Coal Stocks Will Struggle In 2023

Regular readers, God bless you all, will know that I rarely talk about specific coal stocks. There have been occasions when I have identified short-term opportunities to buy one or two, but they are few and far between. When that advice did come, it was almost always accompanied by a warning to, at a certain level, take a profit or even reverse to a short if you were somebody who actively traded on margin. More often though, if I have mentioned the industry at all, it has been to caution against involvement or evenly encourage actively shorting coal stocks. That is why I kept my mouth shut last year. In the exact opposite of what my mother always told me, I couldn’t find something bad to say, so I said nothing at all. I will break that silence today, though, because the temporary headwinds that caused coal stock to show good gains last year are fading, reversing even, and it is a good time to short at least one high-profile name.

2022 was a good year for US coal stocks. As inflation took hold, commodity prices of all kinds pushed higher, and coal was no exception. It, along with other energy commodities, faced supply limitations as Russia invaded Ukraine and as China went back to 2020 style lockdowns, and supply chains there were massively disrupted. That enabled American producers like Peabody Energy (BTU) to ramp up production even as they achieved higher prices. As a result, BTU swung from a loss in the first quarter of the year to quite substantial profits in Q2 and Q3 with EPS of $2.21 forecast for Q4 2022 when those numbers are released on February 9^th.

Still, even with that perfect storm, the long-term problems of coal persist. It is fundamentally a dirty fuel in a world increasingly aware of that as a problem. The move away from it is slowed by cost considerations, and not every country is rushing to do away with coal-fired power stations and industrial sites. But as the existing ones fall into disrepair, they are not being replaced like-for-like. Coal usage may grow short-term if energy demand overall grows, but it is consistently shrinking as a percentage of overall energy output over time, and that isn’t changing.

As we saw last year, that doesn’t mean that coal prices and coal stocks can’t show gains. They certainly can. But sustaining high prices with that long-term overhang is hard, maybe even impossible. So, when I see a chart like this for Peabody…

…it screams sell!

BTU spent the whole year at an elevated price after jumping sharply in the first few months, as did coal. The thing is, though, even as that happened, coal production in China, the world’s biggest producer, was increasing to record levels by the end of the year. If one assumes, logically enough given the prices, that supply chain bottlenecks stopped at least some of that output getting to market, then the picture is about to change significantly. Zero Covid has been all but abandoned in China and supply chains will improve as a result. Stored coal may hit the market, just as central bank rate hikes in the West slow global growth.

I don’t think coal prices will necessarily collapse this year as a result, but I do think they will trend lower. Given that, BTU, a stock whose price has closely followed coal prices for obvious reasons, can be expected to head lower, too. When that happens, the long period of trading at a premium to historic averages will weigh heavily on a stock that is always generally regarded as a short-term play, with traders and investors alike aware that the company operates in an industry whose death is clearly visible from here. In other words, even a slow, steady decline in coal could result in a sharp, steep drop in BTU.

So, if you hold BTU, consider selling it, and if you don’t maybe pick up some long-dated, well-out-of-the-money puts. January ’24 $15 puts can be bought for around $1.50 and, while something like that would usually be unattractive given the time decay that will inevitably occur, a break-even that represents around a 50% drop for a stock as volatile as BTU and with the long- and short-term negatives it has looks more than reasonable. That will be how I will be playing it but, given the long-term nature of it and the fact that it is a trade based on fundamentals, not technicals, I cannot give you exit levels in this case as I usually do when talking about a specific trade.

You will have to set your own based on circumstances, but as long as you don’t commit too much to the trade and keep in mind that no matter how logical all of the above is things can still pan out differently, the risk/reward should turn out in your favor. However, whether you take the trade or not, just understand that the gains in coal stocks over the last two years have been the anomaly, not the series of disasters that came before, and prices will adjust back before long.