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ETF Sector Focus: Investors Will Like This Coal in Their Stockings This Holiday Season

Coal ETFs carry above-average risk but offer compelling reward potential right now.

Robert Goldsborough, 11/30/2011

The stock prices of companies engaged in exploring for or mining coal have been hammered in recent weeks.

Since July, coal companies' seesaw-like share prices have been more down than up, amid investor concern about broad macroeconomic uncertainty. In the last three months, a basket of coal industry companies found in a popular exchange-traded fund is down 15%, while the S&P 500 is actually up 2%.

While coal demand itself isn't necessarily highly volatile, there is no question that coal companies themselves have become more volatile in recent years, as the firms have become more reliant on the production of higher-margin metallurgical coal, which is used in steel making, and have become more exposed to metallurgical coal's inherent operating leverage. Particularly since the start of November, as investors have been spooked about a financial crisis in Europe and slowing steel demand in China, they have driven down the share prices of coal companies.

And more broadly, investors have a right to be concerned about a host of unfavorable dynamics in the coal space--not least of which has involved U.S. power plants' continued switching of their fuel sources to natural gas, given historically low prices of natural gas. That transition has in particular whacked the share prices of coal companies with heavier exposure to Appalachian mines.

On top of all of this, demand by U.S. power plants for coal is lower than it has been in the past, owing to the still-weak economy and greater energy-consciousness.

Powerful Dynamics Still Favoring Coal
In the medium term, however, there are some powerful and favorable trends favoring U.S. coal, including increased demand by China and India, along with proposed new coal export terminals on the West Coast (plus, expansions of some existing West Coast terminals) to help ease the transport of U.S. coal from Wyoming’s Powder River Basin to Asia. In addition, coal remains a generally inexpensive way to generate energy whether it is higher-sulfur coal extracted from the Appalachian region or whether it comes from the Powder River Basin where coal has a much lower-sulfur content (making it better suited for greater regulatory environment) and is far cheaper to extract but carries with it far higher transportation costs on U.S. railroads. An investor taking a tactical position in a basket of coal companies must hold the belief that metallurgical prices will rebound and that growth in China will continue.

Using an ETF to Invest in a Basket of Coal Firms
If one totals up the debits and credits above, one sees that the coal industry has all the hallmarks of an industry that is badly out of favor right now. And Morningstar's equity analysts generally agree. Most of the U.S.-based coal companies that our analysts cover, such as Consol Energy CNX, Peabody Energy BTU, and Arch Coal ACI, are trading substantially below our analysts' fair value estimates.

For those investors who feel that coal companies' share prices are overdone, the exchange-traded-fund structure may be the best option. ETFs allow investors to diversify their risk within an industry by buying a basket of stocks. And for investors wanting to make a tactical bet on companies involved in mining so-called "black diamonds," there are two coal ETFs that offer broad exposure to the global space. Neither fund holds enough companies that Morningstar's equity analysts cover for us to be able to compute fair value estimates for the funds, which are calculated by aggregating and weighting our equity analysts' estimates of fair values for the ETFs' underlying constituents. But we can gain some idea of the relative attractiveness of coal companies right now by looking at our analysts' price/fair value measures for the coal firms that Morningstar does cover. Right now, small-cap Powder River Basin miner Cloud Peak Energy CLD, which my colleague, Morningstar coal analyst Michael Tian, calls his favorite name in the industry, trades at 62% of its fair value. And coal industry giant Peabody Energy is trading at 63% of its fair value, while coal and natural gas industry titan Consol Energy trades at 72% of its fair value. In all three cases, the firms trade at significantly greater discounts to fair value than the S&P 500's current valuation, which is 81% of Morningstar equity analysts' estimate of fair value. (To be fair, one larger coal player, Alpha Natural Resources ANR, which significantly overpaid, in our analysts' view, for its recent acquisition of Massey Energy, trades above our analysts' estimate of fair value, while small-cap and worst-in-breed Central Appalachian miner James River Coal JRCC also trades above our estimate of fair value.)

Robert Goldsborough is an ETF Analyst at Morningstar.
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