Dumping of Coal Stocks Presents Opportunity

OIL'S ROLE IN powering cars seems to be nearing an end. Ironically, that might prove a boon over the next decade for a dirtier fuel: coal. Therein lies an investment opportunity, but it is not one for the cautious, as suggested Wednesday by a sharp selloff in both coal prices and miner shares after weeks of record gains.

June, with its $4-a-gallon gasoline, proved the worst month for U.S. car sales in 17 years. Car makers were caught with too many thirsty vehicles and too few battery-assisted hybrids. But today's hybrids, which ultimately use gasoline to charge their batteries, run just 40 or so miles on a gallon of gas. In two years, showrooms will receive the first hybrids that recharge from electrical outlets. Those should manage 80 miles per gallon on long trips and use no gasoline on short ones. They'll cost a few thousand dollars more than gasoline cars, and the price of a gallon may have dropped. But well-to-do greens will happily pay up, and the premium will disappear soon enough for budgeters. Even chest-thumpers will line up for battery cars after witnessing the face-stretching torque of, say, a Tesla Roadster. As batteries improve (and perhaps, as merchants stock their parking lots with pay-for-use electric outlets to lure customers) gasoline tanks will disappear altogether. America will have lost more than 40% of its present use for oil.

That will give your car something in common with your refrigerator and laptop. All will sip energy from the grid, and leave it to centralized plant owners to decide how to create that energy. For now, that surge in demand will mostly be met, not by windmills or solar panels, but by coal.

Coal generates half of America's electricity, and for good reasons. It's easy to get at; around 40% of coal is merely scratched from the surface rather than dug for. It is plentiful; proven coal reserves will last four times as long as those of oil and natural gas. And it is close; America is to coal reserves what Saudi Arabia is to oil. For all of these reasons, electricity generated from burning coal has long cost just a nickel per kilowatt hour. Wind costs seven cents and solar 20 cents per kWh. Coal is even cheaper than nuclear power, once construction, decommissioning and waste-disposal costs are tallied (and before accounting for pollution costs). And so China and India are inaugurating a new coal plant nearly every week. The U.S. is building more coal plants than at any time in the past 20 years. Even Europe, with its three-year-old system of charging coal plant operators for pollutants that escape into the air, is expected to bring 50 new plants online over the next five years. Coal has seemed cheap, penalties and all.

That is changing. Coal's price has more than doubled in a year. On Wednesday, it lost more than 10% on what those of us who have no explanation like to call profit-taking. Perhaps coal plants are balking at high prices and delaying orders. That can only go on so long, since U.S. ones have less than two months' supply on hand. Perhaps legal action has something to do with it. A Georgia court on Wednesday halted construction of a new coal plant, citing the U.S. Supreme Court's 2007 decision that carbon dioxide is a pollutant under the Clean Air Act, and ruling that the plant permit must set limits on carbon emissions. That would make coal a worse deal, especially if the precedent is extended to other plants under construction.

Of course, Wednesday's selloff might be nothing more than an attack of nerves on the way to even higher prices. After all, China's supply on hand is enough for just a couple of weeks, and hundreds of millions of Chinese still lack access to the electricity grid. Recent plant construction in China has suggested more of an interest in generating power quickly than holding down emissions. The country is likely to become a net importer of coal this year, leaving Asian neighbors scrambling for new supplies.

All of this is to say that, while oil's decline as a fuel source has already begun, coal, for better or worse, will burn brighter before it dims. That will favor St. Louis-based Arch Coal (ACI), which sells the U.S. 12% of its coal and has vast reserves of the most attractive kind, which has little sulfur. I recommended the stock in a SmartMoney Magazine column two years ago at $49. Coal prices plunged on a supply glut shortly thereafter, dragging Arch's stock price to $30. The supply has since been burned off, lifting Arch to $75 by Tuesday. It tumbled Wednesday to $62. The stock recently turned up in a search for companies that are beating earnings forecasts. Have a look at all eight screen survivors if you like, and use SmartMoney's stock screener and the full criteria to run the search for yourself.

The volatility is only one reason Arch is not for conservative investors. The other is price. Even after the selloff, shares fetch 40 times trailing earnings. That's because Arch's earnings are forecast to double this year and again next year, putting them at just 11 times forecast 2009 earnings. But that earnings growth depends on the persistence of high prices. In the longer run, prices are sure to fall as wind and solar become cheaper. Near and intermediate term, they are likely to remain high as coal powers today's new buildings and tomorrow's cars. My guess is that Arch's stock will head well higher over the next decade, but that its run, and coal's, will slow decidedly after that.

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