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U.S. coal companies have been going through tough times, mainly due to oversupplied coal markets, weak economic conditions and lower prices for natural gas. However, I think the worst is already priced in for U.S. coal stocks and the only direction to go from here is up. In recent times, I believe excess supply in coal markets remains the most important factor that has led to lower coal prices and weak market conditions. For a recovery in coal prices, coal producers need to address the problem of an oversupplied coal market.

Lower Production Costs and Depreciation of Australian Dollar Has Kept Markets Oversupplied
To balance demand and supply in the coal markets, coal production cuts are essential. Two of the leading U.S. coal companies, Arch Coal (NYSE:ACI) and Alpha Natural Resources (NYSE:ANR), have already made plans to lower their production in response to depressed coal prices. ACI has idled several of its met coal mines, lowering its total met coal production by almost 2 million tons on an annualized basis. Earlier this quarter, ANR also announced plans to reduce its annual met coal production by 1 million tons. In the last two months, since the 3Q 2013 benchmark price settlement, approximately 6.5 million tons of coal production has been taken off the market. Analysts believe that to balance demand and supply in coal markets, additional and aggressive production cuts, between 15 to 25 million tons, are required.

Production cuts have been slow and less than expected in response to weak coal prices. Lower production costs and depreciation of the Australian dollar are limiting production cuts and quick price recovery. In 1H 2013, an improvement in the cost structure of the coal industry, of almost 8%-9%, as compared to the corresponding period last year, has kept coal markets oversupplied.

Also, the Australian dollar has depreciated 16.5% YTD, which has created a new headwind for U.S. met coal producers. As coal trade around the world is transacted in the U.S. dollar, Australian producers are getting paid in the stronger U.S. dollar which has offset the impact of a decrease in met coal benchmark prices of almost 16% for 3Q 2013 as compared to 2Q 2013. As currency movements offset the impact of lower coal prices, and Australian producers hardly lost any revenues, this has kept coal supply flowing, keeping coal markets oversupplied.

Excess coal supply in markets is not only due to international coal producers but also because of U.S. coal producers. In the recent second quarter, coal production at two major met coal mines in Alabama, mine No. 4 and No. 7, of Walter Energy (NYSE:WLT) increased. In the recent second quarter, production at mine No.4 was up 80% YoY, while WLT mine No. 7 produced 1.4 million tons which was its highest output since 1983.

The following chart, published by the Energy Information Administration (EIA), displays that in recent months production cuts in the U.S. have been slow in response to weak coal prices.

(click to enlarge)
Source: eia.gov

Conclusion
As we move into the second half of 2013, I believe that aggressive production cuts are required to eliminate the excess supply in coal markets and for a recovery in coal prices. ACI and ANR have lowered their production in reply to the low 3Q 2013 benchmark price, but lower production costs and a weak Australian dollar have kept markets oversupplied. In the future, production cuts will determine the magnitude and timing for a recovery in the coal markets. As more production cuts would flow through the markets I believe coal prices will continue to move higher.

Source: King Coal: Industry Rebound Hinges On Production Cuts