Coal Industry Stock Review - Dec 2012 - Zacks Analyst Interviews

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Coal is burned as fuel or gasified to create a synthetic gas (syngas) that can then be used as feedstock for the production of chemicals, fertilizer and electric power. Coal is also used for producing heat through combustion.

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., spread across three coal-producing regions. The majority of current production originates in just five states: Wyoming, West Virginia, Kentucky, Pennsylvania and Montana. China, the U.S., India, Russia and Japan account for 77% of total global coal use.

The Energy Information Administration (EIA) estimates, even if no new reserve is added, the present U.S. coal reserve will exhaust in 168 years, taking into consideration the incremental production rate. This is promising because, in addition to the many existing ways to use coal, the future holds new methods and potential for growth. Products from coal may soon be part of communications and transportation systems, computer networks and even space expeditions.

As per the World Coal Association, proven global coal reserves are estimated to be 861 billion tons. This reserve is expected to last nearly 112 years at the current rate of production. On the other hand, proven oil and gas reserves are projected to last around 46 years and 54 years respectively at current production levels. We believe the volume of reserves and availability of coal in most of the countries across the globe make it a globally accepted source of power generation. At present, around 40% of the global electric generation plants are coal fired.

The importance of coal as a source of generating power increased over time with the rise in industrialization. However, alternatives to coal have now emerged, curbing coal's dominance to a certain extent.

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.

Demand for power in the U.S. also rises during winters, driving a concomitant demand for coal. So, we believe stockpiles of coal accumulated earlier will be utilized over the next few months.

The recovery in the coal sector is also a reflection of a broader recovery in the economy following a period of recession. As per a media report, in May 2012, 85,600 people were employed in this industry versus 77, 200 in December 2007. This implies an addition of around 10,000 employees over the last five years.

The EIA report also suggests that the increase in demand for electricity and an expected recovery in natural gas prices from current depressed levels will result in a hike in coal production post 2015. Coal production, after 2015, is expected to increase by 1% on an average per year until 2035.

Admittedly, the dominance of coal as a source of electricity generation has diminished with the availability of other fuel sources. However, as per an EIA report, coal will continue to be the major source of electricity generation in the U.S. until 2035.

In contrast, petroleum and nuclear power as sources of power generation have been losing market share, displaced by the strong growth of renewable sources of generation and natural gas-fired generation. Petroleum is losing out to coal because it is becoming increasingly expensive. After the Japan earthquake/tsunami in 2011, nuclear power's contribution to total energy generation has declined from the prior year.

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 an 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.

Overall, steel demand in the developing and emerging world will rise 3.0% in 2012 and 3.7% in 2013. This is surely an encouraging sign for the coal industry.

Demand Upsurge in Asian Countries: 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.

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 the continuous need of importing coal. These countries rely heavily on coal for electricity generation.

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.

Given the growing demand from the fast-growing Asian economies, companies find it attractive to export coal to emerging regions. Some of the names making the most from overseas coal exports are Peabody Energy Corporation ( BTU ) and CONSOL Energy Inc. ( CNX ). To cater to the increasing demand for coal in Asian countries, Peabody has acquired Macarthur Coal in Australia and expanded its footprint in high-demand regions worldwide.

Coal Trade

According to an EIA report, U.S. coal exports in 2011 were 107 million short tons (MMst), which reflected growth of 31% year over year. Flooding in Australian mines during 2011 disrupted coal exports, which benefited U.S. producers. The upsurge in coal exports during 2011 mainly emanated from demand from Asian countries. As per the EIA report, with Australian mines back in operation, U.S. coal exports are expected to decline to 100 MMst in 2012. In 2011, United States exported most coal to the Netherlands, approximately 10.7 million short tons.

Besides Australia, the U.S. coal exporters could face competition from Russia. Russia has the second largest reserve of coal, next only to U.S. Now if it starts to export coal in bulk to China and India, it will have a geographical advantage over the U.S.

Headwinds

The 2012 coal volume output in the U.S. is expected be lower than the last five-year average. The projected decline is attributed to lower demand due to adverse weather conditions, large stock of coal and increasing competition from natural gas as an alternate fuel.

In the ensuing year, the demand for coal to produce power is likely to fall 10% from the previous year due to increasing use of natural gas to generate power. EIA forecasts coal use in the U.S. power sector to fall below 900 million short tons in 2012 and 2013.

