This Sector Is Wrapping Up Its Final Rally

By David Sterman,

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A perfect storm was brewing for the coal industry in 2008: carbon-capping climate legislation looked increasingly likely to be approved, demand for electricity began to fall sharply and natural gas -- which can also replace coal in many power plants -- saw a sharp price drop. In addition, the incoming presidential administration promised much more rigorous enforcement of health and safety regulations for miners, which would end the extended period of laissez-faire treatment. With this scenario, the Market Vectors CoalExchange-Traded Fund ( ETF ) (NYSE: KOL ) slumped from $55 in the middle of 2008 to just $15 by year's end.

Today, the industry's obituary looks premature. A host of factors has led to a sharp rebound in coal prices since that crash in  2008 and the coalindex has tripled since then. In fact, it's risen nearly 50% since this past Labor Day. Investors are anticipating brighter results in 2011 and are bidding upshares in advance. But thecommodity 's  winning streak looks set to dim in subsequent years, so this recent rally may indeed be the last sharp upward move that coal will ever see.

From headwinds to tailwinds…
The winning streak began in 2009, when the coal industry managed to control the damage caused by present circumstances -- demand for electricity in the United States fell 4%  that year, while demand for coal dropped a sharp 10% in the same period, as a number of dual-fuel plants switched to natural gas only. Coal producers met that challenge by cutting output by a commensurate amount. With supply and demand back in balance, prices rebounded impressively for both met coal and thermal coal (higher-priced met coal burns at very hot temperatures and is used by steel makers, while lower-priced thermal coal is generally used by power plants).

The industry has also started to cheer a growing export opportunity thanks to China. Until just a few years ago, China was a net exporter of coal, but domestic supply constraints and rising demand has led the country to import more than 40 million tons in 2010 alone. Australia has served as a key provider of thecommodity as well, though plague-like rains in the state of Queensland have pushed up spot prices around the world. As a result, investors began to assume that U.S. coal exports would keep surging, especially as Australia has run up against major transportation bottlenecks and can't keep up with demand.

Lastly, recent changes in the political landscape in Washington have led many to conclude that the Obama administration will now be greatly hampered in its efforts to boost clean energy use at the expense of carbon-spewing coal power plants.

...and back to headwinds
But coal's recent powerful rally seems to ignore some major potholes in the road ahead. These problems are unlikely to become apparent in 2011, but as investors look ahead the dips will likely be reflected in declining stock prices, and the picture of 2012 and beyond becomes much more sobering.

For starters, energy investors have switched statements such as "the United States is the Saudi Arabia of coal" to "the United States is the Saudi Arabia of natural gas." With the discovery of recent shale plays, natural gas reserves have become so abundant that this source of energy is likely to stay quite cheap for some time. Natural gas also produces less carbon dioxide (greenhouse gas) than coal or oil. For a host of reasons, new gas-fired plants are being built while a wave of coal-fired plants are slated to be de-commissioned during the next five years. Existing plants that can burn either fuel are likely to stick with natural gas for the foreseeable future.

In addition, Washington is unlikely to pass any major climate legislation in the next few years, especially any package that taxes greenhouse gas emissions -- even if the Obama administration tries to take advantage of the fact that the U.S. Environmental Protection Agency (EPA) can now monitor and regulate carbon dioxide emissions of power plants and oil refineries. It's still unclear what this government supervision might mean to the industry, but an ever-increasing number of coal-fired plants could be forced to upgrade emissions scrubbers or even shut down completely.

And although greenhouse gas emission taxes do not have bipartisan support, state and federal governments are likely to steadily increase the renewable portfolio standards (RPS) to roughly 20% by 2025 (RPS is the minimum percentage of energy derived from renewable resources that electricity providers must generate). These RPS mandates could start to really eat into coal demand.

Let's not forget about China, which derives roughly two-thirds of its electricity from coal. The country is working hard to boost other energy sources such as wind and solar, but unless it can get major efficiency gains from them, coal will remain the primary energy resource in that country. Yet it's also unlikely that the United States can play a major role in the Chinese energy industry in the long term. Australia, which is located much closer and thus holds key logistic advantages, is slowly tackling its shipping bottlenecks. Only within a few years the land Down Under may be able to drastically improve exports.

Analysts' predictions range from neutral to bullish on most coal stocks, anticipating a decent supply/demand environment in 2011. Even as they don't generally focus on the longer-term looming headwinds, they note thatshares are already fully-valued on what currently looks to be a solid pricing environment in 2011. However, they seem to be unanimously optimistic on one name: coal company Peabody Energy (NYSE: BTU ) . The appeal is simple. Peabody has been heavily investing in Australia and will soon see half of itscash flow derived from that country. As production at Peabody's mines continues to ramp, so will free cash flow , which is projected to be a cumulative $5 billion during the next four years, according to Goldman Sachs.

Action to Take --> The coal sector looks more appealing on the short side than the long side, though no clear negative catalysts exist in the near-term. The only ones that might pop up in 2011 are a sharp slowdown in China, which will curtail demand; early stirrings of any bipartisan efforts to tackle climate legislation, which again won't be as onerous as thought to be a few years ago; or even further drops in natural gas prices, which will accelerate fuel source switching at power plants. Short sellers should start to look at the math for 2012 and beyond, and look to set up short positions in 2011.

-- David Sterman

David Sterman started his career in equity research at Smith Barney, culminating in a position as Senior Analyst covering European banks. David has also served as Director of Research at Individual Investor and a Managing Editor at Read More...

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

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

© Copyright 2001-2010 StreetAuthority, LLC. All Rights Reserved.

This article appears in: Investing Commodities
Referenced Stocks: BTU , ETF , KOL

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