Industrial Metals

Can investors still make money investing in the beaten-up US coal sector?

The American coal industry is facing many headwinds these days. Tightening environmental standards, increased scrutiny of safety measures, weak economic growth and competition from cheap natural gas are all causing problems for the sector and have led critics like New York’s mayor, Michael Bloomberg, to call the coal sector a “dead man walking.”

But data shows that the sector is not dead yet.

Yes, domestic US coal consumption has been declining. In July 2011, America was consuming 99.6 million short tons per month, according to data from the US Energy Information Administration (EIA). By April 2012, monthly usage had dropped 43 percent, to 57 million short tons.

Overall, domestic consumption for the full 2012 year fell 11.3 percent, to 889.3 million short tons.

Further, Alpha Natural Resources (NYSE:ANR) fell 90 percent between mid-2011 and mid-2012, and has recovered little since. Peabody Energy (NYSE:BTU) is down over 70 percent from its early-2011 high.

Numbers like those have fueled speculation that the US coal sector is done for, but a closer look reveals some cause for optimism.

Lackluster consumption in 2012 was mainly caused by weak demand during the first half of the year: between January and June 2012, American coal use fell by 17 percent year-on-year.

But the situation turned around significantly in the second half of the year, with year-on-year demand decreasing only 5 percent between July and December.

Things have been even better in 2013. Coal consumption is up 11 percent year-on-year, averaging 76.3 million short tons per month. That’s not far off the monthly average for the past two years, which stands at 78.6 million short tons.

Could circumstances be getting back to normal in the coal patch?

Challenges ahead

The question is: will American coal demand hold up?

That largely hinges on the power sector, which made up 93 percent of total US coal demand in 2012.

But there are a number of X factors, with the tightening of environmental standards being one of the major challenges. The US Environmental Protection Agency (EPA) has been ramping up standards for coal-fired power plants since determining in 2009 that greenhouse gases like carbon dioxide are pollutants.

The regulations are having an effect. A Washington Times article notes that in January, Georgia Power announced the closure of 15 plants, citing the high cost of new EPA rules as part of the reason.

Overall, EPA regulations have contributed to the retirement of more than 250 coal-fired plants, according to the American Coalition for Clean Coal Electricity.

These closures are reducing coal demand. In 2012, coal use for power generation in America fell by nearly 108 million short tons. That’s a drop of 11.5 percent from 2011 levels. The industry will also have to contend with competition from cheap natural gas for power generation.

While it’s not clear what the ongoing impact will be, the brunt of that issue lies at least a few years out, at which time a new crop of gas-fired power plants may be built.

America: export nation

But the American coal sector may be able to bear some contraction in domestic power demand.

For one, tighter EPA regulations are crimping coal supply. Alpha Natural Resources announced this year that it will close coal mines in Virginia, West Virginia and Pennsylvania, eliminating some 1,200 jobs.

Overall, US production in the 52 weeks ended March 2, 2013 fell 8.7 percent year-on-year. That amounts to nearly 95,000 short tons of coal production taken out of the market over the past year.

This flagging supply takes a lot of the slack out of the US market, which is to the benefit of coal producers with quality assets that remain in production.

The US market is also getting a lift from a more unexpected source: exports. Even as American coal demand fell in 2012, foreign buyers increased their purchases.

EIA figures show that US coal exports to Europe jumped 29.4 percent year-on-year during the first nine months of 2012, an increase of 11.5 million short tons. Exports to Asia also rose significantly, increasing 23.7 percent, or nearly 5 million short tons.

Overall, EIA information shows that US coal exports for the first nine months of 2012 totaled 97.7 million short tons, up 22.8 percent from 2011 and a rise of over 18 million tons.

Increased exports are helping to fill some of the gap left by falling US electrical demand, and with countries like India and China both eyeing increased coal imports, this trend is likely to continue.

The bottom line for investors

The US coal sector is far from dead, but it’s a space where investors need to tread carefully.

Demand is not what it was a few years ago. To make matters more difficult, domestic coal projects are facing a more stringent regulatory environment and higher associated costs.

But well-positioned projects will continue to sell into the still-sizeable domestic power market.

Ironically, dirtier coal may do better going forward. The EIA recently reported that high-sulfur coals like those from the Illinois Basin are seeing resurgent demand because of the current regulatory environment.

That’s because this coal is sold cheaply because of its impurities. In the past, power plants paid more for cleaner coal, which they could burn in conventional power plants and still meet emissions standards, from places like Central Appalachia.

But with stricter regulations, many plants are being forced to install scrubbers to remove impurities like sulfur from their waste gas — regardless of what coal they burn.

With such technology in place, both clean and dirty coal can be burned without breaking emissions rules. As such, there’s no longer any reason to pay more for clean carbon. So cheap Illinois coal is the most economic option.

That’s good news for companies that hold Illinois Basin coal licenses. The major ones are Peabody Energy and Alliance Resource Partners (NASDAQ:ARLP), along with private firms like Murray Energy and developing producer Foresight Energy.

The sector won’t be friendly to all, but for the right producers it will be plenty lively.

 

Securities Disclosure: I, Dave Forest, do not hold equity interest in any companies mentioned in this article.

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