Traders edge 7/25/12- Coal and Watch the $132 level on the SPY

Futures are mixed this morning with the Dow Jones and S&P 500 futures pointing to a higher open while the NASDAQ futures, dragged down by Apple's less-than-expected results, point lower. Although we are insulated, to a degree, from negative market moves, our portfolios were hurt by the poor results in coal stocks. This follows Peabody Energy's (ticker BTU) second quarter earnings announcement. BTU's second quarter earnings were ahead of estimates, but third quarter guidance was light. It is our opinion the BTU's management have historically been conservative in their guidance, probably more so now considering the current operating environment.

If you can take the volatility, we would take the contrary position and continue to add to coal stocks, which we have been doing to own sort-term detriment. That said, we are long-term investors and our thesis is that many of the problems faced by the industry are short-term and are being exacerbated by transitory events, namely the weather. Unlike other industries, the weather can have an out-sized effect on coal demand and thus coal stocks. Our analysis shows that weather can affect coal demand by up to 50% of total demand. This should be taken into context that the warm winter last year put significant pressure on utilities' coal burn rates and helped create the back-up in coal supplies we currently witness. That said, the one thing you can expect concerning weather is that it will change.

The situation in the natural gas market did not help matters either, as the warm winter dragged down energy demand. In addition, natural gas supplies ramped up with increased shale gas drilling. We continue to see natural gas storage levels that remain higher than the five-year average as the industry works through the high storage levels. That said, we think these levels will normalize as the year progresses. First off, increased natural gas burn rates from both increased market share and an overall increase in energy demand, a result of hot summer temperatures, will reduce natural gas supplies. In addition, a decrease in natural gas rigs and lower capital spending by gas drillers show that the industry is rationalizing its operations. The market also seems to be anticipating a more rationalized market in natural gas, as the price per Mbtu is approaching $3.20.

Longer-term, we remain positive on coal stocks. For one, the group appears in a buy-range on our long-term technical indicator, shown below.

 The above chart shows the average price for coal stocks since 2003. (Note- we would typically use the coal ETF- ticker KOL- to represent the group but KOL has a short trading history and cannot be used appropriately in this context), and a low indicator suggests a buying opportunity. More short-term, we are also seeing positive divergences in the RSI, MACD, and stochastic versus the price chart of the KOL ETF.

Fundamentally, we think that a continued build out of infrastructure in the developing world will lead to increased coal demand. In addition, we see India and China being large drivers of the marginal demand, as both countries coal supplies are inferior to higher quality supplies elsewhere and both lack the infrastructure to mine enough coal to meet demand, especially India. We also see the beginning of natural gas exportation, estimated to begin in 2015, as being a positive long-term catalyst for coal demand in the U.S. Right now, natural gas supplies are essentially locked in to the country, thus creating a large discrepancy between U.S. based natural gas prices and world prices.

It is also our belief that many investors do not understand the dynamics of shale gas or fracking and equate these processes to conventional gas rigs. They forget that fracking is higher cost relative to conventional gas drilling and that the production schedules for fracking wells peak two or three years after the production begins, again adding to production costs.

Finally two items of note. First, coal stocks generally react positively to inflation expectations, as one would expect being leveraged to price fluctuation in a traded commodity. It is our belief that an increase in monetary supply and subsequent gain in inflation expectations would have an out-sized positive effect on coal stocks. Lastly, higher quality coal supplies are dwindling world-wide. In fact, the U.S. coal supplies have already passed peak energy content some years ago. We think that as the availability of higher quality coals diminish, the price of the commodity will react positively.

One quick market update, we think investors should watch around the $132 level on the SPY. This appears to be an important swing point and that a lot of information on the future direction of the market will be released at this price level.