Are Coal and Oil Stocks Value Traps?

Noted short-seller Jim Chanos recently stated his bearish outlook on coal and large-cap oil stocks. He believes they're value traps, a term used to describe stocks that look cheap on the surface only because their future profit declines haven't been properly priced in yet.

Even well-run coal and oil stocks fell shortly after Chanos's remarks. His fund, Kynikos Associates, is short many coal stocks and is also negative on oil majors, including ExxonMobil (XOM 0.57%). Is Chanos right to call coal and oil stocks value traps? And, if so, should you follow his advice and head for the exits?

Is big oil a value trap?
Jim Chanos believes that falling returns on capital, which he deemed "ominous," mean oil majors are ripe for a fall. There's no doubt that ExxonMobil and many of its integrated peers have had profits hit hard this year, due to falling refining margins. Indeed, Exxon's downstream segment, which includes refining activities, saw profits fall by $2.6 billion in the third quarter. That being said, upstream and chemicals together increased profits by nearly $1 billion, helping to offset some of the decline.

Refining might not turn around for some time, but management is fully committed to providing cash to shareholders in the meantime. ExxonMobil distributed nearly $6 billion to shareholders in share buybacks and dividends during the quarter, and increased its dividend earlier this year. Plus, the energy supermajor now has the financial backing of Warren Buffett, whose firm Berkshire Hathaway recently bought 40 million shares of ExxonMobil.

Coal feels the heat
Jim Chanos has maintained a negative view of coal for some time. In his estimation, the natural gas boom has directly led to falling coal prices and end users switching from coal to gas. There's reason to believe his take, as coal usage in the United States has indeed declined in recent years.

As a result, it's important to separate the winners from the losers within the coal space. Certain coal companies are definitely under intense pressure. For example, Peabody Energy (BTU) is also struggling mightily. Its third-quarter revenue fell 12%, due largely to lower pricing and flat volumes for its U.S. coal shipments in comparison to the same quarter last year. In all, it's been a tough year for Peabody: Adjusted earnings are down 82% through the first nine months of the year.

Unfortunately, weak business conditions are expected to persist for the rest of the year. Management projections are for U.S. revenues per ton to decline between 5% and 10% for the full year. Furthermore, Peabody expects full-year 2013 adjusted diluted earnings to drop 57% from the company's full-year 2012 results.

At the same time, coal hasn't disappeared by any means. There are still coal companies doing well, and assuming natural gas prices don't stay at depressed levels forever, it's likely coal will see at least a modest comeback. As a result, it's important to separate the winners from the losers within the coal space. One coal company thriving even while the industry struggles is Alliance Resource Partners (ARLP 0.47%).

Alliance Resource has actually seen its most important metrics strengthen so far this year. The company generated record production and sales volumes through the first nine months of the year. Tons produced and tons sold jumped 15% and 14%, respectively. What's more, revenues clocked in at $1.6 billion and EBITDA increased 23% to $510 million through the first three quarters, which both set company records.

And, since Alliance Resource is classified as a limited partnership, it's required to distribute the bulk of its cash flow to investors. This means investors enjoy a very high yield, which stands at 6.75%. Furthermore, thanks to its sterling operations, Alliance Resource has increased its distribution for 22 consecutive quarters.

Short-selling: too risky for the average investor
Jim Chanos is one of the most well-known and successful investors in the world, and his bearish take on coal and oil isn't without supporting arguments. Each industry faces certain headwinds. Coal is under pressure as natural gas gains prominence, and integrated oil majors are suffering from a terrible environment for refining.

That being said, shorting stocks is a dangerous game for individual investors to play, which is particularly true when the targets are well-run businesses that have produced strong results for years. As a result, investors should weigh the risks carefully before selling or going short these great companies.