When we added Cimarex Energy (NYSE: XEC) to our portfolio last year, we raised some eyebrows given that natural gas was in the doldrums. However, we were correct in our belief that natural gas prices had bottomed and would likely tick up.

As a major producer of oil, natural gas and natural gas liquids, Cimarex has thrived since we recommended it in May 2013 (see our main feature).

But now that natural gas prices have climbed above $5 per million British thermal units (mmBtu), coal plays are also becoming increasingly attractive, as the cost difference between the two commodities narrows.

Cloud Peak Energy (NYSE: CLD) is one of America’s largest coal producers and the only coal miner that operates solely in the Powder River Basin, with its three surface mines located in Wyoming and Montana. Last year, the company shipped 90.6 million tons of low sulfur, subbituminous coal, of which 4.4 million tons were exported to Asia.

Cloud Peak is attractive because it employs relatively little leverage compared to other industry players and has also maintained a strong liquidity position. As of the third quarter, it held $219 million in cash and equivalents on its balance sheet with a further $81 million in marketable securities. It also has access to an additional $253 million under two separate revolving lines of credit.

The company’s senior debt amounts to $600 million, with two $300 million chunks of notes outstanding—an 8.25 percent note due 2017 and an 8.5 percent note due in 2019. Its total debt-to-equity ratio comes in at just 0.7.

Cloud Peak is also one of the lowest cost producers in the region, with an average cost per ton of $9.78 in the third quarter and an average realized price per ton sold of $13.03.

In addition to Cloud Peak’s intrinsic financial advantages, fundamental shifts are unfolding in the coal market that will ultimately pan out in the company’s favor.

First and foremost is the meteoric increase in natural gas prices over the past few months. While additional regulation on coal burning power plants has been a major drag on coal, low gas prices also encourage utilities to shift their generation mix to favor the cheaper energy source. Coal and natural gas are still nowhere near parity in pricing, but rising gas costs reduce the incentive for utilities to shift to mix.

In the first half of 2013, well before natural gas hit $5 per mmBtu, electric utilities were already curtailing their use of gas-fired generators by 14 percent, according to the US Department of Energy. Much of that was made up for by coal, with coal-fired generation jumping 7.5 percent in the first half of 2013.

This dynamic helped draw down stockpiles of coal in the Powder River Basin, leading to price stabilization in coal.
Export demand for coal has also remained relatively steady, with 118 million short tons exported last year, mostly to Asia.

While China’s economy may be slowing, it continues to build coal-fired electricity generators at a record clip to meet its growing demand. At the same time, Japan is being forced to find other fuels for its power needs, as it continues shutting down its nuclear power plants in the wake of the Fukushima disaster.

Thanks to Cloud Peak’s central location, it has easy access to four existing export terminals via Burlington Northern Santa Fe (NYSE: BNI), Canadian Pacific Railway (NYSE: CP) and Canadian National Railway (NYSE: CNI). Its transshipment facilities are also more centrally located to railheads, reducing shipping costs for potential customers.

Despite the company’s advantages, it’s important to realize that Cloud Peak does face challenges. Largely thanks to weak coal prices, the company has averaged revenue growth of just 2.75 percent over the past three years while earnings per share (EPS) are off by nearly 24 percent. That said, EPS jumped from $0.08 cents in the second quarter to $0.29 in the third, with analysts estimating a strong earnings recovery this year.

That’s largely due to the fact that Powder River Basin coal is once again competitive with natural gas on a cost basis across much of America’s heartland, further encouraging a shift back to coal.

In the first nine months of this year, Cloud Peak’s revenue totaled $1.042 billion, versus $1.141 billion in the same period last year. With fundamentals shifting, it will easily be able to make up lost ground, although it may take some time before it gets back to its peak of $1.554 billion in 2011.

But coal valuations are so depressed right now, it won’t take much improvement to drive a rally, particularly for those operations that are truly low cost with solid margins.

A higher risk commodities play with substantial upside potential, Cloud Peak Energy is a buy up to 22.