Despite its many doubters, the coal industry could soon roar back to life

(Photo: Macarthur Coal/Reuters)

The darkest day in the coal industry’s recent past arrived on July 9, 2012. About five minutes after the market closed, St. Louis–based Patriot Coal Corp. filed for bankruptcy and destabilized an already troubled sector. The company, one of the largest metallurgical coal producers in the U.S., had nearly as much in debt as it had assets and, thanks to plummeting prices, its balance sheet was simply under too much pressure. Stock prices across the sector fell quickly. James River Coal Co., which many thought would follow Patriot into bankruptcy, saw its shares drop 44% that week. Some of the more stable businesses, such as Consol Energy and Cloud Peak Energy, fell by 10%.

At the time, no one was sure when or even if coal would recover. But after a lousy year that saw the commodity’s price get slashed nearly in half, many experts believe that the sector has finally hit its nadir. The industry will still be volatile this year, and may see another bankruptcy or two, but stock prices have nowhere to go but up. “You need to get in early,” says Matthew Peterson, a portfolio manager with Newgate Capital Management. Coal stocks move quickly, he says, so if you wait for good news, you’ll have already missed much of the upside.

While coal experiences more ups and downs than other commodities—the weather can have an effect on prices—the black rock has been in use for centuries. Even though it’s considered the dirtiest of fossil fuels and as a result is being burned less in many developed countries, there’s no way that it would suddenly stop being used. Still, every so often demand and supply get out of whack. Last year, two events caused North American thermal coal—the coal used by utilities to generate electricity—to fall by about 30%. The first was that natural gas prices also fell hard in 2012, hitting a 21st-century low of around $2 per thousand cubic feet (MCF) last June. Many utilities can generate power using either coal or natural gas, so if the latter’s price gets cheap enough—typically below $4.50 per MCF—power companies will make the switch.

The second reason is that the winter of 2011–2012 was the one of the warmest on record. Mild winters mean less home heating, lower natural gas prices and therefore lower coal use. Marc Scott, a portfolio manager at American Century Investments, says that the warm weather in 2012 caused demand to fall by 12% from the same period the year before. The low natural gas prices caused coal’s share of the power grid to fall from 42% in 2011 to 37% in 2012. During the same time period, the share for natural gas rose from 25% to 30%. “It was all natural-gas-driven last year,” Scott says. “So if you think gas prices will move higher, then coal should regain the share it lost.”

Thermal coal gets most of the attention, since it’s used daily by many North Americans. But another type of coal, metallurgical or coking coal, also saw prices fall by about 50% last year. This commodity has a higher carbon content than thermal coal and burns at much higher temperatures. It’s mainly used to make steel. A slowing Chinese economy, coupled with a troubled European economy, caused global demand for steel to fall, says Michael Dudas, a senior research analyst with Sterne Agee Group, just as supply was going up.

So far in 2013, coal prices are recovering—metallurgical by 6%, thermal by upwards of 20%—and there are signs that will continue. Natural gas prices have climbed to around $3.80/MCF in the U.S., getting close to the switch-over price for utilities. Investors, says Scott, need to form an opinion on where natural gas is going. If the price is going to continue to rise, then coal’s price will follow. “These two commodities are joined at the hip,” he says. Many coal companies have curtailed production, but utilities have more coal stockpiled than usual. “If you believe that production will continue to decline, coupled with demand improving, then you’ll start seeing inventories begin to be drawn down,” Scott says. Coking coal production is also down by about 10% worldwide, says Dudas. That, combined with signs China’s economy is improving, will help put supply and demand back in balance.

When it comes to buying into the sector, Peterson suggests sticking with North American companies. You can buy U.S.-listed Chinese companies, and there are Australian coal producers, but the factors that affect prices in those countries are different from the fundamentals here. As well, he advises buying individual stocks rather than the one coal exchange-traded fund on the market. The Market Vectors Coal ETF (NYSEArca: KOL) holds some non-American companies and some smaller players, which adds downside risk. It’s also difficult to buy coal futures, says Peterson, as utilities typically negotiate prices directly with the producer. There is a futures market, but it’s not nearly as liquid or as developed as other commodity markets.

Eric Green, a portfolio manager at PENN Capital Management, suggests owning a mix of metallurgical and thermal coal producers in order to benefit from both prices rising. Dudas, however, is partial to met coal; he thinks its prices will recover faster. When it comes to thermal coal, first look for companies that operate in Wyoming and Montana’s Powder River Basin, says Scott. It’s cheap to produce coal there, which means that utilities in the area will typically switch to coal when natural gas prices get to $3.50/MCF. They’re there now.

It’s also important to look at debt levels. A lot of these companies are highly leveraged; there’s been a lot of acquisition in the industry. Some, like Walter Energy, have debt-to-market-cap ratios of nearly 100%. Whether or not you should stay away from a highly leveraged company depends on where you think the market will go, says Dudas. If coal prices rebound, debt can be a good thing. These companies will grow faster. If there’s still some downside, all that leverage could spell trouble.

Because of these debt issues, it’s important to look at enterprise value to EBITDA (earnings before interest, taxes, depreciation and amortization), rather than price-to-earnings, when determining affordability, says Green. Enterprise value takes debt levels into account, so companies with higher debt will have a higher EV/EBITDA ratio. That makes it easier to see what price you’re paying for cash flow. It also puts companies with a lot of debt on the same playing field as ones with little debt. Right now, EV/EBITDA ratios for coal producers range from five to 10 times. The lower the number, the cheaper the stock. But even at the high end, “those metrics look pretty attractive,” Peterson says.

Investors need to keep in mind that they’re not buying a blue chip here. “These are not your grandmother’s companies,” Green warns. There’s a lot of risk, and you need to be able to handle volatility. But with prices this low and all signs pointing to a recovery, this could be the time to jump in. “I’m buying now,” says Green. “I’m getting excited by what I’m seeing.”

The CB hotlist

Teck Resoruces (TSX: TCK.B)

EV/EBITDA: 5.7 | Yield: 3.0% 1-year total return (C$): -20.3%

This Vancouver-based miner is one of the largest coal producers in North America. Its base-metal mines make it more diversified than its peers.

Consol Energy (NYSE: CNX)

EV/EBITDA: 11.8 | Yield: 1.8% 1-year total return (C$): 3.3%

This Pennsylvania-based company also produces gas, so it can make money on rising prices for both fuels.

Cloud Peak Energy (NYSE: CLD)

EV/EBITDA: 5.2 | Yield: 0% 1-year total return (C$): 7.9%

Based in Wyoming’s Powder River Basin, this company is able to produce coal more cheaply than its peers.

Walter Energy Inc. (NYSE: WLT)

EV/EBITDA: 9.8 | Yield: 1.8% 1-year total return (C$): -52.5%

This is a riskier play, as it’s one of the most leveraged coal companies.

Peabody Energy Corp. (NYSE: BTU)

EV/EBITDA: 6.1 | Yield: 1.6% 1-year total return (C$): -32.9%

St. Louis–based Peabody owns 30 operations, including met and thermal mines in Australia.