King Coal: Thermal Coal Displays Signs Of Improvement

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 |  Includes: ACIIQ, ANRZQ, ARLP, BTUUQ, CLD, CNX, KOL
by: Equity Watch

King Coal has remained an important part of energy portfolios in the past, and I believe it will stay so for many more years to come. The U.S. coal industry has been recovering slowing from a downturn as in the last two years lower natural gas prices and economic crises in key economies around the world have taken their toll on the industry. Lately, thermal coal has shown signs of improvement, as coal continues to regain a share in power generation, while coal inventories are trending downward and natural gas prices increase.

Recently, the U.S. thermal coal market showed signs of improvement as demand continued to outpace supply and coal inventories began to trend downwards. According to recent data published by the Energy Information Administration (EIA), coal inventories at electricity producers dropped by more than 26 million tons year-on-year to 155 million tons in September and fell 14% year-on-year to 159 million tons in October. According to EIA estimates, by the end of October, closing inventories at electricity producers accounted for approximately 63 days of coal burn, down from its last three-year October average of 65 days. The EIA anticipates monthly coal inventories to fall to 154 million tons by January 2014, down 13.9% year-on-year. The decreasing coal inventory levels will result in improved supply and demand fundamentals of domestic thermal coal and a price recovery, which will portend well for thermal coal producers like Peabody Energy (BTU), Arch Coal (ACI), CONSOL Energy (NYSE:CNX), Cloud Peak (NYSE:CLD) and Alliance Resources Partners (NASDAQ:ARLP).

It is being forecasted that at the end of the current year, 2013, coal inventories at electric power producers will be the lowest since 2008. U.S. thermal coal production has been trending downwards in the recent past in response to soft coal market conditions. It is being projected by the EIA that primary coal supply will total approximately 905 million tons as compared to 1,000 million tons in 2011.

Coal-fired electricity generation increased 6.5% year-on-year and natural gas-fired electricity generation dropped by more than 6% year-on-year in September 2013 due to a gas-to-coal switch. As natural gas prices continue to rise, it will lead to higher coal-fired electricity generation. Currently natural gas prices are $4.19 mmBtu, and are expected to remain above $4 mmBtu in 2014. Natural gas prices have been rising since April 2012, when prices fell below $2 mmBtu, resulting in higher natural gas-fired electricity generation.

Moreover, I believe thermal coal production will remain low in the near future in comparison to the 2011 and 2012 levels. Despite the fact that idle capacity can be brought back easily, coal companies will not do that because of a lower coal hedge position for 2014 as compared to recent years. According to the 3Q2013 earnings releases, BTU, ACI, CLD, ARPL and Alpha Natural Resources (ANR) are approximately 85% hedged/contracted for 2014 as compared to the last three years average of approximately 90%. As the companies have lower hedge/contract rates for next year, 2014, as compared to the historical average, there is little incentive for production to increase.

U.S. monthly coal exports have shown signs of improvement in recent months. U.S. East Coast exports, from Hampton Roads, have increased 16% month-on-month and 28% year-on-year to approximately 4.2 million tons in November, which is the highest since May earlier this year. The improvement can be attributed to an economic recovery in Europe and lower railroad rates. Strengthening of U.S. coal exports remains an important stock price driver for U.S. coal companies and will portend well for the industry.

Conclusion
I believe that U.S. coal stocks have bottomed out and the worst is priced in. Thermal coal markets are displaying early signs of improvement and better coal supply management, rising natural gas prices, strengthening U.S. coal exports and an increase in coal-fired electricity generation will benefit the thermal coal companies mentioned above. Also, due to the recent downturn in the industry, the coal stocks are trading at attractive valuations, which provide idle entry points for investors to initiate long positions. The table below shows that the coal stocks are trading at attractive and depressed valuations, in comparison to their own last five years average.

BTU

ACI

CLD

ARLP

ANR

Last 5-Year Average

Price to sales

0.7x

0.28x

0.8x

1.2

0.3x

1.75x

Price to book value

1.1x

0.4x

1.3x

2.6

0.4x

2.75x

Click to enlarge

Source: Yahoo Finance and Ycharts

Following are the links to my recent articles on three of the coal companies mentioned above:
- BTU
- ACI and,
- ANR

Risks
Tougher regulations and a hostile attitude on the part of the political administration toward coal mining and consumption remain risks for the coal industry. Changes in legislation related to coal mining and its usage could result in higher costs and lower demand, which could adversely affect the financial performance of the said coal companies. Also, the companies have high debt-to-equity, which could become an incremental risk, if operating costs remain high and coal prices deteriorate further. The following table shows the high debt-to-equity ratio of the coal companies.

BTU

ACI

CNX

CLD

ARLP

ANR

Average

Debt to Equity

130%

195%

85%

80%

100

80%

115%

Click to enlarge

Source: Yahoo Finance

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.