Tickers in this Article: BTU, ACI, CNX, SPY
Peabody Energy (NYSE:BTU), the nation's largest producer of coal, reported second-quarter profit that was up a decidedly un-modest 100% from the prior year's quarter. Despite the outsized earnings growth (which surpassed upbeat guidance) and the raising of the bottom of estimates for the full year, Peabody shares fell on broader concerns about the spot price of coal, which has fallen back a bit after reaching the highest levels in a decade during the second quarter.

While shares of all the coal miners have been on a roller coaster ride of late, I think the recent pullback represents a good opportunity for long-term investors who can handle a bit more volatility to place themselves in an industry with a tight supply/demand balance and strong secular trends in place.

Inside the Numbers
Peabody reported earnings of 86 cents per share, or $233 million, on a shade over $1.5 billion in revenue. The latter represents over 40% growth in the top line year-over-year, and nearly 20% sequential growth from the first quarter of 2008.

Net earnings were more than double the 40 cents per share posted a year ago, and shockingly, they were higher than the Bloomberg consensus estimate of 55 cents per share. Such wide discrepancies are not uncommon in these commodity-based businesses, especially when underlying spot prices are breaking through major resistance levels. The more volatile the spot prices become, the more that speculators and hedge funds tend to throw their weight into the market. (For further reading on hedge funds, be sure to check our Taking A Look Behind Hedge Funds.)

We've seen similar activity in the price of crude over the past few months; both commodities have strong fundamental trends driving the price higher (global demand, infrastructure buildouts, finite supplies), but heavy speculation can create short-term spikes in volatility. This will affect the stock prices of all the companies directly involved in the production and consumption of coal, but it has a more focused effect on companies like Peabody and Arch Coal. (NYSE:ACI), which are pure plays. Broader energy companies like CONSOL Energy (NYSE:CNX) will see a more muted response in their stock price to the daily machinations of the spot price, as they have other revenue sources and variables in play.

Coal Seeing Massive Bull Market
Results were especially good from Peabody's Australian operations. The coking coal (also known as metallurgical coal) produced there is a necessary component for steel production, and revenue was up over 80% in the second quarter. Spot prices and contract rates for coking coal are up nearly 300% from a year ago, and Peabody is already locking in gains from the rapid advance, stating that contracted rates through the beginning of 2009 are roughly $300 per metric ton.

Thermal coal (coal used for electricity generation) prices are sitting at about $125 per ton for contract rates, while spot rates got up as high as $175 per ton in early July before pulling back in recent weeks. While some of this is due to speculation and short-term supply disruptions, this is still about as booming as booming gets.

Even in the Powder River Basin - the largest source of mined coal in the U.S. - prices were up over 80% since the beginning of the year, and Peabody has more proven reserves there than any competitor.

Why have there been surge in prices after years of coal languishing as the "other black fuel"? The reason is two-fold, and rooted in good-old fashioned economics:

Supply & Demand - The Tried and True Market Force
China is running terribly low on coal stockpiles, and switched gears in May to become a net importer rather than exporter to meet surging domestic demand. Vietnam (a nearby supplier to China) has announced it will be cutting coal exports by more than 35%, while on the conference call Peabody executives mentioned shortfalls in other nations such as South Africa and Indonesia.

This drop in international exports has many coal consumers scrambling to restore stockpiles heading into the second half of the year, leading to much of the spike in spot prices. (Learn more about the supply/demand relationship in our Economics Basics Tutorial.)

Long-Term Trends Still Intact
Peabody is also waxing poetic about prospects in India, where it predicts that an extra 78,000 MW of coal-fired electricity will be needed over the next four years. This adds up to an additional 265 million tons of coal. As a frame of reference, that's more than what Peabody sold in all of fiscal 2007. The company's expanding operations in Australia serve as a powerful geographic base to serve the Asia region, a source of major growth for many years to come.

Overall demand for coal is expected to rise not only because of organic growth in the global economy, but because the increasingly prohibitive cost of crude oil makes all other fuel sources look that much more attractive.

The activity of Peabody's shares during the second quarter tells the story of how unsure investors are over the long-term story of coal. After rising over 60% from early April until the end of June, Peabody shares have given up all those gains in just a few short weeks. The stock is now basically flat for the year, which is still much better than the 12% drop in the SPDR Trust Series ETF (AMEX:SPY).

The company's hard focus on expanding international sales has paid off quite nicely. More than half of Peabody's net earnings are generated from outside the U.S. This figure was only 1% as of five years ago. This makes Peabody a great weak-dollar play, a solid energy play and a commodity play in a rapidly developing world.

Parting Thoughts
All of this globe-trotting is meant to highlight one vital point: All roads seem to be leading to a sustained, high price of coal. This should place Peabody into the industry's driver seat over the next few years, as it has the world's largest known coal reserves at over nine billion tons, and a higher base price of crude oil only increases the competitiveness of coal as a primary fuel source. The relatively tight supplies seen across the industry should keep margins high and the profits flowing.

If Peabody can earn the $3.00 per share this year that is the upper end of company forecast, it will be producing 50% more in net income than in 2006. Shares traded at a price-to-earnings ratio of 25 or so for much of that year, when the market price of coal was much less bullish. A similar valuation today would put shares in the mid-$80s level, giving investors an attractive risk/reward scenario.

For related reading, check out Investment Valuation Ratios: Price/Earnings Ratio.

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