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Whitehaven no safe haven

It’s a bold investor who backs coal.

Yes, there’s a case to be made for the black rock — and some leading brokers are doing just that, at least in terms of our largest ‘pure-play’ producer, Whitehaven Coal (ASX:WHC).

The argument goes something like this; higher grade coal will remain relatively attractive, there’s not likely to be a reliable fuel substitute for base load power generation any time soon, and demand is growing in places like India. Moreover, output for Whitehaven is increasing, and despite some headwinds, the current market price is cheap enough to offer a meaningful margin of safety.

But at the same time, other experts point to significant regulatory risk (that is, potential for a carbon price of sorts, and/or tighter environmental standards), shifting preference to natural gas, rising efficiency in renewables, decreasing demand for metallurgical coal from China (used in steelmaking), and currency risks. Many are actually forecasting the price of coal — already at an eight year low — to remain subdued for some time.

Harder for some

All investments face some risk, but to me it seems that for investors to do well in a company like Whitehaven, a whole lot of factors — almost all of which are notoriously difficult to forecast — need to go their way. And, if they do, you stand to get a modestly market beating return. If, however, things don’t work out as expected, the downside risks are substantial.

Just look at Whitehaven’s financial performance in an environment of falling coal prices. Although sales have grown seven-fold since 2007, the company has failed to make a profit for the past three years. Even excluding certain one-off factors, the profit performance has been abysmal. And long term shareholders have certainly suffered as a result — the average annual loss for Whitehaven investors has been about 30% per year over the past 5 years. It’s a similar story for the other producers.

That isn’t to criticise the business. Like all commodity producers, it just operates in an extremely tough industry. Producing coal is extraordinarily capital intensive, and you have zero pricing power. The best you can hope for is to keep costs low and hope demand and prices remain buoyant. It’s a very tenuous proposition! Especially so when you are burdened with substantial debt. The size of Whitehaven’s long term debt is about the same as it’s entire market value.

To complicate matters, the rise of ethical investing has seen an increasing number of institutional and sovereign funds shun investments in fossil fuels. Certain lenders are also turning their backs.

Foolish Takeaway

Investors have to remember that they have the luxury of choice when it comes to deciding where to invest their money.

It’s not that a company like Whitehaven can’t or won’t do well — for all I know shares could double over the next year — but on a balance, the odds seem stacked against it. Especially when it takes just a few things to go wrong for the situation to get a whole lot worse.

But there are other investments that face far less uncertainty, and have significantly superior characteristics and outlooks.

Investing legend Warren Buffett once said, “I don’t look to jump over 7-foot bars: I look around for 1-foot bars that I can step over.”

Whitehaven and its ilk are very high bars indeed — even at these seemingly subdued prices.

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Motley Fool contributor Andrew Page has no position in any stocks mentioned. Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.