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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 credits 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.

Another operator in this space, DTE Energy (DTE - Free Report) is planning to wind down its old coal-fired electricity generation units. Meanwhile, the company will add increase the share of natural gas and renewable energy in its generation portfolio in order to its carbon footprint over the long run. This stock has surpassed earnings estimates in three out of the last four quarters.It currently has a Zacks Rank #2 (Buy). You can see the complete list of today’s Zacks #1 Rank stocks here.

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.U.S. coal production during the second quarter of 2016 was 160.5 million short tons (MMst). This reflects a decline of 7.2% sequentially and 24.4% year over year.

Per a release from the U.S. Energy Information Administration (EIA), the decline in U.S. coal production is expected to continue through 2016, with output expected to tumble 19.1% or by 171.1 MMst from the 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 megawatts (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 of phasing it out gradually to lower carbon emission.

Due to such legislative stringency, coal usage in electric generation is expected to witness a decline this year. In fact, the EIA forecasts coal consumption in power generation of 673 MMst, down 9.1% from 2015.

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 contribute to 35% of the total generation in 2016, while coal represents 30%. However, in 2017, the share of natural gas is expected to dip to 34% while coal’s inches up 31%.

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 expectations of a 6.3% year-over-year increase in renewable energy consumption to 10.513 Quadrillion Btu in 2016 and a 3.7% rise to 10.533 Quadrillion Btu 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 & 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.

According to the EIA, weak coal demand, lower international coal prices and higher output of other coal exporters have jointly led to a decline in coal exports from the U.S. In fact, in 2016, U.S. coal exports are expected to tumble by 19.5 MMst (down 26%), while in 2017, it will decline by 2.5 MMst (down 5%).

Bankers Retreat: Capital-intensive coal projects are gradually losing favor among primary funders like banks and financial institutions. Bankers like Bank of America Corp. (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 ‘Coal Stocks Can Provide Returns to Investors in Long Term,’ we have focused on the factors that can drive the industry forward.

However, the continuous fall in demand and soft prices have stretched the financial capabilities of 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 Westmoreland Coal Co. (WLB - Free Report) , which not only has a Zacks Rank #4 (Sell), but has also registered negative earnings surprises thrice in the last four quarters. In addition, its projected loss per share in 2016 widened to $1.53 from a loss of 83 cents in the last 60 days.

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.

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