As Natural Gas Inventories Plunge, Investors Should Watch Coal Stocks Again

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Based on the reaction of natural gas and coal stocks on Thursday, it appears that the market ignored the very bullish natural gas weekly inventory report. In fact, the report was hardly mentioned in financial media.

For those that originally missed it as well, the weekly inventories for the last full week of March plunged 94 Bcf. In fact, the plunge was so significant that the inventory level dropped below the 5-year average. Normally this time of the year the inventories flat line during the transition season from the heavy usage in the winter to the heavy drilling in the summer.

On top of the plunging inventory scenario, the lack of an energy policy in the US actually has the amount of rigs drilling for natural gas at historically low levels right at the time the numbers should be ramping up. Even worse, the desire to drill for natural gas is also compromised, as oil is more profitable at the current levels. The question is whether coal stocks are an attractive addition to a portfolio as natural gas is set to rise and drilling isn’t going to fill the demand equation.

Plunging natural gas inventories

The weekly natural gas inventories dropped 94 Bcf for the second straight week causing the 5-year average to quickly move from a surplus to a deficit. The turning point around March of each year can have a very wide range. The range has been nearly double from top to bottom with last year having 2,466 Bcf in storage and the low point in the previous years at nearly 1,200 Bcf. The scary part is that the inventory levels were at the highest levels in that span back around the peak in October 2012 and within one winter season the inventory levels are now below average and plunging.

As the chart below shows, the current level of 1,687 Bcf is only 2.1% below the average though the concerning point has to be the trajectory, as only two weeks ago the current inventory levels were 9.5% above the average.

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Historically low rigs drilling for natural gas

Bringing inventory levels into typical ranges is normally a good thing except when the oil exploration companies have moved on to a more lucrative commodity. With the dramatic shift in inventory levels, the industry clearly isn’t prepared or incentivized to drill more. Not only have the best rigs shifted to oily areas, but most of the crews have moved as well. The question is how many are even available to move back to drilling for natural gas and how many explorers are even prepared to add rigs.

The weekly Baker Hughes report showed last week that rigs drilling for natural gas plunged 29 more rigs to 389. The amount of gas-directed rigs is at the lowest since May 21, 1999. The total has plunged 76% from the all-time high of 1,606 reached in late summer 2008.

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Top coal stocks

Investors can use this data to go several directions from investing in oil service providers to drillers to exploration to coal minors. Though, the most devastated group has been the coal companies that have been hit by the double whammy of cheaper natural gas used as a replacement fuel and slowing global growth cutting back export growth. In general, investors can probably invest in the group and make comparable returns from the group. The most intriguing are the following:

Peabody Energy Corp (NYSE: BTU) – Peabody is undoubtedly the leading coal miner in the US with a market cap of over $5B and a revenue base of around $8B. The company is also very profitable having earned $2.05 in 2012 with forecasts of making $1.82 next year.

The stock has dropped from a peak over $70 back at the beginning of 2011 to around $20 now.

Alpha Natural Resources (NYSE: ANR) – the company is the best bet for improving global growth and demand for met coal used in steel making. Alpha Natural has the largest domestic reserves of met coal and is the 3rd largest producer in the world. It also is reliant on Powder River Basin and Central Appalachia thermal coal. The company though has struggled with surging costs in the Appalachia region.

With a market cap of only $1.6B and a revenue base of over $5B, the company has great potential for a rebound. The stock plunged from $70 to start 2011 to nearly $7 now. It needs to turn earnings back into the green for a sustainable move, but rebounding demand could be the answer.

Arch Coal (NYSE: ACI) – the company has been as devastated as the majority of the coal stocks with the market cap plunging to just above $1B. As with Alpha Natural, it isn’t profitable now so increased use of thermal coal in domestic power plants is a must for stock gains.

The company has a revenue base of around $4B and has plunged from $35 to the current price of around $5. It operates 32 mines and controls approximately 5.5B tons of proven and probable recoverable reserves.

Stock Performance

The stock performance of the sector has been horrendous since the start of 2011. The group mentioned above has greatly underperformed the Market Vectors Coal ETF (NYSE: KOL) during that period.

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ANR data by YCharts

Bottom line

The combination of natural gas inventories plunging to below average levels and decade lows in rigs directed at natural gas drilling sets up the perfect storm for a rebound in thermal coal prices in the US.

The above coal stocks are down an average of 80% since the start of 2011 suggesting the potential for a huge snap back rally. Peabody Energy is the best of the sector and Alpha Natural will provide the best returns if met coal rebounds as well. For a pure rebound in thermal coal, Arch provides the best investment. The sector may never reach the peaks of 2011, but the stocks should be set up for a solid rebound in 2013. Both Alpha Natural and Arch could rebound 200-300% without even approaching the previous peak suggesting investors don’t even need to be positive on the coal to see a major snap back rally.

Mark Holder and Stone Fox Capital Advisors, LLC have a position in Alpha Natural Resources. 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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