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Industry Outlook

The coal industry continues to fight a very difficult battle, with challenges being flung from all quarters, domestic and international. In the U.S., declining natural gas prices, stringent regulations and additional impetus to solar and wind power generation through the extension of tax credit are steadily driving away utility operators from coal.

Jittery development in key global markets and higher production countries like Australia and Indonesia, and, importantly, a stronger greenback, are making the export market fiercely competitive for U.S. coal players.

The new Clean Power Plan, unveiled in Aug 2015, calls for CO2 reductions of 28% by 2025 and 32% by 2030, from 2005 levels. This is slightly stricter than the draft proposal wherein the EPA had proposed total CO2 reduction of 29% by 2025 and 30% by 2030. Utilities like NextEra Energy (NEE - Free Report) and Dominion Resources (D - Free Report) are investing consistently to increase their green generation portfolio.

Failing to cope with the continuous fall in demand and declining prices of coal, some coal miners have filed for bankruptcy. The latest on this list is Peabody Energy, preceded by names like Arch Coal Inc., Patriot Coal, Alpha Natural Resources and Walter Energy. These companies tried all possible means to remain solvent, but we have to accept the harsh reality that coal demand is down and almost out.

In response to the anti-carbon drive, utility operators are shutting down coal-based power plants and are directing fresh investments toward constructing natural gas facilities and adding more renewables.

Per a release from the U.S. Energy Information Administration (EIA), U.S. coal production in May 2016 was 50 million short tons (MMst), down 28% from May 2015. Coal production declines are forecast to continue through 2016, with output expected to decline 17% or 155 MMst from 2015 levels.

Here are some of the severe headwinds that the coal industry is up against:

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 are much less harmful to the environment. Concerns over the emission of greenhouse gases and global climate change have resulted in the formulation of new legislations and policies which emphasize the use of environment-friendly fuel sources, particularly in the power sector.

This has considerably slowed down 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.

The final version of the Clean Power Plan will ensure that coal consumption for power production in the U.S. will go down from the present level, unless the utilities pour more money to upgrade existing plants.

Xcel Energy Inc. (XEL - Free Report) has already reduced carbon dioxide emissions during power generation by around 22% since 2005 and American Electric Power Co., Inc. (AEP - Free Report) has eliminated over 5,500 megawatt (MW) of coal-fired capacity. NextEra Energy’s unit Florida Power & Light Company decided to purchase a 330 MW coal-based power plant with the intention to phase it out gradually to lower carbon emission.

Natural Gas Substituting Coal: A major substitute for coal in energy generation is another fossil fuel – natural gas. Coal is being dumped in favor of natural gas, which due to extensive exploration and production and a shale gas boom in onshore U.S., 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. This trend is encouraging power generators to not only convert their existing plants to gas-fired ones but to build new units.

The EIA expects natural gas to feed 34.4% of total generation, while coal will fuel 29.9% of total production in 2016. The EIA however forecasts the share of natural gas to fall slightly to 33.3% and coal to rise to 30.9% in 2017.

Besides power generation, clean burning natural gas is being utilized in new projects in the fertilizer and chemical sectors.

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.

The EIA report reveals renewables used in the electric power sector to increase by 13.0% in 2016 and by 3.3% in 2017. These renewable additions will eat into coal’s share of electricity generation.  Production of power from renewable sources is supported by most of the U.S. states though there is no national consensus regarding the percentage of renewables in the total energy mix. However, the Clean Power Plan will encourage energy conservation and efficiency plans, use of renewables and clean alternative technologies for lowering air pollution.

The extension of the Investment Tax Credit (ITC) for solar and Production Tax Credit (PTC) for wind will drive further additions in renewable generation units at the cost of coal. Making use of the government support, NextEra Energy expects to bring on-line nearly 2,400–3,800 MW of new wind projects over the 2017–2018 timeframe.

Rising Competition and Stronger Dollar: Besides competition from renewables and natural gas, U.S. coal producers are also affected by rising export from Indonesia and Australia and a stronger dollar, which is making this commodity dearer in the international markets. International players enjoy the benefit of low mining and transportation costs, which also make their coal  cheaper than their American peers.

The EIA release sums up that weak coal demand, lower international coal prices and a higher output in other coal-exporting countries have led to a decline in U.S. coal exports. U.S. coal exports are expected to decrease by 8 MMst each in 2016 (down 10%) and 2017 (down 12%).

Bankers Retreat: Capital intensive coal projects are gradually losing favor among primary funders like banks and financial institutions. Bankers like Bank of America Corporation (BAC - Free Report) , Citigroup Inc. (C - Free Report) and Morgan Stanley (MS - Free Report) are distancing themselves from coal projects and are rather getting involved in natural gas based power projects

To Conclude

In “Can Coal Stocks Add Value to Your Portfolio?”  we focused on the conditions which are expected to drive the industry forward.

However, the continuous fall in demand and soft prices have stretched the financial capabilities of the coal miners. Many of these leading companies are being put under the “self-bonding” test. Self-bonding is a government program that allows producers of coal to economically insure their clean-up costs in case of a bankruptcy. At present, we will advise investors to stay away from Alliance Holdings GP, L.P. (AHGP - Free Report) , which not only has a Zacks Rank #5 (Strong Sell) but has registered negative earnings surprises in the last four quarters.

To overcome the difficult times and remain viable, coal producers are idling coal mines, lowering headcount, delaying capital expenditure plans and even resorting to sell their mines. Despite these initiatives, coal producers are bracing themselves for an extended down-cycle, as demand for coal is not going to improve radically any time soon.