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Stock Strategist

Will King Coal's Reign Be Short-Lived?

Investors should look to low-cost assets in today's uncertain environment.

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This summer, to coal industry observers, was 1908 all over again. King Coal was back in charge. Beginning in February, the coal industry was rocked by a series of improbable events. South Africa's power grid suffered multiple failures, forcing it to shut down mines and restrict coal exports; a freak snowstorm buffeted China, disrupting power and coal supplies; heavy rains flooded mining pits in Australia and Indonesia, the biggest coal exporters in Asia; a Japanese nuclear power plant shut down unexpectedly for safety reasons. Coal prices shot up in response. Add to this maelstrom rapid Asian economic growth (especially Chinese) and $140 oil prices, and it seemed as if nothing would check coal's rise.

But the world changed quickly. In just a few months, King Coal is on the verge of being deposed by falling energy prices and fears of global recession. The shares of U.S. coal companies are back to their January levels, even though spot and futures coal prices are still much higher than where they were.

Our Outlook for the Coal Industry
There is no question that we are facing tremendous uncertainty pertaining to the global economy, and there is much to be gloomy about in the short run. The global coal trade is small compared with world consumption, with very tightly balanced and inelastic supply and demand. Earlier this year, a small shift in this balance sent coal prices up over 200%, and an equally small but opposite shift could push prices significantly south. Potential slowing demand growth from China, coupled with less strained supply, can become powerful downward catalysts. We are seeing some reports of improving inventory levels in Chinese ports, and domestic Chinese production is growing robustly. It's hard to tell if this trend is temporary, due to the Olympics and seasonal factors, or a long-lasting change in supply and demand. Thus far, world spot coal prices have fallen more than 30% from their July peak. We would not be surprised if they fell even further.

Longer term, we are more optimistic. However, the most important caveat to this thesis is that strong demand growth from emerging economies, especially China and India, must continue. Given that fact, we think world coal supplies will remain strained for many years, as important exporting countries--such as Indonesia, Russia, Vietnam, South Africa, and Australia--are running against hard infrastructure barriers or are conserving coal for domestic consumption. Even the United States, which may be the only country with material spare production capacity, isn't increasing production as rapidly as we had expected. Year to date, U.S. coal supply rose only 1.2% year over year, much of which fueled domestic power plants rather than export markets. China and India have some of the largest coal reserves on Earth, but getting to them in a timely fashion would require huge investments in infrastructure and controversial regulatory changes. Against this backdrop, we think it's very likely that coal prices will be higher compared with historical averages.

Possible Scenarios
We recognize that it's difficult to accurately forecast pricing trends many years out. However, we find it useful to create several plausible scenarios and determine how different companies will fare in various environments. We think this exercise helps in developing an understanding of the industry, as well as teasing out attractive risk/reward propositions as investment opportunities.

For simplicity's sake, we will address two scenarios--a high-price one, associated with robust world economic growth; and a low-price one, with relative economic stagnation.

Winners and Losers
Although a rising tide will lift all boats in a high-price scenario, certain companies will benefit more than most. These will tend to be companies with high-cost assets concentrated in Central Appalachia, which produces very high-quality coal suitable for export markets. Some of these mine coal with favorable metallurgical characteristics and will have flexibility to sell into either the thermal or metallurgical market, which uses coal for steelmaking. These companies include  James River Coal Company (JRCC),  International Coal Group (ICO), and  Alpha Natural Resources (ANR). Since these companies operate more marginal mines, in a more marginal coal basin, their economics will be much more levered to current coal prices. Furthermore, Central Appalachian coal contracts are becoming shorter and shorter in duration, with many companies only contracting 12 to 16 months ahead, as opposed to multiple years a decade ago. This dynamic is a huge boon as prices rise, but it can be fatal when they fall.

Thus, it should come as no surprise that in a low-price scenario, some of these companies will be permanently impaired. Because a significant portion of mining costs are dictated by geology, location, and mine planning, they will have limited scope to lower costs, and any pricing weakness will pass directly into their bottom lines. In this case, we prefer companies with assets concentrated in the Powder River Basin, which is the largest coal-producing region in the country. Although hampered by high freight rates, Powder River Basin mines are extremely low-cost and rely on long-term contracts, which reduce earnings volatility from year to year. Our favorites here include  Peabody Energy (BTU),  Arch Coal (ACI), and, to a lesser extent,  Foundation Coal (FCL). These companies' contract positions give us a decent idea of earnings and cash flows for 2009 and beyond. For example, we think Peabody Energy will earn from $2.5 billion to $3 billion in earnings before interest, taxes, depreciation, and amortization (EBITDA) next year, versus a current enterprise value of $14 billion--which we think is an attractive valuation.

It seems to us that in the current uncertain environment, this latter group of companies presents the most attractive risk/reward profile. If prices were to stabilize or rise further, they won't accrue the same immediate earnings boost as their more volatile counterparts, but increased pricing will eventually make its impact as contracts are renegotiated over the years. On the other hand, marginal companies like James River Coal may thrive--eventually--but earnings are also at risk of fading to nothing if coal prices actually dip.

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Michael Tian does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.