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 sulfur dioxide, nitrogen oxide and mercury, which have been linked to acid rain, smog and health issues. Coal also emits carbon dioxide, a greenhouse gas that contributes to climate change.

Without proper care, coal mining can have a negative impact on ecosystems, and alter landscapes and scenic views. 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.

An EIA report suggests that in the next five years, between 2012 and 2016, U.S. power plant operators will retire around 27 gigawatts (GW) of coal-generation capacity from their production portfolio. Tepid demand, environmental compliance costs, compliance with state emission regulations and relative fuel prices will lead to the retirement of the power plants. In 2011, total coal fired power generation in the U.S. was 318 GW. The phased retirement of 27 GW over the next five years will therefore constitute 8% of the total 2011 coal-fired capacity.

Sluggish Economic Recovery: The sluggish pace in economic recovery in 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. In September 2012, Peabody Energy decided to permanently close its Air Quality Mine in Vincennes, Indiana. The tepid demand for coal was making the operation of this mine uneconomic, leading to its shutdown.

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. 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 led Peabody Energy to permanently shut down its Willow Lake Mine near Harrisburg, Illinois. The Willow Lake Mine has failed to meet acceptable standards for safety, compliance and operating performance. This makes operation in the mine unsafe and risky.

CONSOL Energy decided to idle its Miller Creek surface operations near Naugatuck, West Virginia, citing a sequence of permit delays that has prevented the company from securing all of the necessary environmental permits required to continue mining.

Natural Gas Substituting Coal: A major substitute for coal in energy generation is natural gas. Coal is being dumped in favor of natural gas, which due to extensive exploration and production, 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. There is an abundance of natural gas in the U.S. markets, resulting in lower prices. This trend is encouraging power generators to not only convert their existing plants to gas-fired ones but to build new nat-gas units.

Electric generation through gas-fired plants 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. As per EIA's reports, 96.65 GW of new electric generation will be added in the U.S. within 2009-2015, out 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 28% in 2035, as per the EIA's long-term outlook. In a best-case scenario, this is expected to go up to 31% in that time period.

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.

Production of power from renewable sources has also been supported by various U.S. states. At present there is no national consensus regarding the percentage of energy to be generated from renewable sources by the power generators.

Undoubtedly, state legislators are giving more emphasis to produce power from renewables. At present, 30 U.S. states and the District of Columbia have enforceable renewable portfolio standards or other renewable generation policies. These policies were designed to spread awareness and encourage the power generators to produce more from renewable sources.

The share of renewable fuels (including conventional hydro) in energy generation is projected to grow from 10% in 2010 to 16% in 2035, as per the EIA's long-term outlook.

Increasing Debt Levels: One of the major concerns for the coal companies is the mounting debt levels. The need for expansion, locating new fields and upgrading the existing system are pushing the coal companies to take more credit from the market by issuing bonds and securities.

However, in some cases, the extra funds which are put into operation are not generating the desired results. Some of the coal companies are on the brink of failure to service its debts. Patriot Coal, for one, has filed for bankruptcy protection.

Spiraling debt and a failure to service these debts on time lower the credit worthiness and credit rating of a company. In such a scenario it gets increasingly difficult for the company to collect funds from the market. And the conditions, if funds are at all granted, get much stricter and less favorable.

Earnings Review and 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 224 out of 260 industries in our expanded industry classification. This puts the industry in the bottom third of all industries, which corresponds to a negative outlook for the industry. None of the 18 companies in the Coal industry has Zacks Rank #1 (Strong Buy) or Zacks Rank #2 (Buy), while 6 have either Zacks Rank #5 (Strong Sell) or Zacks Rank #4 (Sell).

The earnings results of Alliance Holdings GP, L.P. ( AHGP ), Arch Coal, Inc. ( ACI ), Peabody Energy Corporation ( BTU ), Alpha Natural Resources Inc. ( ANR ), Cloud Peak Energy Inc. ( CLD ), Natural Resource Partners L.P. ( NRP ), SunCoke Energy Inc. ( SXC ) and Rhino Resource Partners LP ( RNO ) surpassed the Zacks Consensus Estimates. The highest positive surprise of 35 cents came from Arch Coal with the lowest surprise of 5 cents coming from Rhino Resources.

