Coal Industry Outlook – March 2011 - Industry Outlook

The outlook for the coal industry has taken a turn after the long spell of weakness experienced in 2008 and 2009, driven by several powerful trends in the U.S. and Asia. Recent economic indicators suggest that the U.S. economy is regaining its stability, and sees a rebound in various industries — the coal industry being one of them. The emerging situation in Japan that has given the nuclear industry a black eye also is a net positive for the coal industry.

The World Bank estimates global economic activity, as measured by gross domestic product (GDP), expanded 3.9% in 2010. Global GDP is projected to grow another 3.3% in 2011 and 3.6% in 2012, with developing economies — led by China and India — expanding 6% or more in each year, more than twice the growth expected for high-income countries.

Most coal companies have been profitable in 2010, given the recovery in global and domestic coal demand. This uptrend in demand is largely driven by the improvement in the global economic activity, rebound in domestic power demand, favorable weather patterns and soaring coal demand from Asian countries.

Given the heightened coal demand in the Pacific markets throughout 2010, coupled with late-2010 weather-related demand increases in the Northern Hemisphere and supply constraints in key nations such as Australia, Indonesia, South Africa, South America and Canada, prices for seaborne metallurgical and thermal coal have been escalating.

The key players in the coal industry include: Arch Coal Inc. (ACI), Peabody Energy Corporation (BTU), James River Coal Co. (JRCC), CONSOL Energy Inc. (CNX), Walter Energy Inc. (WLT), Alpha Natural Resources Inc. (ANR), Cloud Peak Energy (CLD) and Patriot Coal Corporation (PCX). There are also coal master limited partnerships (MLP) including Penn Virginia Resource Partners L.P. (PVR), Natural Resource Partners L.P. (NRP), Alliance Holdings GP L.P. (AHGP) and Alliance Resources Partners L.P. (ARLP).

Industry Uptrends

Coal Fuels Power Generation: As we already know, coal as a major source of fuel for power generation dominates the Utility industry. Coal provides the largest share of the world’s electricity generation, accounting for a little less than 50% of total generation. In contrast, petroleum and nuclear power as a source of power generation have been losing market share displaced by the strong growth of renewable sources of generation and natural gas-fired generation. The outlook for nuclear energy, which had been steadily improving over the last few years, has most likely been dealt a severe blow by the current ongoing events in Japan.

Historically, coal has been a dominant energy source for electricity generation because of continued reliance on existing coal-fired plants. 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 in the U.S. The reason is simple: coal is by far the least expensive and most abundant fossil fuel in the country.

As per the “Short-term Energy Outlook” of the U.S. Energy Information Administration (EIA), coal consumption in the electric power sector grew by nearly 5% in 2010, primarily the result of higher electricity consumption during the hot summer. Despite this growth, coal production in 2010 grew only by 1% according to the EIA, as a drawdown in coal stocks, particularly in the power sector, met the increase in coal demand.

Increased domestic coal consumption coupled with muted production increases in 2010 led to a meaningful reduction in U.S. generator stockpile levels from the peak levels in November 2009, with further reduction expected through 2011. This, along with favorable weather, should continue to ease pricing pressures going forward, in our view. Some of the important stocks with good exposure to the thermal coal markets are James River Coal (JRCC) and Cloud Peak (CLD).

According to the EIA, 2011 coal consumption, coal production and utility coal stockpiles in the U.S. are projected to be essentially on par with 2010, due to the lower natural gas prices, which is a major substitute for coal.

Industry reports indicate that utilities are not expected to purchase significant amounts of coal for 2011 beyond what is already contracted for. Utilities that have indicated an interest in purchasing coal are doing so for delivery after 2011. Thus, the U.S. growth is projected to resume in 2012, with the increased consumption being matched with higher production, no way disrupting the utility coal stockpile balance.

Not only the U.S., but also the emerging markets will continue to demand thermal coal to power their growth, in our view. This will definitely improve the demand for coal in the power sector, despite all competition.

Rise in Steel Demand: Coal as a fuel source also contributes to the production of steel. 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 global steel industry. The rise in demand for steel in China, followed by India, acted as a major driver for global demand and influenced the pricing for coking coal in 2010. This was also seconded by a recovering demand in the U.S. and Europe. The U.S. steel industry operated at about a 70% utilization rate in 2010 compared to a 40% utilization rate for most of 2009.

Metallurgical coal prices increased substantially in the first half of 2010 and stabilized in the second half of the year at prices approximately twice that of a year ago. Going forward, we see the prices for metallurgical coal to remain strong based on the overwhelming demand by steel makers across the world.

Starting from the latter part of December 2010 until recently, the coal industry experienced significant supply disruptions due to floods in Australia, Columbia and Venezuela, and rail issues in South Africa. These disruptions have had a significant impact on spot pricing of metallurgical coal and at this time it is difficult to gauge how long supplies are going to be curtailed and its impact it will have on metallurgical coal pricing.

Nonetheless, we believe this constrained supply of metallurgical coal is setting the stage for higher pricing in 2011. While the supply remains tight, we believe metallurgical coal producers in the U.S. can benefit from the increasing demand and high met coal prices. We would thus recommend investing in met coal companies like Arch Coal (ACI), Walter Energy (WLT), Alpha Natural Resources (ANR) and Patriot Coal (PCX).

Common Threats

Environmental Legislations: Coal has been losing its importance as a fuel source over the last few years, particularly in the U.S., with other sources that have lesser impact on the environment gaining prominence. Concerns on the emission of greenhouse gases and global climate change have resulted in the formulation of new legislations and policies which emphasize on the use of environment-friendly fuel sources, particularly in the power sector.

This has considerably slowed 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. It remains to be seen what impact the Japan disaster will have on the industry’s fortunes going forward. But it has to be a net positive.

Natural Gas Substituting Coal: A 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. Cheaper natural gas and large coal inventories have greatly hurt the U.S. and European thermal coal demand in 2009. Looking ahead, we expect the thermal coal demand to remain slightly under pressure based on the expectations of lower gas prices.

Natural gas generation is likely to become more competitive over the coming years given its abundant domestic availability and the threat of regulation hanging over the Coal Mining industry. Not only coal, natural gas also substitutes the use of renewable and nuclear energy for electricity generation, as new natural gas-fired plant is much cheaper to build than new renewable or nuclear plants.

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 like wind, solar and hydro power. Generation from renewable resources grows in response to key Federal tax credits, but it is expected to be lower in 2011 than in 2010 because of lower natural gas prices and higher costs for new wind power plants.

Growth in renewables has also been supported by the many State requirements which stipulate the installation of renewable sources of electricity generation as mandated by Renewal Energy Standards (RES). The share of energy generation coming from renewable fuels (including conventional hydro) is projected to grow from 11% percent in 2009 to 14% percent in 2035, as per EIA’s long-term outlook.

Conclusion

Though there is ample pressure from legislations and competition from natural gas and renewable energy sources, we believe the global power industry will continue to depend on coal for a larger part of their generation. Coal as a fuel source will continue to power the growth in emerging nations like China and India, both for utility companies and steel makers. This trend gets a further boost from problems that Japan has been facing with handling its nuclear reactors following the earthquake and Tsunami.

Coal Industry Outlook – March 2011 – Industry Outlook

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