The first rule of contrarian investing: “Buy when there’s blood in the streets.” And the coal sector sure has been hemorrhaging. The chart of the Market Vectors Coal ETF (NYSE: KOL) speaks for itself.

The reasoning behind the deep hatred for coal is simple. Investors expect the energy source to be regulated out of existence, which has already led a number of electric utilities to switch from coal-fired plants to natural gas. 

​But those fears may be overblown. After all, the U.S. government has yet to craft a concrete and comprehensive energy policy and, thanks to the Republican sweep of the midterm elections, the status quo will remain.

#-ad_banner-#Investors are also concerned about a slump in coal exports, as demand wanes in emerging markets such as China — one of the world’s largest coal burners and consumers of metallurgical coal used in steel making. As Chinese government officials engineer a soft economic landing, investors are limiting their risk by reducing coal exposure, anticipating even weaker demand ahead.

To my mind,  coal represents a huge contrarian play. 

What’s Demand Really Like?
Global demand for coal is not quite as bleak as the headlines suggest. Despite regulatory hostility in the United States, coal is playing a major role in emerging markets  and making a noticeable comeback in some highly developed markets. 

Coal is a cheap, efficient energy source. Put simply, it helps poor countries become rich.

One of the reasons that coal still plays a role in many economies is its sheer abundance. According to energy giant British Petroleum Plc (NYSE: BP), there is more than a century’s worth of proven coal reserves globally based on current consumption rates. Thanks to demand in the Chinese, Indian and African economies, coal consumption is growing at the same rate globally as oil and natural gas.
 

The developed world is also more of a coal user than opponents would have us believe. 

Despite a radical rule change proposed by the Environmental Protection Agency to reduce carbon dioxide emissions by a third over the next 15 years, the United States will still generate more than 30% of its electricity with coal, down from 42% currently. 

Haunted by the Fukushima nuclear plant disaster, Japan is embracing coal as a major, long-term energy source through new energy policy enacted earlier this year. 

In Germany, electricity produced from coal costs half of that generated from natural gas. With mounting tensions and tighter gas supplies from Russia, coal may save Europe’s bacon this coming winter.

From a valuation standpoint, coal mining stocks have been beaten like a rented mule (one of my favorite Deep South colloquialisms). For example, many trade at a sharp discount to book value. 

Here’s a quick glance at three leading pure-play coal companies: Peabody Energy Corp. (NYSE: BTU), Arch Coal, Inc. (NYSE: ACI), and Alpha Natural Resources, Inc. (NYSE: ANR). 
                        

           
The market appears to be pricing them not just for bankruptcy, but extinction. Presumably, each of these companies should at least be worth their liquidation value. 

Let’s look at the largest player, Peabody. According to data from the National Mining Association, Peabody currently claims provable reserves of 8.2 billion short tons of coal. Currently, coal trades at around $52 per short ton. 

That would value Peabody’s reserves at roughly $434.6 billion. The company’s current market capitalization is around $3 billion. 2013 revenues came in a little better than $7 billion. That puts the stock trading at a bargain 0.45 times sales.

When the market overreacts like this, opportunity is created.

To be sure, it’s hard to see these stocks as values in the context of near-term earnings. All three of them are expected to lose $1.50 a share — or more — in 2014. 

The forward outlook is a little less grim. While Alpha Natural is expected to lose roughly $2.60 a share next year (similar to 2014), Arch Coal expects to narrow its per share loss to $1.42. Peabody is the tallest midget in the circus predicting an improvement of over 60% with a $0.50 earnings per share loss.

Delivering better bottom line results relative to those forecasts would be an  upward catalyst for the stock prices, but the real investment potential lies in industry consolidation.

Alpha Natural resources has the most deeply discounted book value on our list, with more than $30 billion in coal assets, roughly $3 billion in shareholder’s equity and a market value of less than $500 million.
 
Acquiring a company like Alpha Natural would be a logical move for  a global giant like BHP Billiton, Ltd. (NYSE: BHP), which can afford to offer a solid premium and still acquire the assets for less than it would cost to buy in the private market.

But the real question is: can these companies hang on?  According to a report published by Energy Transition Advisers, the breakeven coal price for U.S. miners is around $53 per short ton, which is roughly the current market spot price. On an international level, the breakeven price is more than 40% higher. As long as coal prices remain stable and don’t fall further, then these companies should continue to move back toward breakeven. 

Risks To Consider: The biggest risk to these companies is running out of money. With losses forecast and the threat of international economic slowdown and suppressed domestic demand due to a hostile regulatory environment, it’ll be tough to make money. 

However, the outlook for U.S. coal production, consumption and pricing for 2015 looks relatively stable. This should help management adjust to the environment and plan accordingly. International demand is a wildcard.Naturally, any improvement would lead to improved earnings.

Remember, deep or distressed value trades can take a while. There’s no timeline on a buyout trade. Just because conditions look favorable for an acquisition doesn’t mean that it could or will happen. 

Action To Take –> As a basket, BTU, ACI and ANR trade at roughly  43% of book value. As industry results stabilize, a trade up to 75% of book value appears feasible.  The result would be 12-to-18 month gains in excess of 70%. 

If you want the expert’s guide to the natural resource and commodities markets, then consider Scarcity & Real Wealth. Dave Forest, the newsletter’s chief investment strategist, has more than 10 years experience as a geologist and financial analyst. Today, he’d like to share with you an investing opportunity with a very narrow timeframe. There’s a rare chance to earn 29% in two months, but you have to invest by December 10 — details here.