Mr. Energy

Mr. Energy
by Jeffrey Saut, Raymond James

September 20, 2010

“Change of a long-term or secular nature is usually gradual enough that it is obscured by the noise caused by short-term volatility. By the time secular trends are even acknowledged by the majority they are generally obvious and mature. In the early stages of a new secular paradigm, therefore, most are conditioned to hear only the short-term noise they have been conditioned to respond to by the prior existing secular condition. Moreover, in a shift of secular or long-term significance, the markets will be adapting to a new set of rules while most market participants will still be playing by the old rules.”

... Bob Farrell

Over the years I have quoted Bob Farrell, sage ex-strategist of Merrill Lynch, in my missives because his insights have proven timeless. The aforementioned quote is no exception. To be sure, I have often spoken of secular changes before they were widely acknowledged. One of my better observations was the secular change that China was joining the World Trade Organization in the 4Q of 2001, which was going to cause per capita incomes in China to rise. History shows that when per capita incomes rise people consume more “stuff” (oil, gas, coal, cement, timber, agriculture, precious/base metals, etc.). Accordingly, we have ridden that profitable insight ever since. More recently, I have talked about cloud computing and its ability to potentially shake the business models of existing hardware and software companies to their very foundations. I have also discussed smartphones’ potential impact on personal computing (PC) companies since the smartphone market is growing ~5 times faster than the PC market. This morning, however, I want to revisit my long-standing bullish views on coal.

I was reminded of the bullish potential for coal while listening to arguably the best energy portfolio manager on the planet, namely BlackRock’s Dan Rice. To paraphrase his comments, Dan suggested that with 2% world GDP growth the price of crude oil would average $80 – 85 per barrel. That should allow oil stocks to rise by some 40% over the next few years. He also stated that we are living hand-to-mouth on many commodities like oil, copper, and coal. The comments that really struck me were about coal, which he said would rise from a price of $60 – 65 per ton to $85 per ton with a concurrent 300% “hop” in the aggregate share price of many coal stocks.

Piqued by Dan’s comments I reflected on a presentation by Peabody Energy’s (BTU/$47.00/Outperform) CEO, Gregory Boyce, and his belief regarding the “long-term supercycle for coal.” In said presentation Mr. Boyce observed that coal has been the world’s fastest-growing fuel over the past decade, with demand surging by nearly twice the rate of natural gas, and four times faster than global crude oil consumption. “It’s stunning,” he said, “that any mature commodity could expand some 50% in a decade.” He went on to say, “coal (usage) is expected to grow faster than other fuels in the coming decade.” Indeed, in 2010 more than 94 gigawatts of new coal-fired electric generation facilities are slated to come on line, representing roughly 375 million more tonnes of coal consumption. This comes at a time when the burgeoning middle-class of emerging countries is demanding more electricity, as well as more steel, both of which compound the demand for coal! Peabody estimates the demand for coal will increase by ~1 billion tonnes over the next four to five years. Currently, Peabody is exporting 6 – 7 million tonnes of coal per year, but intends to ramp that production to 20 million tonnes over the next few years.

While there are many favorably rated coal stocks in our research universe, there is only one Strong Buy-rated name, Alpha Natural Resources (ANR/$39.35). Conveniently, Alpha had an Analyst Day last week, causing our analyst, Jim Rollyson, to pen the following research note:

“On Tuesday, we attended Alpha's Analyst Day in Pittsburgh. Overall, there weren't any earth shattering revelations. We did, however, come away with several takeaways. The recent Foundation Coal merger is working out better than planned. The balance sheet remains in a strong position with Alpha's net debt position continuing to slide. At the end of 2Q, net debt stood at $159 million (including nearly $662 million in cash and marketable securities). The good news is this exceptional balance sheet leaves Alpha with many opportunities to invest in organic growth projects and/or M&A potential.”

“M&A moves are a matter of when, not if. Alpha has made it known it is looking at acquisition opportunities both domestically and abroad. Additionally, several organic growth projects are in the works. Alpha highlighted several new mine projects under development, or in the permitting stage, anticipated to at least replace production over the next several years and in certain cases enhance it. Finally, valuation remains attractive, especially for a larger cap, diversified coal producer. Touting a cheap valuation has become a normal character trait for Analyst Days, but in this case we have to agree. After successfully completing the Foundation merger, putting up decent results for several quarters (even through the global recession) and continuing to improve the balance sheet, ANR trades not only below the larger, diversified peers it compares itself to, but at a discount to the overall group as well. Our model suggests ANR trades for ~4.5x 2011 EBITDA as compared to 5.6x for the larger peers, which if normalized would drive ANR share price into the low $50s. Note that this excludes any separate value for ANR’s natural gas assets, which we believe could offer another $5-10/share of future potential upside.”

I revisit the coal theme this morning because the La Niña weather pattern, combined with numerous volcanic eruptions that put large amounts of ash into the atmosphere, have allowed the Tropic of Cancer and the Tropic of Capricorn to expand. The result has brought increased hurricane activity, soaring temperatures, Asian floods, droughts (Russia has lost 30% of its wheat crop), and the list goes on. While the current focus is on the unusually warm weather, don’t expect this to continue as the Northern Hemisphere faces an upcoming VERY cold winter due to massive amounts of volcanic ash in the atmosphere. Energy stocks, therefore, should be over-weighted in portfolios with the biggest “bang” going to the Exploration & Production stocks (E&P), as well as coal stocks (70% of China’s energy consumption is coal, while 20% is oil). My favorite E&P name remains Clayton Williams (CWEI/$48.68/ Outperform).

The call for this week: According to Dow Theory, the primary trend of the stock market is “up.” That upward trend would be reconfirmed if the D-J Industrial Average (INDU/10607.85), and the D-J Transportation Average (TRAN/4433.66), break above their respective August 9th closing highs of 10698.75 and 4516.35. Such action would also suggest a run toward the Dow’s April 26th closing high of 11205.03. Last week, however, stocks stalled around their August recovery highs. For readers of these comments that should come as no surprise given my very short-term concerns that with 75.8% of the S&P 500’s stocks above their 50-day moving averages (DMAs) we are currently pretty overbought. Then too, we are at the top of the Bollinger Bands that have contained all rallies for the past year, as can be seen in the nearby chart. Still, as repeatedly stated, I don’t think any selling will gain much downside traction, leading to a re-rally that will carry the major averages above their August highs. Reinforcing that view is my proprietary intermediate-term trading indicator, which is trying to turn “green” after being in a cautionary “red” mode since the first week of last May (see chart). Interestingly, despite last week’s wimpy trading pattern, the Telecommunication Services Sector, and the Consumer Discretionary Sector, both broke out to the upside in the charts (read: no double-dip). And don’t look now, but also breaking out to the upside in the charts was our long-standing bullish positions in the precious metals complex despite China’s currency, the renminbi, trading to new all-time highs versus the U.S. Dollar. Indeed, curiouser and curiouser . . .