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.

Of late, coal prices have been recovering, prompted by increased U.S. and Chinese coal consumption. The unusually cold winter in parts of the U.S. and the restart of steel production in China have led an increase in the demand for coal. We expect 2010 to be a transformative year for the coal industry.

Metallurgical coal is a key ingredient in the production of steel, and most of the metallurgical coal is going to China and India. Global steel production is expected to increase 9% in 2010, with continued growth from China and India and increased output from traditional steel-producing nations as utilization rates recover. This calls for increased demand for metallurgical coal around the world.

Coal demand in the Pacific markets is growing rapidly, with supplies increasingly tight. China became a significant net coal importer in 2009. Other Pacific basin countries are also expected to grow strongly. Because of demand in Asia, some metallurgical coal supply from Australia, Canada and the U.S. that normally would have moved into the Atlantic basin will likely be diverted into the Pacific basin.

Thermal coal is used by electric utilities throughout the U.S. to generate power for businesses and residences. The U.S. relies on coal for about half of its power generation, compared with about 20% for gas. The U.S. faced severely cold weather in the just completed heating season, which led to increased demand for electricity. The higher coal use caused by the cold winter weather has lowered utility stockpiles since early December. As excess coal stockpiles are worked off at U.S. and European power plants, global coal markets are poised for a meaningful recovery.

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. Current spot metallurgical coal prices have increased to the $200 per ton range.


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 (BTU), Patriot Coal Corporation (PCX), Walter Energy Inc. (WLT) and Arch Coal Inc. (ACI) look attractive currently.

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 with the rebound of China and other Asian emerging markets. Furthermore, Peabody has significant leverage to the improving prices for seaborne metallurgical and thermal coal.

Arch Coal has a significant amount of reserves and is a top-three producer in the Powder River Basin (PRB). In our opinion, PRB coal will be in great demand over the coming years. Going forward, the significant coal-fired power plant build-out will increase annual thermal coal demand by more than 43 MM tons, most of which will be fueled by PRB coal.

Tampa, Florida-based Walter Energy has high quality metallurgical reserves, which are advantageously located. It is one of the largest producers of premium metallurgical coal. The company has the ability to expand its production by roughly 50% at its Mine No. 7 East Expansion longwall — taking production capacity up to 9.5 million tons in 2012.


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 continue to roll in.

Another major alternative for the use of coal in energy generation is natural gas. Natural gas has to stay above $5 per million British thermal units to prevent it from being more attractive to utilities at the expense of coal.

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 decreasing demand for it) and would force businesses to use less reliable and more expensive forms of energy.

Furthermore, 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.

Among specific names to avoid in the space include the coal master limited partnerships, such Natural Resource Partners (NRP) and Penn Virginia
(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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