Coal Industry Stock Outlook - Nov 2013 - Zacks Analyst Interviews

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Overview

Coal plays a vital role in the economic development of a country. Coal not only provides a cheap source of electricity production but also creates employment opportunity for thousands of people. Coal with its heat generating capability also plays an essential role in the chemical, fertilizer and steel industries.

Coal is a dominant source of power generation worldwide despite the increasing use of other resources. According to the Energy Information Administration (EIA), coal still plays an important role in the U.S. in the generation of power. However, natural gas is eating away its share at a very fast pace. As per the EIA, coal's annual share of total power generation in the U.S. declined from 50% in 2007 to 37% in 2012. The usage of natural gas and alternate sources for power generation will continue to pose challenges to coal.

The U.S., Russia, Australia, China, India and South Africa have the largest coal reserves in the world. Coal is produced in 25 states in the U.S., though the bulk of current production takes place in just five states: Wyoming, West Virginia, Kentucky, Pennsylvania and Montana.

According to estimates by the EIA, the country's current coal reserves will last for 168 years at the current production rate. They might in all likelihood last even longer with environmental issues coming in the way. However, if the fuel's environmental standing can be improved, there could potentially be new sources of end-market demand in the future, in communications and transportation systems, computer networks and even space expeditions.

As per the World Coal Association (WCA), proven global coal reserves will last nearly 112 years at current production rates. On the other hand, proven oil and gas reserves are projected to last around 46 years and 54 years, respectively, at current production levels. Asia is the biggest coal market and presently accounts for 67% of the global coal consumption.

There is no denying the manifold advantages of coal. However, unchecked usage of this fossil fuel has raised concerns in all quarters. The primary cause of concern related to coal is global warming caused by the emission of green house gases. The U.S. government has been pretty vigilant, enforcing stricter regulations on coal-fired generating units to curb pollution.

President Obama's Climate Plan, followed by the U.S. Environmental Protection Agency's (EPA) proposal for granting permission for setting up new power plants, is putting immense pressure on power producing units. If the new regulations are implemented it will increase the cost of power generation from coal fired plants.

In the light of these issues, if the U.S. electricity generators opt for natural gas for power generation and invest more in alternate sources, what will be in stake for coal companies?

Moreover, Europe is a big export market for the U.S. coal producers. The European Investment Bank (EIB) said it would stop financing the majority of coal-fired power stations to help the European Union's 28-nation coalition reduce environmental pollution. New coal units will not be funded unless the emission level is less than 550 grams of carbon dioxide per kilowatt-hour (gCO2/kW).

Given the mounting environmental pressure, there is definitely a push away from coal as a power source. However, on a global scale, coal still leads the way. There is still hope for coal companies if they can produce high-efficiency coal. Technological advancement and carbon capture and storage offer possible remedies for coal's future.

Zacks Rank

The Zacks Industry Rank, which relies on the same estimate revisions methodology that drives the Zacks Rank for stocks, currently puts the Coal industry at 104 out of 259 industries in our expanded industry classification. This puts the industry in the middle third of all industries, corresponding to a neutral outlook.

The way to look at the complete list of 259+ industries is that the outlook for the top one-third of the list (Zacks Industry Rank of #85 and lower) is positive, the middle one-third of the list (Zacks Industry Rank of #86 to #169) is neutral while the outlook for the bottom one-third (Zacks Industry Rank #170 and higher) is negative.

Please note that the Zacks Rank for stocks, which is at the core of our Industry Outlook, has an impressive track record going back years, verified by outside auditors, to foretell stock prices, particularly over the short term (1 to 3 months).

None of the 20 companies in the Coal industry under our coverage has a Zacks Rank #1 (Strong Buy); 2 have a Zacks Rank #2 (Buy), while 2 have a Zacks Rank #4 (Sell) and none are rated Zacks Rank #5 (Strong Sell). The other 16 have Zacks Rank #3 (Hold). Overall, the Zacks Rank for the industry and for individual stocks indicate our neutral stance on the industry.

