Tech-Free Friday: Coal Stocks Catch Fire

It's an essential component of the infrastructure of American industry. It powers the companies that provide the power for everything from Unix servers to toaster ovens.

More importantly, it's one of the stock market's hottest sectors, now in the midst of a rally reminiscent of some of the great momentum stories of late 1999. And it's just about the furthest thing from tech you can imagine. Yes -- it's coal.

After more than 15 years of underperformance, coal stocks are on fire. In the past year -- a period in which the Nasdaq has fallen about 60% -- names like Penn Virginia (PVA Quote), Consol Energy (CNX Quote) and Arch Coal (ACI Quote) have risen between 110% and 170%. The positive trend is hardly new. But it's still a trend, something many weary tech investors might appreciate.

Supply and Demand

It's been a while since the sector has seen this sort of action. Coal mining was one sweet business during the 1970s, when coal became an important alternative to costly oil and gas. But as in all commodity industries, prices for coal collapsed when demand slackened and left the mining industry with a serious overcapacity problem. Mines started closing in the 1980s, and prices got crushed as inventories got dumped. A 1999 Department of Energy study estimated that in real dollars, coal prices sank 45% between 1986 and 1997, even as the number of operating mines fell by 59%.

But things have finally turned around for coal. Demand for electricity is booming, and the high cost of natural gas has once again made coal an attractive fuel for utilities. Based on present prices, it costs $70 to produce a megawatt of electricity using natural gas, but only $16 using coal, according to Merrill Lynch analyst Daniel Roling. And the coal market has reflected that cost advantage. In the last 18 months, the spot-market price of high-quality Eastern bituminous coal has jumped from close to $20 a ton to about $40 a ton. Western coal now sells for around $12 a ton, up from about $3.50 a ton a year and a half ago.

Compare and Contrast Coal stocks vs. the Nasdaq, one year

"Coal pricing went from bad to worse for 20 years," says R. Wayne Atwell, the coal analyst at Morgan Stanley Dean Witter. "Everybody tried to get the last ton out the door, so they priced the last ton on a marginal basis, and that brought prices down for the entire sector. Now we have the best coal market we've had in 20 years. It's kind of out of control."

The spot-market prices are for coal sold for immediate delivery. Because most companies buy coal in three-year contracts, coal producers haven't felt the benefits of that recent price spike. But they will when contracts start rolling over. Between 30% and 50% of next year's coal hasn't yet been priced, Atwell says. "Utilities are waiting for lower prices, while the coal companies are playing chicken," he says. "Prices are through the roof, but nobody is really benefiting yet."

Rethinking the Upside

Companies are stepping up production to meet demand and capitalize on rising prices. And observers don't see the cycle turning sour anytime soon. For as domestic demand for electricity booms, the inventory of coal held by electric utilities is getting lower and lower; Roling estimates that by the end of 2001, inventories will be at the lowest level in 27 years.

Coal-Fired Brushing off a sooty sector
Stock	2001 price-earnings ratio	2002 price-earnings ratio	Dividend yield	Price-book	Debt-total capitalization ratio
Alliance Resource Partners (ALRP Quote)	17.5	14.1	11%	N/A	N/A
Arch Coal (ACI Quote)	69.2	15.9	1%	4.5	0.83
Consol Energy (CNX Quote)	19.7	14.0	4%	9.5	0.55
Massey Energy (MEE Quote)	7.7	6.7	1%	1.2	0.00
Penn Virginia (PVA Quote)	8.5	N/A	3%	1.6	0.22
Source: Baseline

"U.S. demand for electricity has continued to grow way above trend and expectations," Roling says. "If we have a hot summer, we here in the Northeast are going to experience what California is experiencing. The bottom line is that demand for electricity is exceeding supply, and that's favoring coal, because it's the cheap fuel."

Accordingly, earnings estimates for the group are moving in the opposite direction of those for tech -- up. In the past month, analysts have raised their 2001 earnings forecasts for the sector by 4.3%, according to I/B/E/S International. That puts the consensus for 2001 earnings growth at 35.4%. And 2002, the first year producers will really benefit from recent price spikes, should be even better, with consensus earnings growth estimates currently sitting at 71.7%.

Among the small group of viable coal producers, Arch is most attractive to Atwell. Arch gets most of its coal from the Powder River Basin in Wyoming, and most of its revenue from electric utilities. For his part, Roling likes both Arch and Consol Energy below $30 a share. "Above $30, they're both accumulates," he says. "And if you tell me that California is going to continue to have rolling blackouts because of problems with availability, I may have to rethink my upside targets on these guys." (Roling's firm, Merrill Lynch, participated in stock offerings by Arch and Consol in February 2001 and April 2000, respectively.)