The Other Black Gold—Coal

The proverbial lump of coal is what naughty boys and girls get in their Christmas stockings. But investors who have placed coal stocks in their portfolios over the last year or two have found a gift that keeps on giving. Coal stocks soared by 125 percent from the beginning of 2004 through mid-2005, according to J.P. Morgan Securities. That's better than 12 times the gain of the S&P 500.

With the U.S. thirst for electricity showing no signs of slowing, with oil prices skyrocketing and, perhaps most importantly, with a coal-friendly administration firmly entrenched, the coal industry looks like it is on an extended winning streak. During Bush's reign, Congress already has funneled more than $1.3 billion into “clean coal” research and the $14.5 billion energy bill signed in August promises tax breaks and loan guarantees for the industry, plus more research money.

Another sign of good times for coal: Last year, savvy bottom-fisher and turnaround specialist Wilbur Ross — the man who pocketed a quarter-billion dollars by flipping U.S. steel companies that he bought out of bankruptcy — started buying up mining companies to create International Coal Group, expressing his faith that coal would follow steel's solid march higher.

But how much farther can coal go and how are smart investors playing this sector? The Dow Jones U.S. Coal Index is one indicator. It is trading at 44-times trailing earnings.

Time to Get Out?

Still, investors who have been long on coal are naturally starting to wonder if the rush is running out of steam. From mid-May to mid-June, short interest was up 12 percent for Consol Energy and 30 percent for Peabody Energy Corp., according to Natexis Bleichroeder. While even bullish analysts agree that coal-stock valuations are blast-furnace hot, its long-term investors have reason to remain upbeat. As analyst John Bridges of J.P. Morgan put it in a recent report: “Stay long, buy the dips!”

This may seem a bit counterintuitive at a time of rising concern over the effects of CO2 emissions on global warming (coal is used to produce more than half the electricity in the U.S. and is responsible for 36 percent of fossil fuel CO2 emissions, according to a study by researchers at Harvard University's Kennedy School of Government). But the price of natural gas, a cleaner-burning option for utilities, has risen along with oil. Further, nuclear reactors are still taboo and “alternative” energy sources such as wind power, produce only about 2 percent of the nation's energy. That makes coal a hot commodity for the foreseeable future.

“Over next 10 years when we think as a country about where we're going to get our power from, we're going to have to weigh more heavily on coal,” says Ian Synnott, a coal analyst for Natexis Bleichroeder in New York. “We're not going to see new nuclear power plants getting built for at least another 10 years, and when you look at the cost to generate power, it's still very much skewed in coal's favor.” The price of natural gas, he says, would have to drop to between $4 and $4.50 per million British thermal units to become competitive with coal. In mid-August futures pegged the price at $8.50.

With stocks in the sector trading at a forward P/E of 14 to 15, compared with historical averages of 10 to 12, the sector does seem fully priced. Yet some strategists see more upside potential. Consider this: The market capitalization of the six largest public coal companies stands at about $23 billion, roughly that of just one large oil and natural gas exploration and production company like Burlington Resources or Devon Energy. Meanwhile, coal giant Peabody Energy alone has more reserves on a BTU basis than all of the natural gas in the continental U.S., according to Synnott — but its market cap falls shy of $9 billion. And, when you start looking at P/Es farther out, they become far more reasonable: For 2006, P/E projections for the group stand at about 14; for 2007, an even more reasonable 11, according to analyst Jim Rollyson at Raymond James in Houston.

The U.S. has about 275 billion tons of recoverable coal reserves — which translates in terms of energy generation to four times the oil of Saudi Arabia, according to Johnson Rice & Co. But while supplies are high, demand is likely to stay higher, mainly because of the cost of natural gas, limits on how much coal production can expand and transportation bottlenecks and interruptions that create pent-up demand. Utility company's stockpiles of coal are running low — according to Arch Coal, they were about 15 percent below their five-year average even before the heat wave hit this summer. “If utility companies can't get coal, next year not only will we have demand from normal consumption, you'll have added demand because utility companies will want to build stockpiles back up,” says Bill Burns, an analyst for Johnson Rice & Co. in New Orleans.

Meanwhile, advances in environmental technology could encourage utilities and power generators to rely even more heavily on coal than they already do. And if natural gas prices remain high, it will make financial sense to upgrade power plants to burn coal more cleanly. “You're going to see a lot of scrubbers coming online, and it will increase the demand for coal,” says Burns.

A Pair of Picks

Two companies positioned to take advantage of new environmental standards and the changes that stem from them are Consol Energy and Foundation Coal Holdings. Both mine northern Appalachian coal, which produces high levels of heat but also has a lot of sulfur, a pollutant that utilities will increasingly be able to strip out. Synnott has a fair-value target of $69 on Consol and $38 on Foundation; in mid-August, share prices stood at $69 for Consol and $35.29 for Foundation. (Natexis Bleichroeder co-managed a public offering for Foundation and received compensation for non-investment banking services from the company in the last 12 months.)

Coal companies themselves seem confident that prices will continue to rise. For instance, Arch Coal has about two-thirds of its 2007 production uncommitted, meaning it has not yet contracted to sell it to companies for a set price. “That is definitely a sign that management is bullish on the future pricing for coal,” says Synnott.

Not everyone thinks coal stocks will continue to reward investors. Elizabeth Collins, an analyst for Morningstar, says that not only are coal prices rising, so are the costs of inputs for mining it, like diesel fuel used to run the equipment.

Labor shortages remain a problem, and employees are increasingly able to take advantage of that. “We'll see employees extracting a lot of value from the strength in coal as opposed to the companies,” says Collins. “With the renaissance in coal, they need a lot of new employees and they're just not available — they're having to pay up and train new employees with more technical skills than in the past.”