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The outlook for the coal industry has revived materially from the weakness experienced in 2008 and 2009, driven by several powerful trends in the U.S. and Asia. Various recent economic indicators suggest that the U.S. economy regaining its stability, bringing about a rebound in various industries - the coal industry being one of them.
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 0.3% decline in U.S. coal production in 2010, as drawdown in both producer and end-user inventories are expected to meet the increased coal consumption in 2010.
However, coal production in 2011 is estimated to improve 1.8%. At the current rate of recovery, the EIA estimates that the world coal consumption will rebound, returning to its pre-recession level (2008 level) by 2013.
Generally, most coal companies have been profitable in 2010, given the recovery in the global and domestic coal demand. This uptrend in profits is largely driven by soaring demand from the Asian countries. The scarcity of coal in relation to the growing needs of the Pacific markets, specifically from China and India, has led to improvement in coal exports form around the world.
As a result, the Asian coal prices have risen higher than prices anywhere else in the world, attracting supplies from across the world. These demand and price trends have boosted the profits of coal companies.
Coal companies in turn used these profits to expand business operations. Going forward, we believe 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 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.
Moreover, the prices for seaborne metallurgical and thermal coals are moving up on account of increased imports from China and India and other traditional Asian-based customers are returning to pre-recession growth levels.
Thermal Coal Prices Escalates
Coal provides the largest share of world electricity generation, accounting for a little less than 50% of total generation. In contrast, liquids, natural gas, and nuclear power all lose market share of world generation, displaced by the strong growth of renewable sources of generation.
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. Additionally, electricity generation absorbs more than 87% of total domestic coal consumption in the U.S. The reason is simple: coal is by far the least expensive and most abundant fossil fuel in the country. Thus, competitive electricity generation markets will have far-reaching implications on the coal industry.
The demand for thermal coal, which is primarily used for electricity generation, declined considerably in 2009 due to the reduced demand for electricity caused by the economic downturn. The extraordinary decline in electric generation in turn pushed coal inventories to historically high levels in 2009, causing coal prices to fall significantly.
Despite some recent pressures, the overall trend in thermal 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, with further reduction expected through 2011.
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 along with favorable weather should continue to ease pricing pressure going forward. We expect thermal prices to rise across all basins in 2011.
Met-Coal Markets Slowdown – China Impacts
The demand for metallurgical coal (coking coal), a key ingredient in the production of steel, has increased from 2009 levels based on the recovery of the Asian steel industry. The growth of steel demand in China acted as a major driver of global demand and pricing for coking coal in the first half of 2010, followed by India.
In its most recent report, the World Steel Association noted that China’s steel production in August 2010 declined compared to the year-ago period. However, steel production across other Asian and European countries continued to rise. According to World Steel Association crude steel capacity utilization ratio in the U.S. and around the world declined to a year low of 73.1% in August 2010 from 74.4% in July 2010. Compared to August 2009, the utilization rates in August 2010 decreased by 1.1 percentage point.
We believe the expected moderation in China’s growth may have a significant impact on global steel industry affecting the demand for coal, especially high-volatile metallurgical coal used for steel making. This tempered trend in the steel production and utilization are expected to pose near-term concerns, preventing metallurgical coal prices to rise from current levels. However, the supply of low-quality metallurgical coal is expected to continue to rise.
At the moment we remain skeptical about the future of metallurgical coal as the sustainability of the recent descending trends of the steel industry is yet to be seen. We believe any signs of further slowdown in China or the global steel markets may impact the metallurgical coal producers the most, which includes – Walter Energy Inc. ([url=http://www.zacks.com/stock/quote/wlt]WLT[/url]), Alpha Natural Resources Inc. ([url=http://www.zacks.com/stock/quote/anr]ANR[/url]), Patriot Coal Corporation ([url=http://www.zacks.com/stock/quote/pcx]PCX[/url]) and Massey Energy Company ([url=http://www.zacks.com/stock/quote/mee]MEE[/url]).
A Brief on U.S. Mining Regions
Coal producing regions in the U.S. mainly include Central Appalachia (CAPP), Northern Appalachia (NAPP), Illinois Basin (ILB), Power River Basin (PRB), and Uinta Basin (UIB). The recent quarter reports suggests promising mining results in the prolific Power River Basin and the emerging Illinois Basin, where the companies have been able to contain costs as well. Operators in the PRB benefited from increased demand for coal from electricity producers along with the low-cost nature of mining in the region.
