Investors Pledge Allegiance to Patriot Coal

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Patriot Coal (NYSE: PCX) generated a powerful spark for the U.S. coal industry on Wednesday when it announced plans to acquire rival producer Magnum Coal for $709 million.

Created as a spinoff from Peabody Energy (NYSE: BTU), Patriot Coal has wasted no time pursuing its strategic goal of growing through "synergistic, accretive acquisitions, particularly in the fragmented Central Appalachian region." Any investor who, like myself, suffered in recent years through memorable declines in shares of Appalachian coal companies like Massey Energy (NYSE: MEE) and James River Coal (Nasdaq: JRCC) knows full well the potential impact geography can have on profitability in the coal sector.

Transportation costs and capacity issues have plagued Appalachian coal producers, with antiquated rail lines amid mountainous terrain making the product's voyage to market a costly one. By acquiring a company with 12 coal mines and seven preparation plants in proximity to existing operations, Patriot Coal gains leverage to negotiate lower transportation costs. With this acquisition, Patriot becomes the second-largest producer of coal in the eastern U.S., while Arch Coal (NYSE: ACI) retains a sizable lead.

While geography presents a challenge that Patriot has chosen to address through economy of scale, that same geography is also a blessing. Because coal continues to provide half of all electricity generation in the U.S., the rising tide of concern for the environmental consequences of energy policy will continue to favor the cleaner-burning, low-sulphur coal for which central Appalachia is renowned. The prospects for sustained or higher coal prices are strong, especially while oil continues to trade above $100 per barrel and while global supplies are restocked following weather-related production disruptions in China and Australia.

Given market uncertainty and the inherent volatility of the coal sector, I cannot advocate jumping onboard the Patriot Coal train on the heels of yesterday's impressive 17% move. I do, however, feel that any significant retreats from here could present a more compelling valuation. Meanwhile, investors eager to place a diversified bet within the coal sector can consider the new, aptly titled Van Eck Market Vectors Coal ETF (NYSE: KOL).

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