How to profit from the coal glut

published 13 March 2012

The US natural gas revolution' is quietly transforming the energy sector.

You're probably familiar with the story by now. In short, new fracking' technology has seen the US gain access to vast reserves of natural gas stored in shale'.

So far, the focus of the excitement has been the potential long-term impact on America's demand for foreign oil.

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But natural gas is already having a far more significant impact on a less widely-watched commodity.

Old King Coal may be losing his throne

Coal demand is tumbling

You may not have noticed it's not the most widely reported economic number but the price of coal is at a 15-month low.

This is no doubt partly to do with jitters over Chinese demand for raw materials. But there's a more immediate cause too. There's just too much of the stuff. And that's down to the US natural gas glut.

As fracking' has unleashed new reserves of natural gas, the price of gas in the US has collapsed. Prices have fallen by more than 80% over the past seven years or so.

Falling prices normally act on a market in two ways. On the supply side, supply is normally reduced. However, in the case of natural gas, a lot of the producers have been forced to keep pumping product even at a loss in order to generate cash flow to pay for their projects.

On the demand side, though, people have started to notice. Utility suppliers are increasingly switching to natural gas-fired power stations at the expense of their coal-fired ones.

New regulations in the US are also driving the change. As Bloomberg reports: "Utilities are also switching because of an impending government rule that calls for Texas and 26 eastern states to cap sulphur dioxide to limit acid rain and soot".

Coal remains the largest source of electricity production in the US. But in December its share of the market fell below 40% for the first time since March 1978, reports the Financial Times. At its 1985 peak, coal accounted for nearly 60% of generation.

This declining trend looks likely to continue. And while that could be bad news for coal miners, as Eoin Treacey of Fullermoney.com noted last month, "if power companies are going to be forced to use less coal, then natural gas is likely to be a beneficiary".

What to buy now

So what does all this mean for your portfolio? It's certainly worth keeping an eye on natural gas producers. They've been hit hard by the production glut'. But as a result of low prices, many producers have slashed production. Meanwhile, as demand for cheap natural gas rises, it won't stay as cheap.

I wouldn't use an exchange-traded fund to play natural gas directly. For a start, that relies on your ability to call a bottom in the gas price, which is pure speculation. Secondly, commodity ETFs are complicated beasts. If it's not physically backed (like many of the precious metal ETFs) then chances are it won't do what you expect it to. So steer clear.

Instead, I'd invest in stocks exposed to natural gas. One intriguing play is Consol Energy (NYSE: CNX). US financial paper Barron's had a favourable review of this stock a couple of weeks ago.

Consol is a major thermal coal miner. However, it also produces natural gas. And at current prices, reckons Barron's, "investors are getting one of Consol's businesses free". Given that both coal and natural gas are cheap relative to oil right now, the company looks a good way to hedge your bets.

Another increasingly interesting area is shipping. Tanker stocks have had a torrid time since the financial crisis. Booming global trade came to a halt almost overnight, leaving behind a glut of unwanted ships. The sector has yet to recover.

But if the US is going to turn into an exporter of both coal and natural gas, that's going to affect demand for shipping. For example, notes the FT, "low freight rates are helping US thermal coal producers ship their commodity into the European and Asian market".

Again similarly to the natural gas market, in fact as demand rises for tankers, freight rates will pick up. My colleague David Stevenson has been looking at the tanker sector and recently wrote about what he thinks is the most promising play for the Fleet Street Letter. To find out more about the newsletter, watch this video.

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.