Follow CONSOL Energy's Transformation

NEW YORK (TheStreet) -- CONSOL Energy (CNX) is one of the oldest and largest players in the American coal industry, operating since the days of President Lincoln. Although the company has been the largest producer of coal from underground mines in the United States, it has been working to reduce its exposure to coal in favor of natural gas.

It has recently received the anti-trust clearance related to the sale of its coal mines in West Virginia while at the same time identifying thousands of natural gas locations at Marcellus Shale and will drill 120 wells this year.

Following a drop in income in 2012, and persistent weakness in market conditions, investors expected the current year to be a tough one. It was. According to its recent quarterly results, in the first nine months of 2013, CONSOL Energy swung from an income of $239 million in 2012 to a loss of $78 million in 2013.

However, CONSOL Energy is a company in transition using the cash flows from its struggling coal division to expand its natural gas and NGL operations, where it sees its long-term future. Despite current woes, in the long run the company could yield significant returns for the shareholders due to the considerable increase in its gas output on the back of divestitures, drop in coal capital expenditure and strong liquidity.

CONSOL Energy has struggled due to the weakness in the domestic coal market. Prices of coking coal have been under pressure due to the excess supply while the cheaper gas from shale formations had a negative impact on the demand of thermal coal. Moreover, stricter environmental regulation for coal fired power-plants has also made things difficult. Since CONSOL Energy gets most of its revenues from coal, therefore, the business has struggled with top- and bottom-line growth.

The company's exposure towards natural gas makes CONSOL Energy a unique energy firm with two separate, seemingly unrelated business units in coal and natural gas. The company is clearly not like other coal producers. This is evident in the performance of its shares. In the last 12 months, the Market Vectors Coal ETF (KOL) has dropped by 20%. On the other hand, CONSOL's shares have risen by 16% in the corresponding period.

CONSOL Energy is the biggest holding in the Coal ETF, which includes 32 other leading coal producers from around the world. Without CONSOL at the top, the performance of this fund could have been worse.

CONSOL Energy has amassed significant acreage at Marcellus and Utica plays and now boasts of $4 trillion cubic feet of natural gas reserves. In fact, the company's reserves are similar to that of Antero Resources (AR), a rising mid-cap energy firm which went public two months ago. Antero Resources is loved by analysts who have showered it bullish notes and buy ratings. Like Antero, CONSOL Energy's gas assets could also be hiding significant value that has been overshadowed by its struggling coal business.

Over the last several years, the business has considerably increased its gas output. In 2012, Consol Energy reported an 11% drop in revenues, and a 39% drop in net income ($5.43 billion and $388.1 million, respectively). During this period, it reduced its coal production from 62 million tons in 2011 to 56 million tons in 2012 while its gas production rose from 153.5 Bcf to 156.3 Bcf.

Although the transition towards natural gas appears slow, a longer term analysis over a period of five years reveals that CONSOL Energy has reduced its coal production by 14% while its gas production has more than doubled in the same period.

As mentioned in the beginning, CONSOL Energy is now one step closer towards selling all five of its longwall coal mines in West Virginia for $3.5 billion. Meanwhile, the company will also cut its coal capital expenditure by half, from a little less than $1 billion in 2012 to between $410 million and $520 million in the current year. The company generates significant cash flows from its coal business.

In the previous quarter, the CONSOL Energy generated cash flows from operations of $41 million from high and low volatility metallurgical coal and $207 million from thermal coal.

The business currently has $21 million of cash reserves and $2.28 billion available from revolving credit facilities.

Through assets sales, reduction in expenditure, cash flows from coal division and strong liquidity, I believe CONSOL Energy will be able to successfully increase its exposure towards natural gas.

In the current quarter, CONSOL Energy's coal production should approach 14 million tons, which will take its annual production to around 57 million tons. In other words, annual coal production will be flat as compared to last year. As outlined above, this trend will likely continue in the future and the business will increase its gas output between 25% and 30% through 2016.

Before betting on CONSOL Energy's reliance on natural gas, investors should note that gas prices will remain under pressure in the short term due to excess supply. In the long run, from 2015, the demand could start increasing. Through this massive increase in demand, which will be brought by LNG export facilities and gas-powered petrochemical plants (both of which are currently under development), a more natural-gas-focused CONSOL Energy will be able to generate significant returns for its shareholders.

At the time of publication the author had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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