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Our near-term (6-18 months) outlook for the coal industry has improved somewhat from our previous neutral sentiment to a more positive undertone. Various recent economic indicators suggest that the U.S. economy appears to be stabilizing.
According to the U.S. Energy Information Administration (EIA), coal production in 2009 fell by nearly 8.5% in response to lower U.S. coal consumption, fewer exports and higher coal inventories. Going forward, the EIA estimates a 3% decline in U.S. coal production in 2010, despite increases in domestic consumption and exports due to increased producer and end-user inventories. However, coal production in 2011 is estimated to improve 5.4% on the back of continued growth in consumption and exports, as existing inventories are reduced. We expect the coal markets to continue to strengthen throughout 2010.
Despite some recent pressures, the overall trend in coal prices has been favorable, driven by improvements in demand from the domestic and international markets and reduced stockpiles. The U.S. generator stockpile levels have reduced largely from peak levels in November 2009.
Furthermore, we anticipate smaller build-in stockpiles throughout 2010, with demand being absorbed partially from existing producer stockpiles. These inventory draws and expected mild builds should continue to ease pricing pressure going forward.
Additionally, prices for seaborne metallurgical and thermal coals are moving higher as China and India are rapidly increasing imports and traditional Asian-based customers are returning to pre-recession growth levels. The expected moderation in China’s growth may not have a significant impact on its demand for coal.
Metallurgical coal (coking coal), a key ingredient in the production of steel, is in great demand due to the recovery of the Asian steel industry. The growth in Chinese steel demand is acting as a major driver of global demand and pricing for coking coal, followed by India.
Steel plant capacity utilization rates in the U.S. and around the world continue to improve compared to last year. Domestic steel mills are using approximately 73% of their capacity, while Asian steel mills are currently running at full capacity. This calls for increased demand for metallurgical coal around the world.
Coal is the backbone of electricity generation in the U.S. The U.S. relies on coal for about half of its power generation, compared with about 20% of gas. The reason is simple: coal is by far the least expensive and most abundant fossil fuel in the country. The extraordinary decline in electric generation brought about by the recent economic slowdown had pushed coal inventories to historically high levels in 2009. But, we believe fundamentals are aligning such that substantial inventory declines are likely to be seen in 2010.
We remain bullish on the international thermal coal market than the domestic U.S. thermal coal. Excess supply in the Atlantic market caused by softer demand in Europe and the U.S. is currently being absorbed to some extent by the Pacific markets.
The larger coal players with strong balance sheets will be able to capitalize on the current market environment in the form of acquisitions. In particular, we like companies with exposure to the international coal markets. We also like companies with leverage to metallurgical coal markets. Companies like Peabody Energy Corporation ([url=http://www.zacks.com/stock/quote/btu]BTU[/url]), CONSOL Energy Inc. ([url=http://www.zacks.com/stock/quote/cnx]CNX[/url]), Walter Energy Inc. ([url=http://www.zacks.com/stock/quote/wlt]WLT[/url]) and Arch Coal Inc. ([url=http://www.zacks.com/stock/quote/aci]ACI[/url]) look attractive in the current scenario.
Peabody is the largest pure-play coal producer. Its Australian operations provide direct exposure to Asian markets such as China and India, where substantial increases in coal demand are expected in the years ahead. Peabody’s growth story continues to ride on the strong China-India-Australia connection.
We believe the growth prospects for coal in the regions where Peabody operates are very attractive. Going forward, we expect the company will benefit from its large production and reserve position in the Powder River Basin (PRB) and Illinois Basin, which are safe, low-cost regions that will continue to penetrate the Eastern U.S. markets.
Arch Coal has a significant amount of reserves and is a top-three producer in the Powder River Basin. In our opinion, its Powder River Basin assets reflect visible long-term value, and the Jacobs Ranch acquisition will only enhance it. Furthermore, Arch Coal is well positioned to capitalize on the resurgence in coal demand once the global economy stabilizes, given its decades of reserves, a strong balance sheet and efficient, low-cost operations.
CONSOL Energy’s deep and diversified portfolio, primarily comprising coal and natural gas, is well positioned to benefit from the growing energy demand around the world and provides the company with significant long-term growth potential. It is one of the largest low-cost coal producers in the northern Appalachia basin. The low-volatile metallurgical coal and high-Btu steam coal will command premium prices even in a subdued commodity environment. Furthermore, the company’s gas operations show solid growth potentials.
Coal has been viewed as an industry that is faced with the risk of being abandoned due to the alarming issues of climate change, carbon emission concerns and energy sustainability. This has been prompting increased usage of alternative sources of energy generation like wind, solar and nuclear power.
The reality, though, is that most alternatives are nowhere near ready for primetime use. And political constraints appear to be delaying, if not altogether eliminating, the threat of major environmental regulatory overhaul, a net positive for the coal industry. Solar and wind power are expensive, and nuclear power has issues regarding its acceptance as a major power source. While the production of coal plants has slowed to curb emissions, the coal industry should see the profits continuing to roll in.
Another major alternative for the use of coal in energy generation is natural gas. Cheaper natural gas and big inventories have greatly hurt the U.S. and European thermal coal demand in the past year. Looking ahead, we expect the thermal coal demand to remain under pressure well, driven by lower gas prices. With the discovery of abundant shale natural gas in the U.S., the long-term competitive dynamic may have moved notably against coal. It is, however, far from certain or clear at this stage.
On the regulatory front, there is heated debate regarding the effectiveness of "cap-and-trade legislation. Basically designed to impose a per-ton expense on carbon dioxide emissions, the coal and utility industries have been opposed to this system, claiming that it will drive up the cost of coal and put an effective tax onto people living in the Midwest U.S.
The cap-and-trade system may pose long-term problems for the coal industry as it would increase the cost of coal, thereby decreasing its competitiveness as an energy source (and consequently reducing demand for it) and would force businesses to use less reliable and more expensive forms of energy. Related to the regulatory concerns are issues about mine safety, particularly in the backdrop of recent high-profile accidents. More stringent regulations and oversight in this area may come at the expense of operating efficiencies and higher expenses.
In terms of the macro picture, 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. Investors also have to be wary of the growth outlook for China, given its central role in driving the demand for coal as well as all other commodities. A significant and sustained pullback in Chinese growth will be major negative for the coal group.
Specific names to avoid in the space include the coal master limited partnerships (MLPs) such as Natural Resource Partners ([url=http://www.zacks.com/stock/quote/nrp]NRP[/url]) and Penn Virginia Resources ([url=http://www.zacks.com/stock/quote/pvr]PVR[/url]). The outlook for these partnerships remains weak, as evident from recent guidance. We are not confident of their ability to sustain distributions at current levels. As such, we would be staying away from the coal MLPs.
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