US coal equities are pricing in the thermal coal futures curve and declining coking coal prices. Both will prove conservative. While metals and steel demand is typically weak in 3Q, thermal, coal is entering a seasonally strong period. With natural gas prices near $5/Mcf, we believe sentiment should improve as coal-to-gas displacement concerns ease.
The Association of American Railroads reported coal shipments of 133,149 carloads for the week ending April 24, a 6% increase over the same period in 2009. Coal shipments for the year remain down 4.4% at 2.05 million carloads.
Norfolk Southern, which reported earnings Wednesday, was the most vocal of the Class I carriers in its prediction of a comeback for coal. The railroad believes strengthening economic activity will bring more utilities to market after delivery delays related to winter weather reduced East Coast coal stockpiles in January and February. Some northern utilities are already bringing on more coal and others are expected to follow suit by as early as May.
Transportation analysts, meanwhile, are focused on potential financial benefits from strong demand from international steelmakers for US coal. Coke shipments dropped 12% to 3,042 on the week, but is up 18.4% on the year at 53,708 carloads, the AAR said.
Union Pacific coal shipments rose 5.9% to 35,884 during the week as the railroad's shipments so far this year gained more ground, up 1.3% to 629,784. Coke shipments were up 7.8% to 469 on the week and 44% to 40,592 so far this year.
Estimated US coal production last week came in 4.3% higher than a year earlier, according to the Energy Information Administration. Estimated coal output totaled about 21.4M tons in the week ended April 24, equal to the previous week, with 9.4M tons production east of the Mississippi, 12M tons west of it. Year-to-date U.S. production is down 4% from 2009 at 340M tons, EIA estimates show.
It has been some 12 months since the bullish build up in coal stocks was observed. Since then the coal sector has been one of the best performing sectors in the US.
However, since about mid-October last year, the coal sector has more or less gone sideways. Does this lack of action suggest that the good fortunes of coal stocks are about to change We think not. Given how depressed the coal price has been for the last 18 months, material upside may well be in the offering. A number of contacts in the coal industry in Australia who act as agents between suppliers and buyers in the far east are finding it very difficult to source coal at the moment and have informed a source that they would not be surprised to see coal prices advance another 50% before year end.
The global financial crisis resulted in a near total shut-down in mine expansion and maintenance for almost 12 months (essentially due to the inability to obtain financing). Of course, this shut down has meant that mining capacity is just not there. It is relatively easy to shut down capacity but it takes considerable time to bring it back up. So perhaps a dramatic increase in the price of coal over the coming months is not out of the question.
We think that coal prices are going to surprise on the upside and therefore coal stocks are likely to have dramatic earnings surprises over the coming quarters.
However, there is one catch, US coal producers could feel impact from "headwinds" steel makers starting to face, FBR Capital Market says. US coal producers have seen strong demand, pricing for metallurgical coal used in steel production. But FBR says steel sector showing signs of slowing, including pullback in Chinese property deals, cautious commentary from major producers, slowing in European demand as Greece and other countries take steps to curb costs. "While (metallurgical) coal remains a structurally short commodity, there have been a few data points that make us worried in the short run," FBR says.
Furthermore, the U.S. coal industry faces the prospect of tougher carbon laws, restrictions on mountaintop-removal mining and stricter air-quality rules at a time when anger over the recent explosion at a Massey Energy Co. (MEE) coalmine in West Virgina is sharp and fresh.
Nevertheless, utility coal stockpiles have peaked and we expect thermal coal prices to improve. The supply-demand analysis suggests utilities will continue to draw down stockpiles over the next year due to recovering industrial power demand and rising natural gas prices. Inventories stand at ~190 mmt today – 13 mmt below the peak in November '09 – and we expect will continue to decline heading into the summer cooling season. Stockpile draw downs have historically led to thermal coal price gains. We are more constructive than the market on low-cost US thermal coal and believe miners in low cost regions (PRB, Illinois Basin, NAPP) are well positioned to compete against cheap gas. While we see improving CAPP prices, regulatory compliance requirements and reserve degradation will lift costs. Among US thermal coals, CAPP competes most with natural gas, which could cause some utilities to examine lower cost coal sources.
Natural gas prices are near the key $5/Mcf level. If sustainable, this could lead to an incremental 20-30 mmtpy of coal demand from plants that had switched to gas. This is the first catalyst that could lead to inventory reductions. In 2H10, ~2 GW of new coal-fired power plant capacity is scheduled to come online from August through year-end, requiring a further 5-7 mmt of annualized coal demand.
Arch Coal (ACI)
ACI has the most leverage to thermal coal pricing among coal companies. It fits in well with the thesis that favors playing low-cost producers. In addition, PRB has been subject to less of the regulatory pressures affecting Central Appalachian (CAPP) coal.
Peabody Energy (BTU)
Again, BTU fits well with the thesis suggesting investors play low-cost US thermal coal. It is the only US coal producer with direct exposure to Asia-Pacific markets. It has te=he best in-class growth potential across all operating regions justifies Peabody's valuation premium to US peers.
Alpha Natural Resources (ANR)
ANR is a well-balanced producer with significant metallurgical coal exposure and a diverse thermal coal portfolio. Alpha's low-cost thermal coal operations in the PRB and Northern App provide a solid base on which the Company can leverage its high-cost CAPP coals.
Patriot Coal (PCX)
Patriot is an interesting value play as the majority of unprofitable legacy coal contracts will expire and reprice by 2012. However, conditions that led to the last price rally – high natural gas prices and an export bid for thermal coal – are unlikely in the near to intermediate term. We are less constructive on CAPP fundamentals as this region faces greater pressure from cheap natural gas and cost inflation.