Earnings Review and Outlook

The coal industry's overall earnings results in the third quarter were on the softer side. However, the top four U.S. coal producers, namely, Peabody Energy Corporation ( BTU ), Arch Coal Inc. ( ACI ), Alpha Natural Resources Inc. ( ANR ) and Cloud Peak Energy (CLD) either surpassed the consensus estimates or were in line with expectation. CONSOL Energy Corporation ( CNX ), holding the 5th position, posted third quarter earnings much lower than the consensus.

In total, 53% of the coal companies in our coverage either met or came out with positive earnings surprises in the third quarter, below the 65.3% average for the S&P 500.

The upcoming earnings releases in the fourth quarter are expected to remain soft as well. As per our current projection, Peabody Energy, Alliance Holdings GP, L.P. ( AHGP ), James River Coal ( JRCC ), Walter Energy ( WLT ), Arch Coal Inc. and Oxford Resource Partners, L.P. ( OXF ) are expected to surpass year-ago earnings.

Fourth quarter earnings of Alliance Resource Partners LP ( ARLP ), CONSOL Energy, Cloud Peak Energy and Alpha Natural Resources Inc. are however expected to decline year over year.

We note that the demand for power fluctuates with seasons and a harsher winter may see higher demand for electricity and in turn more robust coal sales.

Tailwinds

Coal Dominates U.S. Power Generation: Coal as a major source of fuel for power generation dominates the Utility industry. Coal is used to generate about half of the electricity consumed in the U.S. and is also the largest domestically-produced source of energy. Electricity generation absorbs about 93% of total U.S. coal consumption. The reason is simple: coal is by far the least expensive and most abundant fossil fuel in the country, though the emergence of large shale natural gas reserves is expected to pose tough competition going forward.

The relative increase in U.S. natural gas price, compared to coal, will also increase the share of coal in electricity generation. The EIA report suggests coal's share in electricity generation in 2013 will reach 39.5%, up from 37.4% in 2012.

Coal production for the first three quarters of 2013 was estimated at 752 million short tons (MMst), 15 MMst (2%) lower than in the same period of 2012. EIA projects total coal production of 1,012 MMst in 2013, marginally down from the 2012 level of 1,016MMst.

At present, U.S. coal stockpiles have come down to nearly 150 million tons, which could lead to an increase in production in the coming year. As per EIA, coal production will grow by 2.7% in 2014 to 1,039 MMst as inventories stabilize and consumption increases.

EIA indicates that total coal consumption will increase by 4.4% from 890 million short tons (MMst) in 2012 to 930 MMst in 2013, as consumption in the electric power sector rises due to higher electricity demand. U.S. coal consumption will however grow at a more modest pace of 2.8% to touch 957 MMst in 2014.

Not Just Electric Generation: Electricity generation is just one use of coal in the U.S. Manufacturing plants and industries use coal to make chemicals, cement, paper, ceramics and metal products, to name a few. Methanol and ethylene, which can be made from coal gas, are used to make products such as plastics, medicines, fertilizers and tar.

Certain industries consume large amounts of coal. For example, concrete and paper companies burn coal, and the steel industry uses coke and coal by-products to make steel for bridges, buildings and automobiles.

Coal As Input for Steel Industry: Due to its heat-producing feature, hard coal (metallurgical or coking coal) forms a key ingredient in the production of steel. Nearly 70% of global steel production depends on coal.

A recent release from the World Steel Association revealed that worldwide steel production was 134 million tons (Mt) in Oct 2013, an increase of 6.6% as compared to Oct 2012 (data from 65 countries). The World Steel Association projected nearly 3% year-over-year growth in global steel usage in 2013 and 2014. Since met coal is a necessity in steel production, positive steel fundamentals can drive up its demand.

Demand Upsurge in Asian Countries: The growing economies of Asia, with ongoing infrastructural development, could keep the U.S. based coal producers afloat. Even if the current pace of economic development in these countries has turned a little sluggish, increasing coal imports from these countries will definitely boost the fortunes of the U.S. coal producers.

