Long term subscribers and those with a long memory may remember that back in August of last year I wrote a piece on coal stocks. At the time I described them as too risky for investors and suggested only one trade, shorting Westmorland Coal (WLB) which, at the time looked seriously overvalued. That trade worked out well as WLB fell from there, dropping around 40 percent until bottoming out earlier this month. That wasn’t the only coal stock to fall in that time. They pretty much all did, but now the risk/reward ratio has shifted enough to make investing in the sector worthwhile for those who don’t mind taking a risk.
The dramatic fall in WLB and others was, at least in part, due to the drop in oil prices, but that had another effect. While the cost of energy was not the point of those who railed against coal and other traditional energy forms, it did lend an economic argument to calls for greater restrictions on fossil fuels and more investment in alternatives. As prices have fallen, the case for transforming electricity generation around the world has seemed less urgent. That observation may be somewhat cynical and it may upset those committed to the environment, but it is a simple fact, and one that can be profited from.
Without regular demands for the effective destruction of the coal industry some existential risk has been removed, allowing potential investors to focus on a couple of relevant, more positive facts. According to the IEA, coal accounts for 40 percent of the world’s electricity generation, and a December report from the same source predicts that, despite pledges for emissions reduction and cleaner energy, demand will continue to rise over the next 5 years, reaching 9 billion tons by 2019. The coal industry, from a global perspective, isn’t going away. WLB, however, along with two other big producers, Peabody Energy (BTU) and Cloud Peak Energy (CLD) are priced as if the demise of the industry is imminent.
The fact that all three stocks found a base when oil prices began to settle earlier this year means that it is possible for investors to buy in with reasonable stop loss levels protecting against the big losses that looked all too likely when I wrote about the sector in August.
WLB, for example is, at the time of writing, trading at just below $30, meaning that a stop set to protect against a break of the previous low, around $25, means limiting losses to less than 20 percent. BTU is around $7.50 with a low of $6 and CLD is just above $8 with a low around $6.50. In both cases stops can also be set that would limit potential losses to around the same amount.
It has to be stressed that this is still a risky trade. The industry here in the U.S. is hardly booming, but with a limited downside, the upside now looks tempting. A Republican controlled Congress and a dead duck President make it unlikely that there will be any further negative action from Washington in the next year or two. If that is the case and the IEA is right about demand, then all three companies are set for a recovery of sorts. It won’t take much positive news to prompt a return to levels before coal stocks started to crash, making returns close to 100 percent a possibility.
The last year or so, coming after a period of consolidation that left many individual companies heavily indebted, has taken its toll on most coal companies’ balance sheets, so diversification is the key here. Usually, for the sake of simplicity, I would attempt to narrow an idea like this down to just one trade, but with the possibility of financial problems at any individual firm, spreading the risk with an investment split between at least three looks like a sensible precaution.
With that proviso and the warning that this is not for the risk averse, it looks like a decent time to invest in an industry that has been hammered in the last year. At some point in the future those predicting the death of the industry will no doubt be right, but it won’t come in the next few years. In the meantime, WLB, BTU and CLD are priced as if it is coming any day, and that looks like an opportunity to me.