Does Coal Have a Silver Lining?

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Despite the highly anticipated crash of the U.S. coal industry, several coal companies such as CONSOL Energy (NYSE: CNX  ) and Alliance Resource Partners (NASDAQ: ARLP  ) have done well in the stock market. These companies are likely to see a reduction in the demand for coal in the long run, but this doesn't mean you should cancel these coal companies right now. Coal companies such as Alliance Resource Partners have several strong points that could still make them worthy investments.  

Legislation is not on coal's side
The Environmental Protection Agency recently issued regulations on carbon emissions for new coal-fired power plants. This is one of the many steps the EPA has taken in recent years to reduce carbon emissions and cut down the usage of coal in power plants. These recent regulations, however, are only relevant for new power plants and don't apply to old ones. This means the regulations will reduce the potential growth in demand for coal in the coming years. But until then, coal companies are likely to remain strongly in business. Let's examine how the recent developments have affected coal companies' projections for 2013.  

Outlook isn't so grim
The coal industry isn't rising but its descent could be much slower than you would think. Coal companies have started to adjust to the recent changes. CONSOL Energy recently sold five mines for a total of $3.5 billion in order to shift its attention from coal to its natural gas operations. Alliance Resource Partners has announced back in September the shutdown of its Pontiki Mine by the end of the year. 

Despite these developments Alliance Resource Partners still projects its coal production will rise by roughly 13% to 14% during 2013 (year over year), which is slightly higher than its initial projection. Its revenues are estimated to rise by 6.4% to 9.4% and its EBITDA to grow by 3.3% to 8.8%. These numbers are in line with the company's first three quarters results.

Most of the growth will come from higher production and despite the moderate drop in coal price. The company's recent third quarter report also showed a 5% increase in revenues (year over year). Other coal companies have also adjusted their outlooks: Peabody Energy  (NASDAQOTH: BTUUQ  ) has slightly increased its total coal sales (in tons) mainly in the U.S., but the company's adjusted EBITDA for 2013 is expected to drop by nearly 40% on account of lower coal prices. CONSOL Energy projects its coal production in 2013 will be close to the level produced in 2012. 

One factor that could benefit coal companies and push up their output is the developments in the natural gas market. 

Shift from coal to natural gas 
It's not new that many utility companies are shifting toward natural gas and aren't building new coal plants mainly on account of the EPA's regulations. But coal still has an advantage over natural gas that could impede utility companies from making this transition. 

Natural gas prices are more volatile than coal prices. After all, coal consumption is mostly (90%) in the power sector. Conversely, natural gas has applications in other sectors, and the power sector accounts for only 30% of natural gas usage. This could partly explain the higher volatility of natural gas prices over coal prices. In the past couple of years the standard deviation of the average monthly price of natural gas was twice as high as coal's. This could result in higher risk for utility companies when they deal with natural gas over coal. 

Source of Data: U.S Energy Information Administration

The chart above shows the rise in natural gas prices and decline in coal prices, which could partly explain the 9.6% rise in coal consumption in the first half of 2013 and the 16% drop in natural gas consumption in the power sector. 

Taking these factors into consideration, let's look at the above-mentioned coal companies and see their current valuation to determine which companies are worth investing in. 

Despite the sharp drop in the prices of leading coal companies such as Peabody and CONSOL Energy in the past year, the valuations of these companies remained high. The table below shows the enterprise-to-EBITDA of these coal companies and the coal market average. 

Source of Data: Google Finance, Wikinvest and Damodaran's site

As seen above, CONSOL Energy still has a very high EV-to-EBITDA ratio of 11.79, which is nearly double the coal market average. Conversely, the valuation of Alliance Resource Partners is the lowest at 5.27. 

In terms of dividends, both CONSOL Energy and Peabody offer relatively low dividend yields of 1.31% and 1.75%, respectively. On the other hand, Alliance Resource Partners is leading the way in this issue and pays an annual dividend yield of 6.07%. The high dividend and low valuation makes Alliance Resource Partners an investment worth considering. 

The coal industry hasn't performed well in the past year, and coal companies have started to adjust to the new regulations and cut down on coal operations if possible. Despite the little growth in coal revenues, the demand for coal in the U.S. remains robust, which could mean an opportunity. Finally, Alliance Resource Partners is an interesting investment to enter into an industry that many have prematurely deemed as unworthy.  

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Lior Cohen

Lior has been a contributor for the Fool since 2012. His main interests are in commodities, and energy and materials companies.You can follow him on Twitter to stay up to date with his industry analysis. @tradingnrg

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