Coal as a sector has been beaten down by lower natural gas prices, muted electricity demand growth, reduced export demand and the need to conform to the Environmental Protection Agency’s (EPA) Mercury and Air Toxics Standards (MATS) regulations.
The regulations have recently forced many power producers to announce plans for the termination of coal-fired plants. In fact, coal prices saw a terrible yearly performance for 2013, falling for the first time since 2000 (read: Are Coal ETFs Back on Track?).
However, after suffering for a year, coal might breathe a sigh of relief at least for the medium term thanks to relatively higher oil and gas prices and relatively lower coal production in 2013.
Near-Term Bullish Price Outlook
U.S. Energy Information Administration (EIA) forecasts that average delivered U.S. coal prices will be $2.39 per MMBtu in 2014, up from $2.35 per MMBtu in 2013. A number of factors can be traced back to this improvement:
Coal as a Substitute Fuel: Lower natural gas inventories and higher household heating demand in winter sent gas prices into a rally. Natural gas – almost exclusively and highly used by commercial and residential customers – has thus seen a considerable price rise in the recent period.
Amid these circumstances, a number of industrial and electric generation consumers sometimes switch over to low-priced coal from high-priced natural gas thus creating demand for coal.
Tight U.S. Supply in 2013: As per the EIA, coal production was down 1.8% in the first 10 months of 2013 and was almost absorbed by consumption growth in 2013. This will leave a short-term supply crunch in the space thus boosting the price of coal. EIA now predicts coal production to grow 2.5% to 1,033 MMst in 2014 bolstered by a balanced inventory outlook and growing consumption.
Notably, consumption surged 4.4% in 2013 thanks to increased share from the electric power sector. Consumption will likely grow 2.2% next year, as per the EIA (see all the Top Ranked ETFs here).
Global Recovery: As the majority of the developed markets came out of recession and the U.S. economy too remains on the growth path, output from industrial sectors are poised to gear up. This will also trigger a certain level of global coal demand especially when coal is a key input in the steel industry. Investors should note that, nearly 70% of global steel production depends on coal.
Growing Asian Demand: As per the PIRA Energy Group – a leading energy marker researcher, Chinese electricity demand expanded considerably in the recent times leading to the strong demand for thermal generation. In spite of being the world's largest producer of metallurgical coal, China continues to import seaborne coal due to flat domestic production.
Yet another global energy and mining research company – Wood Mackenzie – forecasted that the seaborne metallurgical coal market will likely grow 51% by 2035 from the levels of 2012. As much as 69% of this demand will come from Asia while the Atlantic market will account for the rest.
Modest Sector Recommendation: To add to this, Moody’s had upgraded its coal industry outlook to stable from negative in August 2013, helping some to feel a little less bearish on the space (read: Coal ETF in Focus as Moody's Upgrades Sector Outlook). Higher demand for the thermal coal segment through mid 2014 to early 2015 and supply rationalization in metallurgical coal used for steelmaking were the drivers of this upgrade.
The Zacks Industry Rank, which relies on the same estimate revisions methodology that drives the Zacks Rank for stocks, currently puts the Coal industry at 152 out of 259 industries in our expanded industry classification. This puts the industry in the middle one-third of all industries, corresponding to a neutral outlook.
How to Play
There is only one ETF, namely Market Vectors Coal ETF (KOL), which offers a pure play on the U.S. coal industry. The ETF was down about 20% in 2013 but performed quite well to close out the year.
KOL in Focus
Launched in January 2008, KOL tracks the Stowe Coal Index, providing exposure to the companies related to the coal industry. Even though this index has a global focus, nearly 45% of its investments are directed toward U.S. companies, followed by China with a 17% share.
KOL amassed an asset base of $168.3 million and charges 59 basis points in fees annually. This fund holds 31 stocks and the top 10 companies holds 57.9% share of total net assets. Top three holdings Consol Energy, China Shenhua and Joy Global make up for about 21% of the fund (see more in the Zacks ETF Center).
The fund is currently trading a little higher than its 52-week low which leaves room for rally as long as broad trends hold up well. The Fund’s Relative Strength Index is 51.04 currently thus indicating that KOL has way to go to enter the overbought territory.
While KOL currently holds a Zacks ETF Rank #4 (Sell), the valuation has perhaps bottomed out and can call for a trend reversal. KOL has greater share invested in mid-and-small caps thus having potential to bounce back in a trending U.S. economy.
However, the risk quotient of the fund is high; be it in the form of concentration risk or currency risk (as about 50% of assets exposed to foreign currencies). Still, KOL could be due for a bounce back this year.
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