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Buying Coal Stocks Is Still Too Risky: Shorting This One Isn’t

I have been contributing here for about six months and in that time I have covered most aspects of the energy markets, with one glaring exception. Not once have I mentioned coal. There is a good reason for that. I regard coal stocks as inherently too risky and, without wishing to be too blunt, I wouldn’t buy them with somebody else’s money, let alone my own.

Risk is a funny thing, or rather our perception of it is. I well remember sitting in a restaurant with a good friend who was horrified by my choice of tuna as an entrée. “Don’t you know,” he gasped “You can get poisoned by that stuff. I wouldn’t take that risk.” During the evening he drank four or five glasses of wine, then climbed into his car and drove home. Now that is taking a risk!

When it comes to investing, too, our perception of risk is often colored by headlines and conventional wisdom. We have been taught for years that volatility is synonymous with risk, but that to me is too simplistic. When trading and investing we should look at the upside to owning a stock as well as the downside. It is the risk/reward ratio that counts, not the risk itself as, by the judicious and disciplined use of stop-losses, downside risk can be limited. In the case of most coal stocks the potential upside is, to say the least, minimal, leaving us with a lot of downside risk and not much else.

I am not predicting the death of coal. People have been doing that for a long time, but production and consumption continue to grow. The fuel is cheap and the infrastructure in most countries is still geared to its use. According to the World Coal Association, for example it accounts for 43 percent of the grid energy in the U.S. and, perhaps more importantly 81 percent in China and 68 percent in India. Even India though, where growth has long taken precedence over environmental concerns, is looking to reduce coal consumption and since 2008, has adopted a National Action Plan on Climate Change.

Obviously the world is looking to move away from coal as such concerns become more commonplace. At the same time “cleaner” fossil fuels such as natural gas and alternative energy sources are becoming more readily available and economically viable, so the end of expansion for the coal industry at least is in sight. It would be reasonable, then to expect coal stocks to be cheap, but many are far from it; in fact some are just downright expensive.

Westmoreland

Take Westmoreland Coal (WLB), for example. When the coal industry in general was depressed towards the end of last year, they saw it as an opportunity to borrow cheaply and expand operations by buying the Prairie and Mountain coal operations of Canadian company Sherritt International. The market obviously approved, as WLB has gained over 233 percent in the last year.

As a result, the stock is now trading at a staggering 66.79 times forward earnings. Bear in mind that that is a multiple of expectations for the next twelve months of earnings, so any short term benefit of the acquisition is baked in. Multiples like that can maybe be justified in rapidly growing industries, but in coal? It looks to me like a short with enormous potential and very little risk to the upside.

Again, I am not a subscriber to the belief that the coal industry is in its death throes, but nor does it look like an industry that is about to expand rapidly. With that backdrop, buying a company like Westmoreland that is expanding operations would be crazy. Selling it offers far less risk.




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