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Industry Outlook

Coal has been used for nearly as long as mankind has thrived. From the times of the cavemen to the present day, coal is used for everything from cooking to heating to running steam-powered trains to generating electricity.

Today, coal is burned as fuel or gasified to create a synthetic gas (syngas) that can then be used as a feedstock for the production of chemicals, fertilizer and electric power. Coal is also used for producing heat through combustion.

The U.S., Russia, Australia, China, India and South Africa have the largest coal reserves in the world. Coal is produced in 25 states in the U.S., spread across three coal-producing regions. The majority of current production originates in just five states: Wyoming, West Virginia, Kentucky, Pennsylvania and Montana. China, the U.S., India, Russia and Japan account for 77% of total global coal use.

The importance of coal as a source of generating power increased over time with the rise in industrialization. However, alternatives to coal have now emerged, curbing coal’s dominance to a certain extent.

OPPORTUNITIES

Coal Dominates U.S. Power Generation: Coal as a major source of fuel for power generation dominates the Utility industry. Coal is used to generate about half of the electricity consumed in the U.S. and is also the largest domestically-produced source of energy. Electricity generation absorbs about 93% of total U.S. coal consumption. The reason is simple: coal is by far the least expensive and most abundant fossil fuel in the country, though the emergence of large shale natural gas reserves is expected to become a major competitor going forward.

Coal will continue to dominate as the major source of electricity production. Taking into consideration the long-term prospect of coal, one of its key producers, Arch Coal Inc. (ACI - Analyst Report) expanded its reserves in the Powder River Basin (“PRB”) through a successful bidding of a coal lease.

Another player, Alliance Resource Partners, L.P. (ARLP - Snapshot Report), has acquired assets from Green River Collieries, which increased its Illinois basin reserves by 40 million tons. This is apart from the longwall operations in its Tunnel ridge mine, which increased production to 300,000 tons in the second quarter. The partnership has plans to gradually increase production from this mine, allowing the partnership to fulfill its existing long-term coal sales commitments.

The moderate winter in the U.S. this year lowered the demand for electricity, which in turn impacted the demand for thermal coal. The stockpile in the power plants pushed down the prices of coal. However, the warm summer has restored demand and much of the stockpile has been lowered.

Admittedly, the dominance of coal as a source of electricity generation has diminished with the availability of other fuel sources. However, as per an Energy Information Administration (EIA) report, coal will continue to be the major source of electricity generation in the U.S. until 2035. Even in a worst case scenario, coal will account for 36% of the U.S. electricity generation from 2010 to 2035 -- higher than any other form of fuel used to generate power.

The EIA report also suggests that the increase in demand for electricity and an expected recovery in natural gas prices from current depressed levels will result in a hike in coal production post 2015. Coal production, after 2015, is expected to increase by 1% on an average per year until 2035.

In contrast, petroleum and nuclear power as sources of power generation have been losing market share, displaced by the strong growth of renewable sources of generation and natural gas-fired generation. Petroleum is losing out to coal because it is becoming increasingly expensive. After the Japan earthquake/tsunami incident in 2011, nuclear power’s contribution to the total energy generation has declined from the prior year.

Not Just Electric Generation: Electricity generation is just one use of coal in the U.S. Manufacturing plants and industries use coal to make chemicals, cement, paper, ceramics and metal products, to name a few. Methanol and ethylene, which can be made from coal gas, are used to make products such as plastics, medicines, fertilizers and tar.

Certain industries consume large amounts of coal. For example, concrete and paper companies burn coal, and the steel industry uses coke and coal by-products to make steel for bridges, buildings and automobiles.

Coal as an Input for Steel Industry: Due to its heat-producing feature, today hard coal (metallurgical or coking coal) forms a key ingredient in the production of steel. Nearly 70% of global steel production depends on coal. The steel companies foresee a return of prospects in 2012 due to improving demand from the end-markets.

