Our near-term outlook for the coal industry is neutral. Decreased demand for steel and electricity caused by a global recession has pushed global coal prices down off their highs of 2008. In the U.S., this has been perpetuated by mild weather, low natural gas prices and high coal stockpile levels at power generators.

While production cuts will help prices from falling off a cliff, these will likely impact earnings in 2009. Until the economy and investors start to see the tangible effects from the late '08 and early '09 monetary and fiscal stimulus packages put in place on a global scale, there will not be any catalysts to move stock prices in the coal space -- thus trading flat in the first half of 2009.

We believe that contracting for metallurgical coal during 2009 will be delayed. Usually starting on April 1 (the Japanese New Year), steel producers will put off locking in prices until they get a better sense of steel demand for the year. Metallurgical coal will likely be more of an uncertainty than the thermal coal as far as pricing goes.

While the slowing U.S. economy will soften electricity demand, the inelastic or baseload nature of coal has made this commodity more resilient in the past months. While prices have come down in nearly all U.S. Basins, they are still at historically favorable levels. This will bode well for producers when locking in production in out-years.

OPPORTUNITIES

The larger coal players with strong balance sheets will be able to capitalize on the current market environment in the form of acquisitions. With asset prices coming down from mid-'08 levels and smaller producers feeling the strain on margins, this represents an opportunity to acquire reserves on the cheap. Additionally, many producers will generate a significant amount of free cash flow during 2009.

If credit markets remain unfavorable, this would be an opportune time for management to either 1.) Strengthen its balance sheet; or 2.) Buy back shares of its stock. Both of these would likely have positive near-term effects on stock prices.

In particular, we like companies with exposure to the international coal markets as well as the Powder River Basin (PRB) in the U.S. Companies like Peabody Coal ( BTU - Analyst Report ) and Arch Coal Inc. ( ACI - Analyst Report ) look attractive currently.

Peabody is the largest pure-play coal producer, with significant leverage to the Australian export market. Due to the high quality of coal produced and its proximity to Asia (emerging markets) Australian seaborne coal trades at premium to all other coals. Peabody would benefit especially when China and other Asian emerging markets begin to rebound. The stimulus packages enacted by the federal government during the recent months should start to pay dividends in the back half of '09.

Arch Coal has a significant amount of reserves and is a top three producer in the PRB. In our opinion, PRB coal will be in great demand over the coming years. The significant coal-fired power plant build-out will increase annual thermal coal demand by more than 60 MM tons; approximately 50% of this new demand will be met by PRB supply.

WEAKNESSES

Appalachian producers continue to face productivity problems via shortage of skilled labor, MSHA inspections, and other permitting and regulatory hurdles. While the falling cost of steel and fuel will reduce the cost of direct materials, these other issues will more than offset. If the global economy -- particularly regarding its demand for steel -- is slow to recover, this could mean prolonged price suppression for CAPP and NAPP coal, which could lead to reduced production, idled mines and higher unit costs.

Assumptions for 2009 Average Prices:
Thermal Coal Prices: $75 - $90 per ton
Metallurgical Prices: $150 per ton