Our near-term (6-18 months) outlook for the coal industry has improved somewhat from our previous neutral sentiment to a more positive undertone. Based off of various recent economic indicators, the U.S. economy appears to be stabilizing. Although the rest of 2009 is likely to continue on a path of weak steel and electricity demand relative to 2008 levels, several factors should help lift the coal producers in 2010.
Reductions in capex spending from both coal and natural gas producers, the weakening of the U.S. dollar and most importantly, increased steel and electricity consumption in 2010 should all be positive catalysts for the coal industry next year.
As stated in earlier outlook summaries, benchmark metallurgical prices for fiscal 2009 have been set around $120/mt — off markedly from the $300/mt level seen in 2008 but still above historical met price levels. This means that in 2010, producers will still realize triple-digit-average prices for met coal.
This also represents a more long-term indication of what the implied floor for metallurgical coal prices are due to the perfect storm of negative economic data that pervaded the global markets during pricing for this year.
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 opportunities to acquire reserves on the cheap.
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) and Arch Coal Inc. (ACI) look attractive currently. Both have recently engaged in long-term growth acquisitions.
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 a 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 toward the end 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. Its likely acquisition of Rio Tinto’s (RTP) Jacobs Mine will increase ACI’s PRB market share while gaining operating synergies.
We also like companies with leverage to metallurgical coal markets. When the global economy starts to turn around, likely in the beginning of 2010, demand for steel and metallurgical coal should rise. Companies like Walter Energy (WLT) should fare well in this environment.
WEAKNESSES
Appalachian producers continue to face productivity problems via shortage of skilled labor, MSHA inspections, and other permitting and regulatory hurdles relating to the Clean Water Act. While the falling cost of steel and fuel will reduce the cost of direct materials, these other issues will more than offset them.
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.
More recently, there have been several debates regarding the effectiveness of “cap-and-trade.” 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 decreasing demand for it) and would force businesses to use less reliable and more expensive forms of energy.
Among specific names to avoid in the space include the coal master limited partnerships, such Natural Resource Partners (NRP) and Penn Virginia Resources (PVR). 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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