China is one of the largest global steel-producing countries and has recently approved $23 billion in steel projects, which will likely boost the demand for seaborne metallurgical coal.

Coal Trade

According to an EIA report, U.S. coal exports in 2011 were 107 million short tons (MMst), which reflected growth of 31% year over year. Flooding in Australian mines during 2011 disrupted coal exports, which benefited U.S. producers. The upsurge in coal exports during 2011 mainly emanated from demand from Asian countries. As per the EIA report, with Australian mines back in operation, U.S. coal exports are expected to decline to 100 MMst in 2012.

Peabody Energy Corporation (BTU - Analyst Report), a major U.S. coal producer, expects an increase in the global demand for coal for power generation and projects 90 Gigawatt (GW) of new coal-fueled generation to come on line worldwide in 2012. We believe Peabody with its U.S. and Australian platform stands to benefit from the increase in demand for seaborne thermal coal.

Demand Upsurge in Asian Countries: The increase in coal demand in Asian economies like China and India has been a key price driver since the end of the recession in 2009. We expect this trend to continue in the future, mainly due to the growing energy needs in India, China and South Korea.

Of the Asian countries, economic growth in China and India will be the fastest. These two countries do produce coal, but its domestic coal production has yet to match the growing demand, resulting in the continuous need of importing coal. These countries rely heavily on coal for electricity generation.

A major portion of the new electricity generation units, which are expected to come up in these two countries, will utilize coal as a source of fuel. As per The Economic Times, it is projected that coal imports will touch 1 billion tons in China in 2030 from the present level of 175 million tons in 2011.

Indian imports for coal are expected to reach 400 million tons in 2030, up from 80 million tons in 2011.  As per The Centre for Monitoring Indian Economy (CMIE), India's coal imports in 2012 are expected to increase by 28.3% year over year to 127 million tons.

Given the growing demand from the fast-growing Asian economies, companies find it attractive to export coal to emerging regions. Some of the names making the most from overseas coal exports are Peabody Energy Corporation and CONSOL Energy Inc. (CNX - Analyst Report). To cater to the increasing demand for coal in Asian countries, Peabody has acquired Macarthur Coal in Australia and expanded its footprint in high-demand regions worldwide.

Since seaborne thermal coal demand is expected to rise, Peabody has struck an agreement with Kinder Morgan Energy Partners, L.P. (KMP) to utilize the latter’s Gulf Coast export platform. This agreement will allow Peabody to increase its Gulf Coast annual coal export capacity in the range of 5 - 7 million tons between 2014 and 2020.

WEAKNESSES

According to the EIA’s report, U.S. coal production in 2012 will experience a dip from the last five-year average. The projected decline is attributed to lower demand due to adverse weather conditions, large stock of coal and increasing competition from natural gas as an alternate fuel.

In the ensuing year, the demand for coal to produce power is likely to fall 10% from the previous year due to increasing use of natural gas to generate power. EIA forecasts coal use in the U.S. power sector to fall below 900 million short tons in 2012 and 2013.

Coal is plentiful and fairly cheap relative to the cost of other sources of electricity, but its use produces emissions that adversely affect the environment. Coal emits sulfur dioxide, nitrogen oxide and mercury, which have been linked to acid rain, smog and health issues. Coal also emits carbon dioxide, a greenhouse gas that contributes to climate change.

Without proper care, coal mining can have a negative impact on ecosystems, and alter landscapes and scenic views. With governments becoming more and more stringent on environmental issues, the electricity generators are implementing new measures to bring down emission levels of greenhouse gases.

An EIA report suggests that in the next five years, between 2012 and 2016, U.S. power plant operators will retire around 27 gigawatts (GW) of coal-generation capacity from their production portfolio. Tepid demand, environmental compliance costs, compliance with state emission regulation and relative fuel prices will lead to the retirement of the power plants. In 2011, total coal fired power generation in the U.S. was 318 GW. The phased retirement of 27 GW over the next five years will therefore constitute 8% of the total 2011 coal-fired capacity.

