Coal Stocks Could Surge With the Plunge in Natural Gas Inventories

The biggest beneficiary of plunging natural gas inventories might not be a company in the natural gas industry. The coal industry took a big hit due to the suddenly abundant and cheap energy source developed over the last decade. Coal stocks are arguably among the most hated stocks on the planet.

Stocks such as Peabody Energy and Arch Coal will benefit, however, the most from a switch back to coal as a fuel source for electricity production. Alpha Natural Resources might provide the most upside, especially if investors see a global rebound that increases the demand for metallurgical coal used in steel production. In general, the sector has been crushed so much in the last couple of years that any snap-back in demand will raise all the stocks in the sector.

Natural gas inventories plunging
While coal stocks surged an average of 5% last Friday, the majority of these companies still trade around multi-year lows, trading in stark contrast to the surging price of natural gas to levels above $4/btu. This price level will encourage a switch back to coal by some power plants.

Even more encouraging for the coal stocks was the weekly release by the EIA that natural gas inventories plunged 177 Bcf for the week ending Dec. 20. Inventories now sit at 3,071 Bcf, or 177 Bcf below last year's levels at this time. Inventories are now 9.2% below the five-year average of 3,384 Bcf, further increasing the possibility that natural gas prices could surge in the short-term.

Focused on thermal coal
Peabody Energy is the leading domestic coal producer with a market cap of $5 billion and revenue in excess of $7 billion. The company is also rare in that it continues to be profitable and generates EBITDA margins around 17%. Like the industry, though, Peabody continues to see revenues decline due to lower prices. The good news is that it was recently able to reduce U.S. unit costs to three-year lows, providing for increased margins when prices do rebound. At an expected annual adjusted EBITDA level of around $1.1 billion, Peabody trades around 4.7 times that forecast.

Arch Coal now has a market valuation below $1 billion with the stock trading around $4.50. Only a few years back, the stock was trading for over $30, showcasing the level of collapse in the coal sector. Arch recently raised $423 million in net cash proceeds from selling its Canyon Fuel subsidiary. This asset sale provides the company with plenty of cash to survive the pricing collapse of coal.

Arch primarily focuses on thermal coal production in the Powder River Basin, or PRB, along with smaller operations in the Appalachian and Illinois Basin. The Appalachia segment produces a mix of metallurgical coal that provides a significantly higher average sales price, making the relatively small production of 3.3 million tons an important second priority to the PRB.

Metallurgical coal leaning
The financial picture at Alpha Natural improved recently with the announced agreement to sell the 50% interest in Rice Energy for $200 million of Rice common stock and $100 million in cash, for total consideration of $300 million. The IPO for the natural gas producer in the Marcellus shale should occur sometime in early 2014. Even more interestingly, Alpha is only selling interests in 7,500 acres in the Marcellus shale with 10,000 acres remaining. Remember that Alpha only has a market cap of around $1.6 billion.

Though Alpha will benefit greatly from a rebound in thermal coal demand in the U.S., it benefits greatly from global metallurgical coal demand. For 2014, it guided demand at around 20 million tons of Eastern metallurgical coal and 26 million tons of Eastern thermal coal. Alpha has 41% of the thermal coal and 97% of the metallurgical coal unpriced at the end of the third quarter, providing for substantial upside based on an improving pricing situation.

Alpha generated revenue of nearly $7 billion in 2012 and now sits with a valuation for the coal assets of only $1 billion.

Bottom line
The dramatically lower natural gas inventories set up the coal stocks for a surprising rally, likely catching most investors off guard. The above stocks stand to benefit the most from improving demand for coal. Peabody Energy is the safe bet with the market-leading position, and Arch Coal will benefit the most from increasing thermal coal demand. Alpha Natural remains a wildcard coal miner that will benefit from increased thermal coal demand, but investors should buy this one based on expectations of growing metallurgical coal demand in Europe and Asia.

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The article Coal Stocks Could Surge With the Plunge in Natural Gas Inventories originally appeared on Fool.com.

Mark Holder and Stone Fox Capital Advisors clients own shares in Alpha Natural Resources. The Motley Fool has no position in any of the stocks mentioned. 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.

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