Why Alliance Resource, Cloud Peak Soar as Coal Sector Crashes

NEW YORK (TheStreet) -- Coal stocks have been hard hit by the threat of environmental regulations and the rise of natural gas as a cheap and plentiful alternative to coal. But not all coal stocks have suffered the same fate.

From June 2009, the Dow Jones U.S. Coal Index has fallen 41%, with any gain from the past five years and then some completely wiped out. The high of 496.71 on April 1, 2011, sounds like a bad joke, now with the index at 145.17. The largest coal company in the world, Peabody Energy (BTU), is down 53% over five years to $16.79, plummeting from a high of $72.71 on April 1, 2011.

On the other hand, Alliance Resource Partners (ARLP) is up 128% and Cloud Peak Energy (CLD) is up 29.2% over the same time period. Both stocks benefit from boring, stable businesses and the changed regulatory landscape, and neither shows any immediate sign for concern. But as the future holds even more regulatory pressure on the commodity, that rosy outlook could change quickly.

ARLP Closed Friday at $87.36. The stock is scheduled for a 2-for-1 split after the close of trading Monday, June 16. CLD was up 1.4% on Friday to $19.22.

Alliance Resource is a master limited partnership, making it a special case within any basket of coal stocks. MLPs were given special tax status by Congress in the 1980s in order to boost the country's movement toward energy independence. They have few or no employees, and are not subject to corporate tax.

For investors, these tend to be defensive investments, focused on infrastructure and real estate businesses less exposed to risk and able to provide a stable source of revenue. While stocks pay a dividend, MLPs mete out a cash distribution that is treated as a return of capital and isn't taxable until the investor sells his stake in the company.

That's the biggest advantage of MLPs. Investors, known as unitholders, don't have to pay taxes on the cash distribution until they decide to sell their shares. Alliance Resource's yield currently is 5.58%, but that's misleading. While MLPs are designed to be stable workhorses, some, like Alliance, are growing, meaning the yield increases each year. In Alliance Resource's case, the total cash distribution increased 14% year over year in 2012 and 8.8% in 2013.

In a May report on ARLP, analyst Jorge Beristain of Deutsche Bank said he recommended Alliance as a defensive coal stock, but added the company's future prospects were tied to its expansion, particularly at the new Gibson South mine, and that the results of that expansion already were priced in. As a caution against his overall positive outlook for the stock, Beristain added:

Key upside/downside risks to our outlook include global economic growth, energy consumption, further coal inventory changes at utility companies, direction of energy prices, changes in energy and/or carbon policy changes and consequent ramifications in switching fuels.

Alliance Resource also follows what Beristain calls "a highly contracted business model" -- a stable of steady, long-term contracts with reliable partners. Those contracts help insulate the company from the price fluctuations in coal. However, longer-term reductions in coal use by utilities as a result of new Environmental Protection Agency emissions requirements should impact ARLP in the same way as other coal stocks.

Coal and the Clean Air Act

The quality of coal is also an issue for any coal stock. Alliance mines Appalachian and Illinois Basin coal, which tends to have a higher heat content but contain more sulfur and other pollutants that, under the Clean Air Act, need to be removed by coal-burning plants using expensive scrubbers. Because of its sulfur content, Illinois Basin coal went out of fashion for a while after the implementation of the Clean Air Act Amendments of 1990. Now that most power plants have added the scrubbing technology and Appalachian coal has become increasingly expensive, Illinois Basin coal is once again looking attractive.

Cloud Peak, on the other hand, has profited precisely from the imposition of the Clean Air Act standards. Cloud Peak, formed in a 2009 spinoff of Rio Tinto Energy America, mines coal mostly in the Powder River Basin. The coal there has less potential heat content, but contains less sulfur and requires less expense from power plants to bring emissions into compliance. Powder River Basin coal became attractive after the Clean Air Act Amendments of 1990, which, among other things, restricted sulfur emissions.

Powder River is also easier to mine and cheaper than Appalachian or Illinois Basin. The coal is plentiful and close to the surface, making the establishment and operation of a mine less costly. That allows Cloud Peak to ship its product as far as China, where clean coal is needed to meet coming restrictions on emissions, and still turn a profit. This make Cloud Peak one of the few coal companies in the world able to actually benefit from increased emissions regulations.

But if Powder River Basin coal is cheap and clean, it is still coal. As regulations take effect, more and more power is being shifted to other energy sources and coal will suffer, making the long term for Cloud Peak less than a certain prospect.

According to a report last year by the Coal Industry Advisory Board, a panel of industry representatives set up by the International Energy Agency, summarized the threat to U.S.-burned coal from regulation:

A number of pending regulatory rules from the Environmental Protection Agency (EPA) could severely impact the future use of coal. These regulations address traditional air pollutants such as sulphur dioxide and nitrogen oxides; hazardous air pollutants including mercury; cooling water withdrawal from lakes and streams; ash handling; traditional water pollutants; and carbon dioxide emissions. Several of the final rules are the subject of legal actions in the courts and in those instances the final rule will not become effective until the court action is resolved.

Former U.S. Representative and House Majority Leader Dick Gephardt, interviewed by TheStreet's Joe Deaux on Friday, went further and said that Congress would never support the EPA's carbon emissions rules recently proposed under the Clean Air Act. The proposal bypasses Congress by extending the power of the EPA under the act. Gephardt said knocking out coal facilities "will hurt consumers and the poorest of the poor more than anybody" without necessarily accomplishing the goal of global emissions reductions.

Gephardt added that coal is "40% of the electricity in the U.S. today." It is also still a growing energy source around the world.

While growth has slowed to its long-term average of 2.5% per year in recent years after a decade-long burst to 4.4%, the world remains dependent on coal as a stable, cheap energy resource. Tightening regulations in many countries are pushing the development of more efficient burning of coal and the replacement of coal with alternative sources, including natural gas, but also nonpolluting sources like solar, wind and ultimately geothermal. Support by the U.S. government for the "super-critical technology" that Gephardt mentions, including carbon capture and storage technology, is noticeably absent. That technology could make coal more feasible as an energy resource while meeting environmental expectations.

Bottom line: Both Alliance Resource and Cloud Peak are good bets as investments to take advantage of U.S. coal producers' changing landscape. Alliance offers special tax advantages as an MLP and is more insulated from fluctuations in the market price of coal. Cloud Peak's cleaner-burning coal is cheap and in demand around the world, an attraction that will work in its favor even as other coal stocks suffer.

Longer term, be wary, as a fast-moving regulatory trend around the world, new developments in technology and the maturing of alternative energy sources could ultimately hamper or even reverse growth.

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-- Written by Carlton Wilkinson

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