On the other hand results from CONSOL Energy Inc. ( CNX ), Penn Virginia Resource Partners L.P. ( PVR ), Walter Energy Inc. ( WLT ), James River Coal Company ( JRCC ) and Alliance Resource Partners L.P. ( ARLP ) were lower than our projection.

Our proprietary Zacks Ranks indicate the movement of the stocks over the short term (1 to 3 months), which is a reliable indicator of the likely movement of these coal stocks.

The majority of stocks we cover in the coal industry, such as Alliance Holdings GP, L.P., Alpha Natural Resources Inc., Arch Coal, Inc., Peabody Energy Corporation Cloud Peak Energy Inc., CONSOL Energy Inc., Hallador Energy Company ( HNRG ), Natural Resource Partners L.P., SunCoke Energy Inc., Rhino Resource Partners LP and Penn Virginia Resource Partners L.P. presently retain a Zacks #3 Rank (short-term Hold rating).

We presently have a couple of names in our Zacks #4 Rank (short-term Sell rating) radar, which are CONSOL Energy Inc. and James River Coal Company. We also have two short-term Zacks #5 Ranked stocks (Strong Sell rating) which are Walter Energy Inc. and Yanzhou Coal Mining Company Limited ( YZC ).

In hindsight, the third quarter earnings results of the coal sector were more or less satisfactory. Hence we provide a Hold recommendation for the majority of stocks in our coverage in this sector. We expect the measures undertaken by the coal operators to cope with the changing demand scenario will become apparent in the upcoming quarters.

In Conclusion

Though there is ample pressure from legislations and increasing competition from natural gas and renewable energy sources, we believe the global power industry will continue to depend on coal for a large part of its generation.

The coal block controversy in India might open up new export opportunities for the coal operators in the U.S. Coal is a major source of generation of power in India. India's emphasis on infrastructure development will increase the demand for power. The coal controversy far from dying down will in some way force the Indian operators to source coal from outside. The U.S. coal operators with different varieties of coal at their disposal are going to be the top contenders to fill up the supply void.

On the flip side, the debt crisis in Europe is still lingering, despite relief packages that have already been announced to revive the economy. The uncertain economic climate continues to impact the industry and curb its growth prospects. The lackluster demand for steel, which is widely used in different industries, could be an indicator of where we are heading. The exporting of coal to Canada is decreasing with each passing day, as the country has started to lower its dependence on coal-fired units.

We believe cost of transportation plays an important role in this sector. An EIA report says that in the U.S. on an average transportation costs hike the price of coal by 40% and these costs have increased by 50% over the last decade. If transportation costs go up substantially in a short span of time, it will definitely have a negative impact on demand, domestically as well as internationally.

Undaunted the coal operators are using new technology to enhance the ability to identify the shape and composition of untapped coal reserves. Emerging know-how is also likely to look for a solution to the adverse effects of coal on the environment mitigating greenhouse effects and other environmental concerns.

For example, the dry sorbent injection pollution control technology can play an important part in coal usage in the power plants. This technology will aid the power plant operators using coal to lower SO2 emissions and enable them to comply with the Environmental Protection Agency's Mercury and Air Toxics Standards ("MATS"). All coal fired units in the U.S. having a generation capacity of more than 25 MW will have to abide by the MATS rule beginning 2015.

These new technologies focused on achieving near-zero emissions open up avenues for potential long-term industry growth. Clean-coal technology development in the U.S. also has funding earmarked under the American Recovery and Reinvestment Act of 2009. This is an encouraging sign for coal producers.

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. 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

AMER ELEC PWR (AEP): Free Stock Analysis Report

ALLIANCE RES (ARLP): Free Stock Analysis Report

PEABODY ENERGY (BTU): Free Stock Analysis Report

CONSOL ENERGY (CNX): Free Stock Analysis Report

EXELON CORP (EXC): Free Stock Analysis Report

FIRSTENERGY CP (FE): Free Stock Analysis Report

ARCELOR MITTAL (MT): Free Stock Analysis Report

NATURAL RSRC LP (NRP): Free Stock Analysis Report

PVR PARTNERS LP (PVR): 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 , AEP , ARLP , BTU , EIA

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