Some of the big names making the most from overseas coal exports are Peabody Energy Corporation and Alpha Natural Resources, Inc. During the second quarter of this year Arch Coal Inc. opened operations in Beijing to tap the growing metallurgical and thermal coal demand in South Asian markets.

The increase in coal demand in the Asian economies of China and India has been a key price driver. We expect this trend to continue in the future, mainly due to the growing energy needs in India, China and South Korea. In addition, the nuclear debacle in Japan led the country to import coal to generate electricity.

Of the Asian countries, economic growth in China and India will be the fastest. These two countries do produce coal, but its domestic coal production has yet to match the growing demand, resulting in increasing need of imports. These countries rely heavily on coal for electricity generation.

At present nearly 70% of China's electricity is generated from coal-fired power plants. The country is also taking active steps to close down on the high operating cost coal mines. This is wont to create opportunities for U.S. coal exporters.

It is estimated that by 2035, 60% of the world's coal-fired units will be located in China and India. It is quite obvious from the current rate of production that these two countries will have to make bulk coal imports to run its units. So, the future prices of coal and the growth of coal stocks will to a large extent depend on these two countries.

Acquisitions, Merger and Sell Offs: Selective acquisitions and strategic mergers could also turn profitable for U.S. coal operators. In addition, they could also monetize some of their mature coal assets and use the proceeds to further develop their high-quality, low-cost mines. There will always be a market for the high variety coal that emits lesser green house gases.

In August, Arch Coal Inc. decided to sell its Canyon Fuel Assets for $423 million and intends to use the proceeds in assets having a better growth potential. The present focus is definitely on maintaining a balanced production portfolio with a focus on high quality coal mines having lower operating costs.

Per a media report, International Coal Ventures Ltd., a joint venture between four top state-run companies in India, is planning to acquire four overseas coal mines for $1 billion. We believe that U.S. coal operators have a very high chance of being a part of the deal, given the high quality of coal and the existing infrastructure in the mines.

Coal Trade

According to an EIA report, U.S. coal exports in 2012 were 126 MMst, which reflected growth of 17.8% year over year, driven by demand from Asian countries. EIA forecasts U.S. coal export at 110 MMst in both 2013 and 2014. The continued weakness in Europe, decline in international coal prices and increase in production from other coal exporting countries will weigh on U.S. exports in 2013-14. U.S. coal exports are nevertheless expected to reach 155 MMst in 2017-18.

Besides Australia and Russia, which has the second largest coal reserve next only to U.S, the U.S. coal exporters could face competition from Indonesia. Indonesia is the world's largest exporter of thermal coal and its proximity to China and India will give it a geographical advantage over the U.S.

Headwinds

Coal is plentiful and fairly cheap relative to the cost of other sources of electricity, but its use produces emissions that adversely affect the environment. Coal emits carbon dioxide, sulfur dioxide, nitrogen oxide and mercury, which have been linked to acid rain, smog and health issues.

With governments becoming more and more stringent on environmental issues, the electricity generators are implementing new measures to bring down emission levels of greenhouse gases.

Sluggish Economic Recovery: The sluggish pace of economic recovery in the U.S. has to a great extent eroded demand for coal. This has pushed a few of the large operators to lower production, idle mines or even shut down mines permanently to realign output with diminishing demand.

The slower pace of economic recovery is also reducing the realized price of coal. EIA predicts average coal prices in the utility industry to decrease to $2.34 per million British thermal units (MMBtu) in 2013 from $2.40 per MMBtu in 2012.

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 have a lesser impact on the environment.

The climate action plan from President Obama, followed by the U.S. Environmental Protection Agency's (EPA) proposal for implementing more stringent guidelines for setting up new coal power plants, is putting immense pressure on power producing units.

EPA's new proposal suggests a new coal-based power plant will have to limit carbon emission to 1,100 pounds of CO2 per megawatt-hour. In addition, coal based power generators would have the option to meet a somewhat tighter limit if they opt for an average emission over multiple years.

