Traders Edge 7/30/12-Let the good times coal

It appears the good-time feelings in coal investors is set to roll again, following through on Friday's extraordinary gains. On Friday, shares of Arch coal (ticker ACI) led the charge, gaining more than 29%, a result of better-than-expected earnings and short-covering. Other companies in the space saw their shares rise in response to the euphoria, as the stock of Alpha Natural Resources (ticker ANR) gained 20%, Peabody Energy (ticker BTU) up 6%, shares of Walter Energy improved 5.6%, and the Market Vectors Coal ETF (ticker KOL) increased 4%. Today, ACI caught an upgrade from Sterne Agee on cost cutting, better thermal coal competitiveness, and valuation. The rest of coal industry looks to be reacting positively to the upgrade in the pre-open trading.

Look ahead, we continue to think that coal stocks offer an attractive long-term buying opportunity. We see the improving thermal coal economics as providing a catalyst to shares short-term and helping shares stabilize in or around current levels. Coal companies with a higher percentage of thermal coal will likely outperform their metallurgical coal heavy brethren- as the economics in steel production shows signs of waning for now. Just look at the chart of the relative price of Cloud Peak Energy (ticker CLD), the producer of thermal coal from the Powder River basis versus WLT, the coal company with the largest percentage of metallurgical coal in its product portfolio.

CLD has far out-paced shares in WLT, on, in our opinion, the improving outlook for thermal coal versus metallurgical coal.

Another important factor for coal stocks is cost cutting. We believe that those companies that are better able to manage costs will be better performers. Coal mining is a capital intensive business and the industry operates under high fixed costs. For the most part, declining production and sales volumes will lead to higher production costs per ton and lower per ton margins. We are impressed and found surprising that companies such as ACI and Consol Energy (ticker CNX) were able to reduce their per ton operating costs, be it company wide or on a regional basis. With the high level of fixed costs, these cost cutting initiatives are setting up substantial earnings gains once pricing rebounds.

As for the charts, we are seeing a bifurcation for the coal industry share prices. The charts for CLD, CNX, and ACI appear to forming bases while the charts for BTU, ANR, WLT show little signs that the selling is complete.

The above two charts are examples of this dynamic (disclosure we own both ACI and ANR). Shares of ACI closed at the trend line established since February, and if today's optimism holds we could see $10 in a heartbeat. The chart for ANR suggests that more work needs to be done for before the all clear signal is given.

As for the market, futures are mixed this morning despite gains overseas. Although we think the gains experienced last week are fleeting, we also think that market will try another run towards recent highs before failing. We detailed our thoughts more on Sunday post.