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Assessing the Investment Merits of Coal Producers: CNX, PCX, MEE

October 19, 2010 | About:
gururk

Street Authority

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It was not that long ago when it seemed as if some sort of comprehensive legislation to tackle the issue of climate change almost seemed inevitable. But since then, political wrangling and the emergence of more pressing economic concerns have sent the issue to the backburner.

Opponents of the view that climate change is manmade will likely see inaction as a silver lining to the economic downturn, while supporters are obviously disappointed. But no matter your politics, it is important to objectively consider the impact the issue can have on your investments.

Many of the nation's utilities have been doing just that. Electric power producers are some of the largest consumers of fossil fuels in the nation and consequently are some of the largest emitters of greenhouse gases. Thus, they have a strong incentive to stay on top of developments related to climate change.

In that regard, the industry has been taking no chances. Numerous utilities have expressed their intention to shun relatively dirty coal going forward, opting to produce power using renewable resources and natural gas. And while state mandates on utilities to generate more of their electricity using renewables, as well as the new low price paradigm in natural gas have a lot to do with the actions being taken by power producers, concerns about potential future climate change legislation are undoubtedly having an impact as well. [Cash in on the Imminent Natural Gas Rally]

But regardless of why utilities are doing what they are doing, the fact is that these circumstances have created one big loser, and that's coal.

The numbers illustrate just how bad the situation is for this fossil fuel. In 2005, 50% of the nation's electricity was generated by coal. Last year, that number had declined to 44%. Even worse, the future looks just as dismal: the Department of Energy estimates that the share of generating capacity additions in the next three years powered by coal to be 26%, which means the fuel's overall market share is likely to erode further.

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Coal producers have reacted to the decline in demand by cutting production. Year-to-date output has been -7% below that of 2008, and even slightly below the depressed levels of 2009. As coal demand in the electric power sector continues to decline, output will likely fall in step, leading to negative growth rates for many producers.

But not all coal producers are standing still. CONSOL Energy (CNX) has dove head first into the natural gas business, anticipating a much brighter future for coal's number one competitor than for coal itself. Earlier this year, the firm made a $3.5 billion acquisition of natural gas assets from Dominion Resources (D), followed by a nearly $1 billion purchase of the 17% stake in the company's own natural gas division that it didn't already own.

It's not surprising that CONSOL would so aggressively diversify away from coal, as its focus is in the eastern United States, where production costs are the highest in the nation. Nonetheless, the company has paid a steep price for this transition, accumulating debt and diluting shareholders in the process. CONSOL's long-term debthas increased from close to $500 million to $3.2 billion, while its shares outstanding have increased by +25%.

Understandably, the market has punished shares of the company severely as a consequence, with the stock price falling from close to $55 before the Dominion acquisition in March, to as low as $31 at the end of August -- a -44% decline. Since then, shares have rebounded near $40, having benefitted from the broad rally in the U.S. stock market.

Yet while CONSOL has moved away from coal, other producers have chosen to carry on with business as usual.Patriot Coal (PCX), a high-cost producer with operations in the Appalachian and Illinois basins of the eastern United States, is just such an example. Patriot is a spinoff of coal behemoth Peabody Energy (BTU).

Since going public in 2007, Patriot's coal production has declined by -13% on a per share basis, while operating costs have risen from $44 per ton to $57. And although coal prices are at levels high enough for Patriot to barely cover its operating costs, the inclusion other expenses, such as those on interest payments, results in negativeearnings and free cash flow. According to consensus expectations, Patriot is expected to lose $1.69 a share this year, after having lost $1.78 in 2009. Analysts expect an improvement in 2011, when the company may lose only $0.21, but that will likely prove to be optimistic if coal demand continues to decline and costs remain elevated.

Patriot is just one company out of many that will be negatively impacted by the dismal outlook for coal. Another is Massey Energy (MEE), the largest operator in the Central Appalachian region. The firm made headlines earlier this year after an explosion at one of its mines in West Virginia led to the death of 29 miners. The response has been a more stringent regulatory environment that has hindered production and led to increased costs. As a result, Massey's output has fallen -29% on a per share basis in the last five-years.

Action to Take --> Though the future looks bright for many commodities as they benefit from surging demand around the world, investors should not make the mistake of considering them all equal. Domestic commodities such as coal are beholden to domestic supply and demand considerations. And that makes for a very bleak outlook for coal specifically, with intense competition in the electric power sector and the potential for future climate change legislation taking a heavy toll on demand projections.

If you own one of the major coal producers, seriously consider whether they merit a place in your portfolio. Aggressive investors may consider shorting select names in this declining industry. Patriot Coal and Massey Energy stand out as two companies with particularly weak fundamentals, and thus may be primed to fall quickly as the coal story plays out.

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-- Sumit Roy

Sumit Roy has more than eight years of experience covering equity and commodity markets. Sumit's work has been cited in Barron's and Yahoo! Finance. Read more...

Disclosure: Neither Sumit Roy nor StreetAuthority, LLC hold positions in any securities mentioned in this article.

This article originally appeared on StreetAuthority


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