Seldom has royalty looked as pathetic as King Coal does in its current straits.

Though still accounting for nearly 30% of the world’s energy consumption, coal has been hit hard by China’s economic slump and regulation in developed countries looking to curb pollution and global warming. To make matters worse, shale drilling and a long spell of unseasonably mild weather have left the U.S. glutted with dirt-cheap natural gas, eroding demand for coal from power plants.

The regulatory pressure won’t let up any time soon and constantly growing Asian demand can’t be taken for granted any longer.  But the more pressing effects of unfavorable weather and discounted U.S. gas are likely to reverse before long, and when they do an industry thinned out by the spate of recent bankruptcies and mine shutdowns is likely to see a cyclical recovery.

Even for a mining sector in a secular decline, this recovery should result in a significant equity rally. Our chosen vehicles for speculation on this theme are the low-cost coal mining master limited partnership Alliance Resource Partners (NASDAQ: ARLP) and its general partner Alliance Holdings (NASDAQ: AHGP).

Source: Alliance Resource Partners presentation

Even as its first-quarter revenue slid 26% year-over-year, ARLP still turned a profit and produced 97% of the distributable cash flow necessary to keep paying a distribution yielding 18% at the current unit price.

Whereupon the partnership promptly cuts its payout by 35%, citing the need to “maintain access to capital” amid “the contagion caused by the financial struggles facing many of our competitors.”

Translation: as the CEO acknowledged on the conference call, Alliance recently began talks with its bankers on rolling over the $650 million of debt due by next year, and found them unenthused about re-upping for annual interest of 2.1%, the current rate, from a borrower paying an 18% yield on equity.

The partnership has relatively low leverage, with debt at approximately 1.5x the forecast 2016 EBITDA (earnings before interest, taxes, depreciation and amortization.) It will, however, need to begin significant debt repayments starting this quarter, even as it invests in a new oil & gas drilling joint venture.

The distribution cut is meant to produce coverage of  1.6x in 2016, based on contracts that have already fixed 95% of this year’s expected sales. Alliance has also presold nearly 60% of its current output for 2017 and 40% for 2018.

This downside protection probably explains why ARLP’s unit price actually rose after the distribution cut was announced and has since traded in a narrow range. Of course, it’s already down 72% from its July 2014 high, but up 37% since April 4.

At the current price, the recently reduced distribution works out to an annualized yield of 11.5%. AHGP’s units now yield 10.9%, derived entirely from its 42% stake in ARLP and the incentive distribution rights it collects as ARLP’s general partner. These income streams are expected to fully cover AHGP’s reduced 2016 distributions, but only just.

Management hopes to begin increasing the payouts again next year, provided its forecast for a gradual and muted coal market recovery doesn’t prove overly optimistic.

U.S. coal production was down more than 30% year-over-year in the first quarter, and industry output cuts are expected to accelerate in the coming months as creditors of the bankrupt suppliers force them  to shut down the most inefficient mines. And as the price of natural gas goes up in response to reduced drilling activity, the surplus coal stockpiled by power plants will go up in smoke.

The U.S. Energy Information Administration expects coal’s market share in U.S. power generation, eclipsed for the first time ever recently by natural gas, to rebound a bit over the next couple of years. And the EIA expects production in the low-cost Illinois basin, which accounts for the bulk of Alliance’s output, to remain steady even if the courts uphold the Environmental Protection Agency’s controversial plans to curb coal-fired power.  

If and when coal demand does improve, Alliance could quickly and inexpensively restart recently idled mine shifts.

It’s hard to be optimistic about U.S. coal long-term in the face of political pressure and the intensified competition from natural gas as well as renewable energy. But the next couple of years should bring welcome relief for the industry’s survivors. We’re adding ARLP and AHGP to the Aggressive Portfolio. Buy ARLP below $18 and AHGP below $23.

In addition to these recommendations, I also considered CONSOL’s coal-mining spinoff CNX Coal Resources (NASDAQ: CNXC), another low-cost miner organized as a master limited partnership. But CNXC’s cash flow only covered 40% of its most recent distribution, so the 23% yield it currently boasts isn’t as enticing as it might seem. The coverage might have been be weakened by CONSOL’s unseemly rush to stick CNXC with its administrative costs as it transforms into an oil and gas driller.

Alliance’s oil and gas investments seem less attractive than CONSOL’s, consisting as they do of non-operating interests assembled by an expensive outside manager. Alliance  is targeting eventual annual returns of 15-20% on that capital, which seems entirely too optimistic. But the industry didn’t get to be where it is today by planning for the worst-case scenario.