How Can You Profit If the EPA Gets Tough on Coal?

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

President Obama recently announced that he is directing the U.S. Environmental Protection Agency to create regulations that would limit the amount of hydrocarbons released into the atmosphere from coal-fired electricity generating plants.

At first glance you would think that the move would be detrimental for the coal industry in particular, the utility sector and possibly the overall economy. It has the potential to reduce coal mining employment, raise electricity prices and add costs for utilities. Some companies might even go out of business.

Introduction

The average person has little say in the matter. However, the average investor might be able to take advantage.

If the EPA regulations result in reduced coal consumption there may be a need to generate more electricity using natural gas.

The other options include nuclear, wind, hydroelectric and solar. None of them completely address the entire market and wind and solar are not particularly viable based upon the current state of technology. In the case of nuclear there are high capital and operating costs, not to mention the fact that it takes decades to build a new plant.

In the short term costs may increase (unless the government subsidizes the process) if coal-fired plants are converted to gas or brand new facilities are built.

However, over the long term the upstream and midstream segments of the natural gas industry could benefit if things change. 

Upstream

A major player in the extraction of natural gas (and crude oil) from shale deposits is Halliburton (NYSE: HAL).

The company, the leading supplier of hydraulic fracturing ("fracking") services in the world, would see higher revenues once demand for natural gas goes up. Right now that segment, which comprises about 25% of the company's drilling and exploration business, is a bit suppressed due to relatively low prices. Less coal and more gas will change the dynamic. 

Earnings will increase too if the company continues its technological innovation. Lately it has been able to reduce drilling costs by about 4% per well by using improved extraction methods. Expect even more improvement in the future if the trend continues.

Halliburton must deal with the continuing fallout from the 2010 Deepwater Horizon disaster. It was deemed partially responsible for one of the worst oil spills in history. If the issues are not satisfactorily resolved then it could continue to hamper performance. The company reported a charge of about $637 million against earnings in a recent filing.

Another caveat for Halliburton is the P/E ratio of 20 which is a little higher than its peers and the overall market. The stock might be a bit overvalued at the current price. That will change if the price for gas goes up down the road. 

Midstream

After gas is removed from the ground it requires transportation to storage and distribution sites and then to the end user. A lot of that is done by companies called master limited partnerships. They build and own the pipelines that move the gas.

One MLP that might be good for your portfolio in the long term is ONEOK Partners, LP (NYSE: OKS). This well-managed company has been growing earnings and its dividend over the years. Shares currently yield 5.8%.

Revenue, as the result of the drop in gas prices, has taken a hit recently, declining by 6%. As in the case of Halliburton, if prices go higher due to increased demand that will change.

The stock price dropped like a rock this spring probably due to a combination of that lower revenue and speculation that the Federal Reserve will taper its bond purchases sooner than expected.

The thought is that high yielding stocks like MLP's won't be as attractive as less "risky" assets. Again, I would expect a reversal of that trend going forward if demand for gas goes up.

At a P/E of about 19 right now ONEOK stock is priced just about right considering its juicy dividend. 

Chugging along

It takes a lot of sand, pipe, steel, water, chemicals and other supplies to get natural gas out of shale formations. The railroad industry could benefit from transporting those needed materials to the fields.

One railroad, CSX Corp. (NYSE: CSX), derives about 25% of its business from coal shipments. If that declines due to EPA regulations the company will need to replace the revenue stream. One way to do that is by servicing the natural gas industry, which will move in the opposite direction.

The company is preparing for that situation by adding railcar capacity to move fracking sand to the shale fields in the Eastern U.S. Right now the capacity is at 13,000 carloads which should grow at about the same rate as rig count, projected to be around 4% per year.

CSX has been able to double its dividend and increase earnings by 50% over the past five years. That performance should continue going forward. The stock seems fairly priced with a P/E ratio of 13 that is well below the market average and its peers. You might want to get in at the current price.

Conclusion

So all may not be lost for the individual investor if the government cracks down on coal. You may be able to profit if natural gas takes over.

Companies like Halliburton, ONEOK and CSX may benefit if the transformation occurs. Halliburton also needs to address the current issues plaguing it as well. 


Mark Morelli has no position in any stocks mentioned. The Motley Fool recommends Halliburton and ONEOK Partners, L.P.. 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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