2009 Will Transform the Coal Industry
The industry will become friendlier for investors after a harrowing year.
Like many other industries, 2009 was a shock to the coal industry. Demand is on track to fall around 100 million tons, or about 10%, from that of the previous year. Given the role of cheap coal in generating baseload electricity, a drop of this scale would have been unfathomable a few years ago. Several factors converged to make this possible--including a poor economy, very low natural gas prices, and lower export demand.
This demand slump will ripple through the coal industry well beyond 2009. For example, as demand precipitously declined, producers failed to match the market with production cuts. Unsurprisingly, inventories ballooned. Today, we estimate that there's at least 50 million tons of excess inventory in the country, the largest overhang we have ever encountered. The problem is especially severe in the eastern United States, whose more expensive coals were disproportionately displaced by natural gas and lower exports.
Although production gradually declined enough to check inventory bloat, the damage had already been done. In 2010, we expect continued anemic production. More importantly, thermal coal pricing has been kept down by the inventory overhang and still-low natural gas pricing. This means that contracts (especially in Appalachia) signed in 2009 will be less profitable than contracts signed in 2008 or even 2007. And because contracts often run for several years, the disaster of 2009 will blemish income statements for much longer.
The Way Out
That said, coal companies have generally coped very well with these significant head winds. Despite difficulties, we suspect that 2009 will be remembered as a transformational year for the entire industry. Perhaps fittingly, coal equities have done very well this year, with most coal firms in our coverage universe doubling or tripling off their spring lows.
Despite a reputation for fragmentation and irrational competition, the industry successfully cut production. This process became noticeable in February or March and accelerated through the summer and fall. Almost all of the large public companies did their part, and many remain very cautious heading into 2010. Moreover, we think many of the large companies, such as Peabody Energy (BTU) and Arch Coal (ACI), actually led the way in this endeavor, reinforcing our thesis that they are becoming more rational and disciplined over time. This production discipline will be instrumental in resolving the aforementioned inventory bloat, and it sets the industry up for a solid price rebound once the economy recovers.
Given recent industry trends, we are optimistic that the inventory issue will be resolved by mid-2010. Fifty million tons sounds like a lot (and it is when compared with a "normal" inventory of around 140 million tons), but it's still only 5% of yearly production. A combination of a stronger economy, higher natural gas prices, and more exports spurred by a global economic recovery can make short work of this obstacle.
This largely cyclical issue aside, we believe two powerful forces will shape the coal industry for the better in the years ahead. Most of the larger players will benefit.
The Decline of a Storied Coal Basin
The first is the continued decline of Central Appalachia. This is not news, as the basin has been stagnating for years. However, we believe its decline will become even more apparent starting in 2010. One catalyst is the ramping up of federal regulations to improve miner safety--for instance, mines have to install fiber optic communications in case of workers become trapped during an accident. The high cost of these regulations fell disproportionately on smaller mining companies, which riddle the region. We think many of these mines will not be able to afford these safety upgrades and will be pushed out of business, removing inefficient production from the market.
Moreover, many mines, especially smaller and more marginal ones, only survived 2009 because of extraordinarily profitable sales contracts signed in 2008, when prices tripled in a few months. Without these contracts, many mines will be unprofitable, even on a cash basis. Therefore, as contracts start to expire, more production will naturally be curtailed.
The third factor is the increasing scrutiny that the government, especially the Environmental Protection Agency, is placing on new mine permits. This has made it much more difficult for Appalachian miners to obtain necessary permits to expand or even continue production. Most of our covered companies have the permits to operate for the next several years, but this trend will probably raise production costs and restrain supply for many years.
As we mentioned, smaller Appalachian miners will feel the brunt of these trends. In contrast, larger miners, even if they are based in Appalachia, operate larger, more efficient, and lower-cost mines and will benefit from their competitors' pain. Lower regional production should gradually lead to high prices and margins for the stronger companies. That said, some larger miners will benefit more than others. For instance, Alpha Natural Resources (ANR) is better positioned than Massey Energy (MEE) because the latter has a much greater percentage of its production exposed to mining permit scrutiny. The smallest miners we cover, International Coal Group (ICO) and James River Coal (JRCC), are probably going to end up as net losers.
However, the biggest winners are companies outside of Central Appalachia. For instance, CONSOL Energy (CNX), with its large, efficient, and high-product-quality longwall mines in Northern Appalachia, might end up a big winner. Of course, companies with exposure to the Powder River Basin such as Peabody Energy, Arch Coal, and Alpha Natural (through its Foundation acquisition) are well positioned to ride the coattails of rising prices in the East.
The Remaking of Powder River
The second powerful industry force is the remaking of the Powder River Basin. The PRB has long been dominated by four very large miners, led by Peabody and Arch. These two companies have been much more transparent and have been much more disciplined in production than their two compatriots: the former Foundation Coal and Rio Tinto Energy America.
The structure of the basin changed dramatically in the last year. Foundation Coal, which long suffered from a weak balance sheet, was acquired by a fiscally strong Alpha Natural. Furthermore, RTEA will be going public as Cloud Peak Energy and will retain a decent balance sheet. Last, Arch Coal acquired a very large RTEA mine, Jacobs Ranch, cementing the company firmly into the number-two position in the basin.
Historically, Foundation and RTEA suffered from a combination of less transparency (both), less management incentive alignment (RTEA), and a much worse balance sheet (Foundation). These factors made it harder for the two companies to restrain production. The good news is that all three issues have been greatly mitigated by recent events. We are hopeful that these companies will be more flexible and responsive in the coming years.
When combined with the favorable demand dynamic for PRB coal, which will help replace the production being lost in Central Appalachia, the improved competitive dynamics, in our opinion, will lead to higher pricing and margins for everyone in the basin.
Michael Tian does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.