The Coal Conundrum

Douglas is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Thursday’s trading session saw another explosion in the price of coal stocks, including Alpha Natural Resources (NYSE: ANR) up nearly 17%, Arch Coal (NYSE: ACI) up nearly 16% and Peabody Energy (NYSE: BTU) up nearly 9%. The catalyst for the move, however, seems to be a matter of some debate and a subject worth exploring before a cohesive investment thesis can be formulated. The two major factors being cited are the rise in the price of natural gas and the rebound in Chinese steel prices, although there is a healthy dose of campaign jitters thrown in for good measure. While it is likely that each of these forces have influenced prices, deciphering each will help to lead us to an informed decision on coal stocks.

The Political Angle

This is perhaps the most straightforward influence on coal prices moving forward into the U.S. Presidential Election. Generally, Governor Mitt Romney, who openly stated the he “likes coal” in the recent debate, is seen as a supporter. This means that as he pulls ahead in the polls, coal companies are seen to be potentially gaining a supporter in the White House. President Obama, in contrast, has a clear record on his preference for alternative and cleaner energy options. While a U.S. policy shift away from coal could never be announced prior to the election, industry insiders have their fears. An Obama re-elect would be seen as bearish for coal.

Types of Coal

What most careful coal investors already understand, but which is worth repeating anyway, is that coal comes in two varieties: thermal coal and metallurgic coal. Thermal coal is used primarily by power companies to run turbines that produce electricity. Metallurgic coal, however, is a critical element in the production of steel. The factors that drive demand and prices for each type of coal can differ greatly. While most large coal companies produce both varieties, it is important to understand the difference. Alpha Natural Resources and Arch tend to focus more heavily on metallurgic coal, while Peabody has a heavier thermal element.

The Influence of Natural Gas

Natural gas prices hit a new yearly high during Thursday’s trading session, breaking the $3.60 level for the first time. The price of natural gas has a dramatic influence on the price of thermal coal because the two commodities are substitute goods. When natural gas prices are very low, power generation can switch from thermal coal to natural gas in order to operate more economically. Accordingly, and in order to stay competitive, coal prices tend to fall when gas prices do in order to remain competitive. The high output of natural gas from U.S. fracking operations has driven inventories very high and gas prices down. The recent report showed a smaller-than-expected build in inventories that was partially responsible for the price movement in both natural gas and coal.

The Ever-Present China Factor

On the metallurgic side of the coal market is the expectation of increased demand for steel from China. More specifically, some analysts have seen a rebound in the price of Chinese rebar – used to reinforce concrete – which is, in turn expected to increase demand for metallurgic coal. One catalyst for the reversal is the Chinese stimulus program that was recently approved, but the general state of China’s economy seems to have stabilized somewhat, also helping the demand for coal.

Who is in the Driver’s Seat?

While each of these factors had an impact on the recent increases in the price of coal, determining which had the greatest influence is important because it should offer some longer-term indication about the sustainability of the reversal. The political angle clearly has a built-in clock, causing many more cautious investors to stay on the sidelines until after the election. There is some merit in this position, but the demand for coal is largely outside of the U.S., meaning that the results of the election will have a limited impact on the overall market. Plus campaign promises aside, the U.S. has coal and we’re almost certainly going to use it.

If the rise in natural gas is the main driver, the move is likely subject to greater volatility. While some analysts expect gas prices to continue to advance, the price of the commodity has proven subject to large swings that are often hard to predict. Furthermore, the significant inventories may have grown slower than expected, but they are still significant and near or at all-time highs.

<img src="" />

ANR data by YCharts

The best case for coal is if Chinese demand is the principle driver of the surge in coal prices. The outsized moves by ANR and Arch relative to Peabody suggest that this may be the case. As some additional evidence, coal prices have been advancing essentially independently of natural gas prices – the chart above shows the relative performance of ANR and Arch against United States Natural Gas (NYSEMKT: UNG) over the last month. Since late 2010, all three of these stocks have gotten clobbered, meaning the recent pop is minimal on a relative basis – see chart below. As such, given the outlook that metallurgic demand is driving the rally, both Arch and ANR are attractive at current levels.

<img src="" />

ANR data by YCharts

Mr. Ehrman has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. 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.

blog comments powered by Disqus