On the other hand, in Central Appalachia, the oldest coal producing region in the U.S., results were weak due to disruptions in production as well as increased costs.
Production in the mature Central Appalachia was hurt mainly due to the tragic Upper Big Branch mine disaster, which occurred at the Massey Energy mine in April 2010. This deadliest incident created the ground for increased regulatory scrutiny in the region. Though the root cause for the accident is still unknown, regulators have stepped up enforcements and inspections for mining in the region, especially for underground mining, which has hampered the productivity of mine operators. Apart from production declines, the companies operating in the region are faced with the problem of increasing costs, thus, affecting their overall profitability.
Though the clear loser from the incident is Massey, we expect the formulation of stricter safety legislations and rigid penalties for the underground mining will raise costs permanently for all producers industry-wide. Other losers on this front include – Walter Energy, Alpha Natural Resources and Patriot Coal.
Furthermore, Central Appalachia is the prime producer of metallurgical coal in the U.S. These production disruptions, along with rising costs and the already discussed moderation of Chinese demand have strained the outlook of metallurgical coal producers with more emphasis on the Central Appalachia coal producers.
As a result, we like companies with greater exposure to large-scale surface mining with strong presence in the Powder River Basin – Peabody Energy Corporation ([url=http://www.zacks.com/stock/quote/btu]BTU[/url]), Arch Coal Inc. ([url=http://www.zacks.com/stock/quote/aci]ACI[/url]), and Cloud Peak Energy ([url=http://www.zacks.com/stock/quote/cld]CLD[/url]). Although we do not favor producers in the other U.S. coal producing basin, we expect companies with exposure to the Illinois Basin and Northern Appalachia to benefit from their larger-scale mines, constructive geology, and favorable access to markets. Stocks operating in these regions include – CONSOL Energy Inc. ([url=http://www.zacks.com/stock/quote/cnx]CNX[/url]), Alliance Holdings GP L.P. ([url=http://www.zacks.com/stock/quote/ahgp]AHGP[/url]) and Alliance Resources Partners L.P. ([url=http://www.zacks.com/stock/quote/arlp]ARLP[/url]).
Environmental Legislations – Alternative Energy Sources
The major threat to the coal mining industry has been the geological and environmental factors. 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 hydro power.
Of late, President Obama’s administration has been stressing on the use of renewable energy sources for power generation. This shift in governmental policies is expected to cap coal demand from America’s power sector. The resultant low demand can be a major setback for the U.S. coal industry.
The reality, though, is that most alternatives are highly under developed for primetime use. Solar and wind power are expensive, preventing their use as a major power source. While the coal plants have initiated their emission control process, we believe the coal industry should see the profits continuing to roll in.
Natural Gas Substituting Coal
Another major substitute for coal in energy generation is natural gas. 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. Furthermore, governments propagating the reduction of greenhouse gas emissions may encourage the use of natural gas in place of other fossil fuels.
Cheaper natural gas and large coal 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 slightly under pressure based on expectations of lower gas prices. With the discovery of abundant shale natural gas in the U.S., the long-term competitive dynamics may have moved notably against coal. It is, however, far from certain or clear at this stage.
In a macro backdrop, if the global economy -- particularly regarding its demand for steel -- displays a slow recovery and consequently suppressing the prices for CAPP and NAPP coal, it 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 prolonged pullback in Chinese growth will be major negative for the coal group.
In all, we have a favorable outlook for thermal coal producers with exposure to prolific and low-cost Powder River Basin against metallurgical coal producers with greater exposure in the mature and problematic Central Appalachia.
Specific names to avoid in the space include the coal master limited partnerships (MLPs) such as Natural Resource Partners L.P. ([url=http://www.zacks.com/stock/quote/nrp]NRP[/url])
and Penn Virginia Resources L.P. ([url=http://www.zacks.com/stock/quote/pvr]PVR[/url])
. The outlook for these partnerships remains weak. We are not confident of their ability to sustain distributions at current levels. As such, we would be staying away from the coal MLPs.