What You Should Be Aware Of Before Jumping Into Coal Stocks

These days, we feel justified going bargain-hunting for stocks. At the same time, we want to choose our industries carefully, and focus on those that may be unfairly depleted. Zacks senior coal industry analyst Neil Malkin offered us his insight recently.

With a major pullback in energy stocks of late, what’s your take on how this affects coal companies under your coverage?

I would be quick to point out that investors should not put crude oil and coal in the same class. Global fundamentals for coal have stayed strong. Coal companies should see solid earnings in ‘08/’09. Crude oil’s slide on fears of a global slowdown is unrelated to the price of coal as supply/demand fundamentals are strong and prices have remained elevated.

Can you give us some background on this?

Currently, coal markets are strong as electricity and steel demand from emerging economies coupled with supply constraints have kept deliverable prices elevated. With China and India leading the way, growth in both coal and steel demand should keep prices at favorable levels as automobiles, buildings and power plants require increasing amounts of the fossil fuel to sustain growth.

Although the tightness of the credit market has sparked fears of a global slowdown, recent coordinated events suggest that the global central banks’ efforts to assuage the doubt between banks and other counterparties might be working and lending activities may resume to more normal levels. This should help support emerging economy outlooks and growth profiles.

Going forward, deliverable coal prices on an international scale will remain strong. Likewise, domestically U.S. prices should remain favorable as the increase in exports should help offset the forecasted slowdown in electricity demand.

Are you seeing some buying opportunities in the current market?

Besides being near 52-week lows, most companies in the coal industry have seen fundamentals strengthen as prices have climbed in nearly every basin and producers have locked in long-term contracts. As older-priced legacy contracts roll off, the ability to lock in production at higher prices will have the effect of increasing pricing bases, margins and earnings.

Coal stocks have been trading in line with exploration and production company [E&P] stocks. However, these two commodities are not related, and as such should not trade in a correlated manner, but rather should trade around the outlook for future coal prices. While crude oil prices have declined more than 45% since July, global coal prices have stayed elevated.

A favorable bullish indicator for long-term coal prices is that occurrence of long-term pricing for seaborne coal supply at levels 2x higher than in 2007. As another favorable indicator, a leading manufacturer of mining equipment has seen a large increase in orders for new equipment through 2011. This supports our long term view of favorable coal prices.

So which companies would you recommend here?

Investors should look for companies that have large cash generating abilities and a history of reliability and safety in operations. Exposure to seaborne markets will provide increased cash flow and margins, as seaborne coal trades at a premium to domestic coal as well. Peabody Energy (BTU) and Arch Coal (ACI) look promising.

Are there any caveats investors should be aware of before jumping into coal stocks?

Although the coal companies under coverage our rated as Buys, there are risks associated with the coal segment that investors should consider. If there is a global recession, growth in emerging economies might contract significantly. This would negatively affect the prices for coal somewhat. This would also create less of an incentive for companies to expand either organically or through acquisitions.

With prices lower, companies would most likely leave production in the ground, which would decrease top- and bottom-line results. The U.S. market may also experience some near-term weakness as electricity demand will likely decrease due to forecasted slow or no growth. As more liquidity is poured into global markets, inflation will likely follow. This will likely increase input costs such as steel, fuel, explosives and rubber. Higher input cost will put pressure on operating margins which can negatively impact earnings.

Neil Malkin is a senior analyst covering the coal industry for Zacks Equity Research.

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