Why Coal Stocks Are a Savvy Long-Term Bet on Natural Gas
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The relationship between coal and natural gas is widely understood by traders in the energy sector, but with the stock prices of companies like Arch Coal (NYSE: ACI) and Alpha Natural Resources (NYSE: ANR) falling to historically low levels, below $7 per share, the sector presents real opportunities.
While most investors interested in playing the expected rebound in natural gas prices look to the top two producers – ExxonMobil (NYSE: XOM) and Chesapeake Energy (NYSE: CHK) – the issues involved with each of those companies are far more complex. Companies in the coal complex will benefit when natural gas prices eventually rebound; when this occurs, investments in coal companies should pay handsome rewards to those who have been patient.
The Coal/Gas Relationship
One of the most prevalent uses of both coal and natural gas is to fire the turbines in electric power generation plants. The two commodities represent substitute goods for this purpose, so when the price of one falls, the other is likely to follow suit to a large extent. When power plants can use cheap natural gas instead of coal, this substitution drives up coal inventories. A building inventory tends to lead to a decline in price.
As can be seen from the chart below, the performance of both Arch Coal and Alpha Natural Resources has followed the performance of United States Natural Gas (NYSEMKT: UNG). When the price of natural gas recovered from its historic lows, while there was a lag, the prices of these coal companies recovered as well. At prices this low, the demand for coal and the prices of coal stocks are likely to be very sensitive to any moves in the prices of both of these underlying commodities.
Why Not be Direct?
While it may seem unnecessary to invest in coal companies in order to gain natural gas exposure, this approach has certain advantages. ExxonMobil is the world’s largest producer of natural gas, but is obviously also a well-diversified energy company. With the price of oil flirting with $100 per barrel, there is a strong argument that oil has made a significant part of any upside move it is going to make. This necessarily limits the commodity-driven price appreciation likely to be seen in the stock. Chesapeake, the second largest producer, is a solid company but is still managing significant debt issues and questions about its CEO, Aubrey McClendon. Both of these companies have certain benefits, but investors looking for pure exposure will receive a greater benefit in the coal complex.
While one might also choose to invest directly in UNG, there is likely to be greater volatility in the ETF than in other proxy options. The downside risk if gas prices dip back to historic lows is greater in UNG than in either coal option. Furthermore, UNG is one of the few commodity ETFs that has experienced price changes based on investor demand rather than moves in the underlying commodity.
The Risk/Reward Profile
At these depressed prices, both Arch Coal and Alpha Natural Resources are trading in close correlation to the price of natural gas. Each reached its respective 52-week low at roughly the same time as natural gas briefly fell below $2. Both stocks are off of these lows, but not by much on an absolute basis.
While these levels are significantly lower on a percentage basis, the upside for each stock is many times higher. Natural gas prices have remained at depressed levels for an extended period of time, and far longer than was expected. It is unlikely that these levels will persist indefinitely, meaning that the prices of each of these coal stocks is likely to rebound as well. With the price of each stock below $7, they may be seen as perpetual call options on a real rebound in gas prices. Investors should not expect immediate results, but over the long term, the reward should justify the wait.
Mr. Ehrman has no positions in the stocks mentioned above. The Motley Fool owns shares of ExxonMobil and has the following options: long JAN 2013 $16.00 calls on Chesapeake Energy, long JAN 2013 $25.00 calls on Chesapeake Energy, long JAN 2014 $20.00 calls on Chesapeake Energy, and long JAN 2014 $30.00 calls on Chesapeake Energy. 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. If you have questions about this post or the Fool’s blog network, click here for information.