at Buchanan Mine are perhaps the lowest cost metallurgical coal assets in the country. While I believe that the investment community has has been more focused on lower prices from a softer world-wide met coal market, our ability to successfully manage costs has helped mitigate the impact of lower prices on profitability.

Arch Coal (NYSE: ACI) is a top five global coal producer, selling 141 million tons in 2012. The company has mines in Wyoming, Utah, Colorado, Illinois, West Virginia, Kentucky, Virginia, and Maryland, representing 15% of America's coal supply. Domestic reserves total approximately 5.5 billion tons, of which 70% is low in sulfur.

The CEO of Arch Coal echoed similar sentiments as CONSOL's:

Despite the global coal market headwinds that have prevailed over the last 18 months, we are delivering strong cost control, exercising capital restraint and minimizing cash outflows in the trough of the market cycle, while maintaining our commitment to safety and environmental excellence. As the market cycle turns, we are confident that our low-cost operations will generate strong cash flows and value for our shareholders.

Outlook for both coal stocks

We must now look forward and see what the future holds for these two coal stocks. Both companies have reduced costs and have positioned themselves for an improving market. Chinese economic data has been improving, and that means more steel demand for construction projects and more coal needed to produce that steel. The U.S. economy has been recovering as well, and that bodes well for steel demand.

Natural gas prices are forecast to continue rising and that favors more natural gas to coal switching. Natural gas prices are double of where they were a year ago. As the market cycles turn, look for coal demand to pick up, supply to decrease, coal prices to rise, and profits to increase at these two coal producers.

Two rail stocks

In the rail space, it's important to understand that most coal production is east of the Mississippi. To play the coal rebound, you want to be in rail stocks that have good exposure to the coal producing regions.

CSX (NYSE: CSX) transports coal to electricity-generating power plants, steel manufacturers, industrial plants, and deep-water port facilities. The company operates approximately 21,000 route mile rail network covering 23 states east of the Mississippi River. The company operates over 4,000 locomotives.

The other rail stock on the east coast is Norfolk Southern (NYSE: NSC). Norfolk Southern transports coal to utilities, industrial plants, export facilities, and to steel manufacturers. The company operates approximately 20,000 miles of rail over 22 states and the District of Columbia.

Outlook for these two rail stocks

The lack of coal demand has been a problem for the rail industry. An estimated 40% of all railroad tonnage is coal. Low natural gas prices not only hurt the coal stocks, but the rail industry as well as less coal was shipped. Both CSX and Norfolk Southern have traded at lower multiples than the biggest railroad, Union Pacific, because they are more exposed to the coal cycle. As the commodity cycle is turning for coal, look for both stocks to catch up to Union Pacific in terms of multiples. CSX and Norfolk Southern both have P/Es just above 14, whereas Union Pacific trades at a P/E of over 18. Look for CSX and Norfolk Southern stock to rise and trade closer to Union Pacific's 18 P/E.

Foolish assessment

I see the coal cycle as having bottomed out and the tide is now turning for these coal and rail stocks. All four are great ways for investors to play this rebound and capture profits.

With 21,000 miles of track serving two-thirds of the U.S. population, CSX maintains a valuable proprietary asset. Still, this railroad will face difficult obstacles in the years ahead due to a domestic surplus of natural gas and coal’s declining popularity. To help investors better understand how CSX can deal with these challenges, The Motley Fool has released a brand-new premium research report authored by Isaac Pino, Industrials Bureau Chief and transportation expert. Isaac provides an in-depth look at CSX’s competitive advantages, risk areas, and prospects for the future. Simply click here now to access your copy of this invaluable investor's resource.

Mark Yagalla has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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