The new recommendation will make electricity generation from coal units far more costlier than before. This will definitely have an adverse impact on coal usage for power generation in the U.S., ultimately hurting coal producers.

Natural Gas Substituting Coal: A major substitute for coal in energy generation is natural gas. Coal is being dumped in favor of natural gas because of its relative fuel efficiency, low emissions, quick construction timelines and low capital costs.

There is an abundance of natural gas in the U.S. market and its usage is eco-friendly. Power generators are not only converting their existing plants to gas-fired ones but are also building new nat-gas units to meet regulatory standards.

As per EIA's reports, 96.65 GW of new electric generation will be added in the U.S. within 2009-2015, of which 20% will be natural gas-fired plants.

The share of natural gas for power generation is projected to grow from 24% in 2010 to 30% in 2040, as per the EIA's long-term outlook.

Very recently, CONSOL Energy decided to sell a large chunk of its coal assets and utilize the proceeds to further develop its natural gas assets.

Competition from Alternative Energy Sources: Apart from natural gas, the coal industry has been losing a major share to renewable sources of energy like wind, solar and hydro power.

Production of power from renewable sources has also been supported by various U.S. states. Undoubtedly, state legislators are laying more emphasis to produce power from renewables. Thirty-five U.S. states and the District of Columbia have enforceable renewable portfolio standards or other renewable generation policies.

Even though the percentage of electricity production from renewable sources is not uniform across all states in the U.S., the objective behind this move is common. They are all eager to cut down on greenhouse gas emission.

As per an EIA release, renewable energy's share of total energy use (including biofuels) would improve from 9% in 2011 to 13% in 2040. This increase inevitably comes at the expense of coal-fired units.

To Sum Up

At present the top four coal producers contribute more than 50% of U.S. coal generation volume. Despite the stringent legislations and regulations regarding coal-fired generation, we could see some positive news for the coal industry. A release from Peabody Energy indicates a 15% to 20% recovery in metallurgical coal prices from third quarter levels.

There is no denying that in the U.S. coal continues to lose ground to other fuel sources for power generation. As per EIA, coal will continue as the largest source of electricity generation, but its share of total electricity generation, which was 51% in 2003, would decline to 35% in 2040. This will be still substantial given the expected rise in U.S. electricity generation in the next few decades.

An EIA report also suggests that in the U.S. within the 2012 to 2016 timeframe nearly 27 Gigawatts (GW) of coal generation capacity will be retired, which is nearly four times the 6.5 GW retired in the prior five-year period. Renewable energy sources and natural gas powered units will be the main beneficiary of the lost ground. Renewables and natural gas will come up in a major way in the next three decades.

The gradual shutdown of coal-fired units has started to take its toll on employment levels, as per the data released from the U.S. Bureau of Labor Statistics (BLS) in the first 10 months of 2013. U.S. coal employment was down 2.2% from the same period last year. We believe unless resolved the job loss could create a serious problem for the administrators.

All said, even if alternate sources of fuel generation are available, coal's advantage lies in its price, which is far cheaper than other sources of fuel. If we look at the global picture, it is evident that cheap source of reliable power is a driving factor for economic development. Reinvigorating demand from growing economies and steady demand from the U.S. will continue to drive the coal industry in the future.

ARCH COAL INC (ACI): Free Stock Analysis Report

ALLIANCE HLDGS (AHGP): Free Stock Analysis Report

ALPHA NATRL RES (ANR): Free Stock Analysis Report

ALLIANCE RES (ARLP): Free Stock Analysis Report

PEABODY ENERGY (BTU): Free Stock Analysis Report

CLOUD PEAK EGY (CLD): Free Stock Analysis Report

CONSOL ENERGY (CNX): Free Stock Analysis Report

JAMES RIVER CL (JRCC): Free Stock Analysis Report

OXFORD RES PTNR (OXF): Free Stock Analysis Report

WALTER ENERGY (WLT): Free Stock Analysis Report

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: ACI , AHGP , ANR , CLD , EIA

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