Environmental Legislations: Coal has been losing its importance as a fuel source over the last few years, particularly in the U.S., vis-à-vis other sources that have a lesser impact on the environment. Concerns on the emission of greenhouse gases and global climate change have resulted in the formulation of new legislations and policies which emphasize on the use of environment friendly fuel sources, particularly in the power sector.

This has considerably slowed the expansion of coal-fired capacity in the power sector, with utility companies now building new natural gas-fired plants and resorting to alternative sources of energy generation like wind, solar and hydro power. To meet the environmental regulations, American Electric Power (AEP - Analyst Report) has decided to retire 4,600 megawatts (MW) of coal-fired generation from its portfolio.

Natural Gas Substituting Coal: A major substitute for coal in energy generation is natural gas. Coal is being dumped in favor of natural gas, which due to extensive exploration and production, is seeing significantly lower prices than in the past.

Natural gas is usually an attractive choice for new generating plants because of its relative fuel efficiency, low emissions, quick construction timelines and low capital costs. There is an abundance of natural gas in the U.S. markets, resulting in lower prices. This trend is encouraging power generators to not only convert their existing plants to gas-fired ones but to build new nat-gas units.

Electric generation through gas-fired plants is likely to become more competitive over the coming years given its abundant domestic availability and the threat of regulation hanging over the coal mining industry. As per EIA’s reports, 96.65 GW of new electric generation will be added in the U.S. within 2009-2015, out of which 20% will be natural gas-fired plants.

Large electricity generators in the U.S., like Exelon Corporation (EXC - Analyst Report), FirstEnergy Corp. (FE - Analyst Report) and others are turning to natural gas for additional electrical capacity.

Duke Energy Corporation’s (DUK) subsidiary Progress Energy Carolinas has decided to move forward the shutdown of its coal-fired generation units, which were scheduled to be closed in 2013. The company will retire its 316 MW Cape Fear coal-fired plant and the 177-MW H.B. Robinson Unit 1 coal-fired plant, on October 1, 2012. The retirement is a part of the ongoing modernization process, and the closed coal-fired units will be replaced by natural gas-fired units and oil-fired combustion turbines.

The share of natural gas for power generation is projected to grow from 24% in 2010 to 28% in 2035, as per the EIA’s long-term outlook. In a best-case scenario, this is expected to go up to 31% in that time period.

Competition from Alternative Energy Sources: Apart from natural gas, the coal industry has been losing a major share of its electric generation demand to renewable sources of energy like wind, solar and hydro power.

Production of power from renewable sources has also been supported by various U.S. states. At present there is no national consensus regarding the percentage of energy to be generated from renewable sources by the power generators.

Undoubtedly, state legislators are giving more emphasis to produce power from renewables. At present, 30 U.S. states and the District of Columbia have enforceable renewable portfolio standards or other renewable generation policies. These policies were designed to spread awareness and encourage the power generators to produce more from renewable sources.

The share of renewable fuels (including conventional hydro) in energy generation is projected to grow from 10% in 2010 to 16% in 2035, as per the EIA’s long-term outlook.

Increasing Debt Levels: One of the major concerns for the coal companies is the mounting debt levels. The need for expansion, locating new fields and upgrading the existing system are pushing the coal companies to take more credit from the market by issuing bonds and securities.

However, in some cases, the extra funds which are put into operation are not generating the desired results. Some of the coal companies are on the brink of failure to service its debts. Patriot Coal, for one, has filed for bankruptcy protection.   

Spiraling debt and a failure to service these debts on time lower the credit worthiness and credit rating of a company. In such a scenario it gets increasingly difficult for the company to collect funds from the market. And the conditions, if funds are at all granted, get much stricter and less favorable.

