A Challenging Future Awaits Arch Coal

| About: Arch Coal (ARCH)

Being one of the world's largest coal miners of thermal and metallurgical coal, Arch Coal (ACI) serves customers in more than 25 countries. Arch controls more than 5 billion tons of high quality thermal and metallurgical coal reserves. The company's stock price and financial performance have deteriorated in the last couple of years, primarily given the soft coal market conditions. Total quarterly revenues for the company have dropped to $0.765 billion in the second quarter of 2013 from nearly $1.0 billion in the second quarter of 2011. Due to the aforementioned soft market conditions, which had an adverse impact on Arch's financial performance, the stock has plunged 76% in the last 24 months.

Reference : google.com/finance

Not the best conditions
Demand for coal has weakened globally in recent years because of cheap natural gas prices, tougher regulations and the prevalent economic crises in key world markets, including Europe, China and India. Coal markets are expected to stay weak in the near term, as coal demand and prices remain soft. The coal industry has been facing intense pressures from the Obama administration, which has been pushing hard on power utilities to use environment friendly fuels for power generation.

The Environmental Protection Agency is scheduled to release environmental rules this week, which would require coal plants to bed in expensive carbon-capture technology to control environmental pollution. These pollution control measures are likely to discourage coal usage for electricity generation, which poses a serious threat to the coal industry over the long term. According to Bloomberg, a lobbyist for utilities, Scott Sega, stated, "Low-cost natural gas is leading utilities to build new plants using that fuel and shutter coal-fired plants. The effect of the new standard would lock out coal over the long term. Once you set something in stone, you discourage investment in that sector, and you take a flexible market and ossify it."

As major economies across the globe go through tough economic times, U.S. coal exports are expected to weaken, which would translate into additional pressures on the already feeble coal market. In 2013, U.S. coal exports are projected to drop by 5%.

Recently, Arch presented at the CEO Energy-Power Conference; the focus of its presentation remained centered on mining cuts and controlling production costs. Arch, along with the other coal miners, including Peabody Energy (BTU), Alpha Natural Resources (ANR), Walter Energy (NYSE:WLT) and James River (JRCC), is scaling back its production costs to navigate through the prevalent though times for the coal industry. Since the fourth quarter of 2012, in Appalachia, Arch has reduced its cash costs by $4.53 per ton to $65.70 per ton in the second quarter of 2013. Arch also lowered its Powder River Basin costs by nearly 10% per ton to bring its operational costs to support its depressed earnings. In order to control operational costs, its efforts are directed towards reducing diesel costs, shorting miners shift times and eliminating contractors. Also, Arch has been curtailing its capital expenditures, as markets conditions stay feeble. Arch projects its capital expenditure to total $280 million to $310 million for 2013. The company signaled that it could announce additional cuts to its capital expenditures for 2014 if markets conditions remained soft.

Addressing the conference, Arch CEO John Eaves said, "An area that we spent a lot of time on over the last year to year-and-a-half is our cost. It's something that's always very important to us. But, given the challenges that we have seen in the current market place, we put a laser focus on our cost reductions and you can see the success that we have had particularly in the PRB and Appalachia.''

Given the tough times for the coal industry, coal miners have lowered their coal supplies to keep the market in balance; coal inventories are down nearly 16% since May 2012. Despite the fact that coal miners have been curtailing their coal supplies, a slow price recovery is expected, as long-term coal demand stays uncertain, and the markets remain oversupplied. Given that cost reduction efforts have lowered the cost curve of major coal miners in the U.S., and idle capacity remains present, a slight recovery in coal prices will result in a wave of increased coal supply, which will keep markets oversupplied. Barclays analyst David Gagliano expects that the prices of U.S. thermal coal will remain weak through 2015.

Wrap Up
Coal markets are expected to remain weak in the near term due to tougher environmental regulations, cheap natural gas prices and idle capacity. These factors are expected to keep Arch's stock price depressed in the near term. If markets conditions do not improve in the near term, Arch might have to face liquidity problems and may be forced to sell some additional assets to generate liquidity; adversely impacting its future earnings potential. Last month, Arch sold its subsidiary, Canyon Fuel Company, to Bowie Resources for $423 million to boost its liquidity. Currently, Arch's total liquidity stands at $1.6 billion, out of which $1.3 billion consists of cash.

I think investors should stay away from Arch. The stock is expected to trade at depressed valuations in the near term due to the prevailing soft coal market conditions. Also, investors should wait for recoveries in both coal prices and demand before initiating a long position in the stock.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.