In the current global energy crisis as the Western world cuts off Russia, the world's third-largest supplier of oil and natural gas, the demand for coal has exploded. This has reversed several years of declines for the industry, which was almost on the verge of bankruptcy only a couple of years ago.
Investors have been shunning the coal industry due to a combination of its high polluting nature and alternatives becoming more cost-effective. Coal is one of the dirtiest fuels to burn and use globally, and only last year politicians agreed on a landmark deal to significantly reduce the use of coal around the world over the next few years as part of their ambitions to slow down climate change.
A lot has changed over the past couple of weeks, however. Coal prices have spiked as oil and natural gas have become scarce, and companies with exposure to the industry are experiencing one of the best environments they have ever seen.
However, investors have rushed to declare that they are exiting hydrocarbon investments over the past couple of years, and it's more than just a financial decision - many are exiting hydrocarbons for moral or public relations reasons. This is now leading to an interesting opportunity in the sector. Many institutional investors have declared that they do not want any exposure to the hydrocarbon industry, but the industry is now achieving record profits. As a result, a valuation gap is growing. Companies' profits are rising, but there is no one to buy their shares. Due to this discrepancy, the businesses are only becoming cheaper.
Cheap equities
A great example of what is happening with coal stocks right now is the coal producer Consol Energy (CEIX, Financial). Based on current Wall Street growth estimates, the stock is currently trading at a forward price-earnings ratio of around 4 for 2022.
Analysts expect profits to fall next year as the price of metallurgical coal declines from recent highs. Nevertheless, even based on these downbeat estimates, the stock is trading at a 2023 forward price-earnings ratio of 4.6.
This company has been a favorite of value funds for the past couple of years because it has been in a distressed debt restructuring situation. This is one of the reasons why the equity is so cheap. A combination of bad acquisitions and low coal prices brought the company close to collapse. It has been working through these issues over the past couple of years.
The current environment could allow management to significantly reduce the group's debt and stabilize its balance sheet, helping the enterprise lay the foundations to achieve stable, predictable growth and returns for investors.
According to the company's fourth-quarter 2021 results, it was able to reduce total debt outstanding by $31 million in the fourth quarter. Overall net debt in the year declined from $662 million at the end of 2020 to $524 million at the end of 2021.
The company built a substantial cash reserve and repurchased $101 million of outstanding loans and bonds during 2021. These actions put the business on a stable financial footing, and it looks as if the enterprise will be able to make further progress in the year ahead.
Cash cow
At the beginning of February, Consol Energy was fully contracted for output in 2022 with around half of output contracted for 2023. Based on these projections, management has clarity over cash flows for the next two years.
Assuming the company can repeat the performance it achieved in 2021, which seems likely considering the fact that coal prices have jumped over the past few weeks, I do not think it is unreasonable to estimate that the business can reduce debt by a further $200 million in the next two years while building its cash reserves further. As leverage continues to fall, I also think management will likely look to return more cash to investors.
So, while some investors might not want to touch this business for ESG reasons or lack of extremely long-term potential, the stock's current valuation and free cash flow growth over the next two years look highly appealing to me.