Earnings Trends and Zacks Rank

The companies in the coal industry have started to report their second quarter earnings results. The initial earnings trends are promising, with Alliance Resource Partners, L.P., Alliance Holdings GP, L.P. (AHGP), Arch Coal, Inc. and Peabody Energy Corporation surpassing the Zacks Consensus estimates.

While CONSOL Energy Inc., Cloud Peak Energy Inc. (CLD) and Penn Virginia Resource Partners L.P. (PVR) fell short of our expectations, SunCoke Energy Inc. (SXC) matched our expectation.

Our proprietary Zacks Ranks indicate the movement of the stocks over the short term (1 to 3 months), which is a reliable indicator of the likely movements of these coal stocks.

Over the short term we have only one name in our Zacks #2 Rank (short-term Buy rating) radar, which is Alliance Holdings GP, L.P.

The majority of stocks we cover in the utility industry, such as Alliance Resource Partners, L.P., Alpha Natural Resources Inc. (ANR), Arch Coal, Inc., Cloud Peak Energy Inc., CONSOL Energy Inc., Hallador Energy Company (HNRG), James River Coal Company (JRCC), Natural Resource Partners L.P (NRP - Analyst Report), SunCoke Energy Inc., and Walter Energy Inc. (WLT), presently retain a Zacks #3 Rank (short-term Hold rating).

We presently have only one name in our Zacks # 4 Rank (short-term Sell rating) radar, which is Rhino Resource Partners LP (RNO). The few Zacks #5 Ranked stocks (short-term Strong Sell rating) are Peabody Energy Corporation, Penn Virginia Resource Partners L.P. and Yanzhou Coal Mining Company Limited (YZC).

In Conclusion

Though there is ample pressure on coal from legislations and increasing competition from natural gas and renewable energy sources, we believe the global power industry will continue to depend on coal for a large part of its generation. Coal as a fuel source will continue to power the growth in emerging nations like China and India, both for utility companies and steel makers as it is cheaper compared to other energy sources.

On the flip side, the debt crisis in Europe is still lingering, despite relief packages that have already been announced to revive the economy. The uncertain economic climate continues to impact the industry and curb its growth prospects. The lackluster demand for steel, which is widely used in different industries, could be an indicator of where we are heading.

ArcelorMittal (MT - Analyst Report), a major producer in the global steel industry, has as yet idled 5 of its 25 blast furnaces in Europe due to tepid demand. Likewise, demand for coal is expected to decline in Europe as the steel industry, consuming a large volume of high-quality coal, continues to struggle.

The EIA estimates, even if no new reserve is added, the present U.S. coal reserve will exhaust in 168 years, taking into consideration the incremental production rate. This is promising because, in addition to the many existing ways to use coal, the future holds new methods and potential for growth. Products from coal may soon be part of communications and transportation systems, computer networks and even space expeditions.

In addition to these new and increased uses of coal, new technologies will continue to enhance the ability to identify the shape and composition of untapped coal reserves. Emerging know-how is also likely to look for a solution to the adverse effects of coal on the environment mitigating greenhouse effects and other environmental concerns.

For example, the dry sorbent injection pollution control technology can play an important part in coal usage in the power plants. This technology will aid the power plant operators using coal to lower SO2 emissions and enable them to comply with the Environmental Protection Agency’s Mercury and Air Toxics Standards (“MATS”). All coal fired units in the U.S. having a generation capacity of more than 25 MW will have to abide by the MATS rule beginning 2015.

These new technologies focused on achieving near-zero emissions open up avenues for potential long-term industry growth. Clean-coal technology development in the U.S. also has funding earmarked under the American Recovery and Reinvestment Act of 2009. This is an encouraging sign for coal producers.

Even if alternate sources for generating fuels are available, coal’s advantage lies in its price, which is far lower than the other sources of fuel. We believe reinvigorating demand from the growing economies and steady demand from U.S. will continue to drive the coal industry in the future.

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