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Coal Industry Stock Outlook - April 2013

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Overview

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

Metallurgical coal or coking coal is used in steel production. Coal remains a dominant source of power generation worldwide, with around 40% of the total global generation capacity coal fired.

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. though the bulk of current production takes place in just five states: Wyoming, West Virginia, Kentucky, Pennsylvania and Montana.

According to estimates by the Energy Information Administration (EIA),  the country’s current coal reserves will last for 168 years at current production rate. They will most likely last even longer with environmental issues coming in the way. However, if the fuel’s environmental standing can be improved, there could potentially be new sources of end-market demand in the future, in the communications and transportation systems, computer networks and even space expeditions.

As per the World Coal Association, proven global coal reserves will last nearly 112 years at current production rates. On the other hand, proven oil and gas reserves are projected to last around 46 years and 54 years respectively at current production levels. Asia is the biggest coal market and presently accounts for 67% of the global coal consumption.

Zacks Rank

The Zacks Industry Rank, which relies on the same estimate revisions methodology that drives the Zacks Rank for stocks, currently puts the Coal industry at 247 out of 261 industries in our expanded industry classification. This puts the industry in the bottom third of all industries, which corresponds to a negative outlook.

The way to look at the complete list of 260+ industries is that the outlook for the top one-third of the list (Zacks Industry Rank of #85 and lower) is positive, while the outlook for the bottom one-third (Zacks Industry Rank #170 and higher) is negative.

Please note that the Zacks Rank for stocks, which is at the core of our Industry Outlook, has an impressive track record going back years, verified by outside auditors, to foretell stock prices, particularly over the short term (1 to 3 months).

None of the 17 companies in the Coal industry has a Zacks Rank #1 (Strong Buy) or Zacks Rank #2 (Buy), while 5 have either Zacks Rank #5 (Strong Sell) or Zacks Rank #4 (Sell). This reflects our bearish outlook on coal.

Earnings Review and Negative Outlook

In terms of Q4 earnings surprises, Alliance Resource Partners LP (ARLP), Alliance Holdings GP, L.P. (AHGP), Alpha Natural Resources Inc. (ANR), Cloud Peak Energy Inc. (CLD), CONSOL Energy Inc. (CNX), Natural Resource Partners L.P. (NRP), SunCoke Energy Inc. (SXC), Rhino Resource Partners LP (RNO) and Hallador Energy Company (HNRG) came out ahead of expectations.

Of those that missed expectations, the notable names are Arch Coal, Inc. (ACI), Penn Virginia Resource Partners L.P. (PVR), Walter Energy Inc. (WLT), James River Coal Company (JRCC) and Peabody Energy Corporation (BTU).

In total, 57% of the coal companies in our coverage came out with positive earnings surprises in the fourth quarter, below the 62% average for the S&P 500 as a whole. The soft performance of the coal industry in 2012 is expected to linger in the first quarter of 2013 and demand for coal is likely to pick up in the subsequent quarters with the expected increase in natural gas prices. However, currently we expect first quarter performance of most of the coal stocks in our coverage universe to be lower than the year-ago quarter.

Tailwinds

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 pose tough competition going forward.

The EIA report also suggests U.S. coal production will increase by 1% in 2013 and 1.3% in 2014, primarily due to an expected rise in natural gas prices from 2012 levels.  The relative increase in US natural gas price, compared to coal, will also increase the share of coal in electricity generation. The EIA report suggests coal’s share in electricity generation in 2013 will reach 39.5%, up from 37.4% in 2012.

Admittedly, the dominance of coal as a source of electricity generation has diminished with the availability of other fuel sources. However, as per an EIA report, coal will continue to be the major source of electricity generation in the U.S. 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 in 2011, nuclear power’s contribution to 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, hard coal (metallurgical or coking coal) forms a key ingredient in the production of steel. Nearly 70% of global steel production depends on coal. Any improvement in the production of steel will also bring in fresh demand for coking coal. In Feb 2013 global steel production increased 1.2% year over year. ??Global steel demand in 2013 is expected to improve marginally from 2012 levels, which will benefit the coal industry.

