Melvin: Dirty Fuel Has a Bright Future

Editor's Note: This article was originally published at 3 p.m. EDT on Real Money on Aug. 20. Sign up for a free trial of Real Money.

I find it mildly amusing to talk about energy stocks with investors who only pay attention to the headlines. Most people seem to think that we are the verge of a tremendous green energy future and that in virtually no time at all we will be getting the bulk of our power needs from wind , solar and other renewable sources. Of course, they also think that renewable means cheaper and that is far from the case at this moment in time.

I am a big believer in renewable energy technologies but that cheap green future is still a long way off. It may the norm for my kids at some point, but for the foreseeable future we will need to burn stuff to meet global energy needs.

The consensus view is that we will see the demise of the coal industry sometime soon as well. While coal is considered a dirty fuel, it is also necessary for much of the world. Far from declining, coal demand is projected to grow over the next decade as emerging markets burn the coal that the U.S. may stop using.

Even the U.S. will still use a significant amount of coal to produce electricity for several decades. As International Energy Agency Executive Director Maria van der Hoeven recently pointed out: "Like it or not, coal is here to stay for a long time to come. Coal is abundant and geopolitically secure, and coal-fired plants are easily integrated into existing power systems. With advantages like these, it is easy to see why coal demand continues to grow."

Coal stocks have been beaten up pretty badly the past few years. Shares of industry leader Peabody Energy (BTU) are down about 80% from their 2008 peaks. Arch Coal (ACI) shares have gone from more than $70 to less than $5. Alpha Natural Resources (ANR) was once a triple-digit stock and now it, too, languishes in the sub-$5 neighborhood. While a price decline in and of itself is not a reason to buy the stock, it does appear that the market is underpricing the long-term realities of coal companies. If your idea of long term is the next options expiration, then coal is not for you. However, investors who are willing to think in term of five to 10 years could see enormous profits from this dirty sector.

The coal industry is starting to show some of the classic signs of bottoming. We have seen a few bankruptcies so far in the sector, as marginal and over leveraged players are forced out of the business. Private equity investors are starting to move into the space, buying coal producing assets and companies on the cheap.

Apollo Global Management (APO) executive Jordan Zaken announced a partnership to buy coal assets and said, "We believe the long-term prospects for the global coal industry are highly compelling." Blackstone (BX) was a big buyer of Arch Coal shares in the past quarter, snapping up 5.4 million shares of the coal miner. Eventually, we will start seeing mergers as coal companies join forces to achieve economies of scale and pool resources to improve access to export markets around the world.

On a price-to-book value basis, shares of Arch Coal and Alpha Natural are now among the cheapest globally. At these prices, the stocks are basically undated call options on the future of the coal industry. If they survive, the stocks could pay off tenfold or more over the next decade. If they are acquired, you will make a few bucks. If they fail, then you will obviously lose the few dollars you pay for the bargain basement shares today. It is an excellent risk/reward for long-term investors. At these prices, even a small position can have huge rewards.

Industry leader Peabody has been a little trickier to play. I like to buy stocks that are trading at less than 90% of book value and this stock has stubbornly refused to dip below that level. On pullbacks, it is proving profitable to sell the near-term puts in hopes of backing into the stock when the price eventually falls to an attractive entry point. Until it does, you can just pocket premiums on cash-secured put sales.

We may have a cleaner, greener energy future someday. But that day is not today. Coal is still very much a part of the global energy picture.

At the time of publication, Melvin was long ACI, although positions may change at any time.

Tim Melvin is a writer from Stevensville, Maryland, who spent 20 years a stockbroker, the last 15 as a Vice President of Investments with a regional firm in the Mid Atlantic area. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Melvin appreciates your feedback; click here to send him an email.

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