Commodities Bearing Down on Your Portfolio

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Both iron and coal entered bear markets earlier this year, meaning that a number of portfolios have been feeling the pressure, mainly due to weakness in China. The commodity-using giant appears to be at the root of much of these declines. Bank of America recently reduced its estimate on China’s 2013 gross domestic product growth to 7.6% from 8%, noting that Chinese macro data is deteriorating. 

Coal downfall

Next to the China slowdown, another big headwind for the coal companies is increased competition from cleaner-burning natural gas, which is stealing market share in the U.S. This has been the direct result of the switch from coal to gas by utilities, where low natural gas prices have made the energy source more attractive. 

Back to China, coal is China's key energy generator, and the commodity is heavily reliant on the macroeconomic environment. Thus, any slowdown in China's bustling economy will have a negative impact on coal demand. The coal companies saw impressive growth over the past decade with the rapid growth in the global economy and real estate boom, but since early May 2012, the coal market has started to cool. 

Peabody Energy (NYSE: BTU) is the world's largest publicly traded coal company, having some 9 billion tons of coal reserves. Peabody's coal fuels 10% of the electricity generated in the U.S. and 2% worldwide. Peabody also has a significant Australia mining operation and more international exposure than some of its coal peers. The one positive note is that this international coal exposure helps better insulate Peabody to country-specific headwinds. 

However, there still appears to be various headwinds. Peabody recently issued EPS guidance for second quarter of 2013 between a loss of $0.25 and a gain of $0.01. Meanwhile, analysts had consensus estimates at $0.01 before the announcement. Analysts have also turned bearish on the remainder of the year. A month ago the fiscal 2013 EPS estimate was $0.17, and its now down to a loss of $0.07. 
Alpha Natural Resources (NYSE: ANR) is the third largest coal producer in the U.S. -- operating in the Appalachia and the Powder River Basin. Revenues are expected to be down 23% in 2013 due to lower coal volumes and coal prices. One big issue that Alpha is faced with, relative to Peabody, is that U.S. natural gas production is on the rise.
Alpha also posted a first quarter loss of $0.50 per share, compared to its $0.13 per share loss a year ago. Part of the EPS compression was related to bringing Massey mines up to safety standards, but one of the other issues was a 30% decline in coal revenues. 

With the weak demand in the coal markets, many of the coal companies are looking to improve cost structures. This is a positive for Alpha. Last fiscal quarter, the company saw its cost per ton down to $43.50, compared to analysts' estimate of $45.50. However, the coal company is still expected to post negative yearly EPS in both 2013 and 2014. Over the past three months analysts have widened their loss expectations by 7% for 2013 to a loss of $2.07, and lowered 2014 expectations by 33% to a loss of $1.73 . 

Iron weakness

Iron has also fallen into a bear market on the back of slowing China growth. One of the overhangs is the fear of China credit tightening, including a slowdown in its housing market. The biggest end use for iron is steel. 

Vale (NYSE: VALE) is the world's largest iron ore miner and the world's second largest nickel producer. Sales for the iron ore company were down 24% in 2012, but are expected to be positive in 2013. Despite previous weakness in Chinese steel, the World Steel Association expects Chinese steel demand to grow by 3.5% in 2013, which is a positive for iron producers. 

Last quarter, Vale posted impressive results, with operating income up 40% year over year and operating margin expanding to 38%. And unlike some of the major coal and iron ore companies, analysts expect Vale to see slight EPS growth in 2013, albeit a mere 1%. 

One of the potential demand positives for Vale could come from a changing demand profile in China. China has primarily been an investment-driven (i.e. infrastructure) country, but with a rising level of urbanization, there could be a shift toward a more consumption-driven country. This could lead to a boost in nickel demand, another big product of Vale. Nearly 65% of Nickel is used in stainless steel, which is used in products such as food storage equipment and kitchenware.

Hedge sentiment

Going into 2013 there were a total of 23 hedge funds long Vale's top peer Cliffs Natural Resources, a 5% increase from the previous quarter. This includes high-profile billionaire Steve Cohen's SAC Capital, which had a $115 million position in the stock (check out SAC's high upside picks).

Meanwhile, Vale had 21 hedge funds long the stock going into the second quarter. The top hedge fund owner by position was billionaire Jim Simons' Renaissance Technologies (see Simons' cheap stock picks).

Having some of the most robust interest is Peabody, which had 35 hedge funds long the stock at the end of the first quarter. The top hedge fund was Perry Capital, with 2% of its hedge fund invested in the stock (see Perry's top stock picks).

Bottom line

I do tend to like the iron/steel industry more than the coal industry. The demand for steel should be boosted by a rise in auto sales, which is one of the biggest consumers of steel. Other potential tailwinds for he industry include a rise in residential and nonresidential construction. 

When trying to wade through the rubble of the industries, we find that Vale might be best positioned to weather a further decline. Vale has the lowest debt to equity ratio.

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With a current ratio that's near 2, and well above peers.

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All of these companies have underperformed the market over the past three years, and this pressure could easily continue over the interim. 

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However, if I had to pick one of the iron/coal companies that could make it through with the least downside, it would be Vale.

Marshall Hargrave has no position in any stocks mentioned. The Motley Fool owns shares of Companhia Vale Ads. 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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