Demand Upsurge in Asian Countries: The increase in coal demand in the Asian economies of China and India has been a key price driver. 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 for importing coal. These countries rely heavily on coal for electricity generation.

It is estimated that by 2035, 60% of the world’s coal fired units will be located in China and India. It is quite obvious from the current rate of production that these two countries will have to make bulk coal imports to run its units. So, the future prices of coal and the growth of coal stocks will to a large extent depend on these two countries.

As per the World Coal Association (WCA) report, 36% of China ’s global investment is directed towards advanced coal technology, which we believe is a good sign for the coal industry. Indian coal giant Coal India Ltd has earmarked a fund of $6.5 billion to buy and develop mines overseas of which more than $5 billion is set aside for coal assets in countries including the U.S., South Africa, Indonesia, Australia and Colombia.

We believe the infusion of funds from China and India would help the U.S. coal producers. As it is these coal companies have been hard pressed in 2012 with dwindling demand forcing them to idle a few coal mines.

Given the lackluster coal market at home, coal companies are looking to export coal to the fast growing Asian economies. Some of the names making the most from overseas coal exports are Peabody Energy Corporation and CONSOL Energy Inc. 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.

Coal Trade

According to an EIA report, U.S. coal exports in 2012 were 126 million short tons (MMst), which reflected growth of 17.8% year over year, driven by Asian countries. EIA forecasts US coal export will be 110 MMst in both 2013 and 2014. The continued weakness in Europe, decline in international coal prices and increase in production from other coal exporting countries will weigh on U.S. exports in 2013-14.

The disruption in coal operations in Australia due to flooding and interruption in coal supply from Columbia are likely to benefit U.S. coal exporters, albeit temporarily. The debt crisis continues to linger in Europe. However, some positive news from Poland, Germany and the Czech Republic regarding coal usage is reassuring for US coal exporters.

Besides Australia and Russia, which has the second largest coal reserve next only to U.S, the U.S. coal exporters could face competition from Indonesia. Indonesia is the world’s largest exporter of thermal coal and its proximity to China and India will give it a geographical advantage over the U.S.

Headwinds

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. 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 regulations and relative fuel prices will lead to the retirement of the power plants. In 2012, 7.9 GW of coal fired power units were retired in the U.S., which is nearly 2.5% of the total coal fired generating capacity.

Sluggish Economic Recovery: The sluggish pace of economic recovery in the U.S. has to a great extent eroded demand for coal. This has pushed a few of the large operators to lower production, idle mines or even shut down mines permanently to realign output with diminishing demand. In 2012, Alpha Natural Resources Inc. decided to shut eight mines in Virginia, West Virginia and Pennsylvania. Peabody Energy decided to permanently close its Air Quality Mine in Vincennes, Indiana. The tepid demand for coal was making the operation of this mine uneconomical, leading to its shutdown.

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.

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.

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. Thirty 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.

In Conclusion

Though there is ample pressure from regulators on environmental grounds 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.

The coal block controversy in India might open up new export opportunities for coal operators in the U.S. Coal is a major source of generation of power in India. India’s emphasis on infrastructure development will increase the demand for power. The coal controversy far from dying down could open up new export opportunities.

If Chinese and Indian imports look encouraging, the lingering debt crisis in Europe continues to cast a pall over coal fundamentals. Despite relief packages, the crisis in Europe is far from over and will continue to hold back a revival in coal demand.

We also believe cost of transportation plays an important role in this sector. An EIA report says that in the U.S., on average, transportation costs increase the price of coal by 40% and these costs have increased by 50% over the last decade. If transportation costs go up substantially in a short span of time, it will definitely have a negative impact on demand, domestically as well as internationally.

Undaunted, the coal operators are using new technology 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 of fuel generation are available, coal’s advantage lies in its price, which is far cheaper than other sources of fuel. If we look at the global picture, it is evident that cheap source of reliable power is a driving factor for economic development. Reinvigorating demand from growing economies and steady demand from the U.S. will continue to drive the coal industry in the future.

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