Investors Beware, Only These 2 Coal Stocks Are Cheap!

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

A near-term, sustained rebound in coal stocks may be little more than wishful thinking. It's essential that investors understand key factors underlying the coal market and be cautious when reading bullish articles.

Yes, the coal stocks have been slaughtered from their 52-week highs. However, consider this in the framework of other natural resource sectors. Risk-off strategies are impacting not just coal, but iron ore, copper, gold, silver, uranium and potash, among others.  

This is a real headwind as it would likely be very difficult to experience a big rally in coal without rallies in most other natural resource sectors.

What's Your Hurdle Rate? 

Another important consideration is the hurdle rate of return an investor requires. For a high-yielding utility stock, perhaps the expected return is 10%-15%. However, for a high-risk, highly volatile coal stock, one's hurdle rate should be far greater, say 40%-50%. Otherwise an investor needs to look at other natural resource stocks for ideas. 

A Few Coal-Specific, Fundamental Factors

Recent articles on coal are largely based on the thesis that 1) the stocks are cheap/oversold, and 2) curtailed supply will drive coal prices higher. I respectfully disagree. Coal stocks can only be considered cheap if one accepts a bullish view on coal prices in 2014-15. However, visibility into next year is quite poor. There's simply no fundamental reason to believe that 2014 will be any better than 2013.

The curtailed supply argument is flawed because even with ongoing U.S. production cuts, exports from other countries, most notably Australia, Indonesia and Colombia, are at or near all-time highs. Coal markets are increasingly global. Global markets are great when U.S. coal exports are increasing, but currently exports are in decline, albeit from record years in 2011 and 2012. Eventually, reduced GLOBAL supply of coal will drive prices higher, but not necessarily anytime soon.

Hard to Forecast and Expect Sustained Higher Coal Prices

Even if coal prices rebound substantially, how sustainable and how large a rebound could it be? Given excess global capacity, there will always be an overhang of supply that can flood the market. The U.S. Powder River Basin ("PRB") of Wyoming and Montana is a prime example. Peabody Energy (NYSE: BTU), Arch Coal (NYSE: ACI) and Cloud Peak (NYSE: CLD) have curtailed tens of millions of tons of annual thermal coal production, yet PRB coal prices remain depressed because export opportunities for PRB coal are constrained.

This is why Peabody made acquisitions of coking coal properties in Australia and has aspirations in Mongolia and Indonesia. However, Peabody's deals in Australia left it with too much debt. Likewise, Arch made an ill-timed takeover of an east coast coal company with coking coal assets. But, the 2011 deal was at the top of the market and left Arch with a boatload of debt and no assurances that the sought after coking coal projects will be profitable.    

Only Two "Coal" Companies Offer Compelling Investment Opportunities

Only Natural Resouce Parnters (NYSE: NRP) and Alliance Resource Partners (NASDAQ: ARLP) offer compelling investment opportunities in the coal space. Both are Master Limited Partnerships. Natural Resource Partners is yielding over 10% and Alliance more than 6%. Natural Resource Partner's annual distribution is safe, but probably not growing in the next 12 months. Alliance's distribution rate has grown 15% per year for the past 10 years and is likely to continue growing at 8%-10% in 2013-14. 

Natural Resource Partners is tarred and feathered as a coal company but is diversifying into other natural resource segments. More importantly, the company is NOT a coal operator; it leases owned coal reserves to operators. Therefore, Natural Resource Partners is immune to cost inflation and permitting challenges.

Alliance Resource Partners is a coal producer, but the single-best of the bunch. It has the highest margins, strongest organic production growth, highest proportion of contracted and priced tonnage in 2014-15 and the lowest debt leverage. Alliance is the safest way to play the coal sector, if one is hellbent on going there. 

Conclusion

Coal stocks are not cheap. They would only be cheap if an investor had confidence that coal prices would improve a lot relatively soon. However, there's little evidence that coal prices will move substantially higher. Coal stocks are not cheap simply because they have fallen so much; other natural resource sectors are down as much. Only two high-yielding, relatively safe coal companies are worthy of consideration, Natural Resource Partners and Alliance Resource Partners. 

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Peter Epstein owns shares of Alliance Resource Partners, L.P. and Natural Resource Partners LP. The Motley Fool recommends Alliance Resource 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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