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Last year, due to incremental production by global miners, the met coal supply surplus was about 8.5 million metric tons, which is about 3% of the global demand. Despite this, BHP Mitsubishi Alliance (NYSE:BMA) and Arch Coal (NYSE:ACI) haven't cut down the production of met coal this year. BMA's met coal production increased by 22 million tons last year, and it is expected to increase by an additional 6 million tons this year. One of its projects at the Daunia mine in Queensland, Australia is expected to produce about 4.5 million tons this year. Arch Coal has also projected to increase its annual production capacity to about 3 million tons of met coal by the first quarter of this year at its Leer mines in Northern- West Virginia.

With expected incremental supply this year, met coal prices are expected to remain low this year. Analysts are expecting this year's average price of met coal to remain around $154 per metric ton, which is similar to 2013's average price of $153.41 per metric ton. Even though the average price will remain the same this year in comparison to last year, this is significantly lower than 2012's average price of $210 per metric ton.

Lower met coal prices will negatively Alpha Natural Resources' (NYSE:ANR) revenue, as it accounts for about 40% of the company's coal revenue. Along with revenue, lower met coal prices will also impact the company's margin due to its higher cost structure. The company's cost of sales for met coal is about $71 per ton to $73 per ton, while its competitor Arch Coal's cost is about $67 per ton. In addition to the higher cash cost, Alpha Natural has more exposure to the market price. Only 54% of the company's 2014 met coal production volume falls under a supply contract.

Due to global oversupply and the lower pricing environment, Alpha Natural is cutting its met coal production this year to about 18 million metric tons from 21 million metric tons in 2013. In addition, to offset low met coal prices, it is taking cost cutting initiatives. The company plans to eliminate about 230 jobs and is trying to cut its selling, general, and administration expenses. With these initiatives, the company expects to cut its operational expenses by $200 million in the coming years. With fewer expenses, its cost of sales will reduce to $64 per ton - $70 per ton this year.

For this year, the company has also reduced its capital expenditure budget to about $250 million - $350 million from $260 million - $290 million in 2013 and $490 million in 2012. Lower spending will help the company offset weak met coal prices and improve its margin this year.

Weak demand for Appalachian coal

The U.S. electricity generated by coal is expected to increase to 40.2% compared to 39.1% in 2013. The reason for this is the expected rise in natural gas prices due to colder winters, which reduced natural gas inventory by about 42.8% since November 2013 compared to a 28.7% drop during the same period last year. Winter conditions are expected to stay until March this year, further reducing the inventory. Due to the rise in consumption, natural gas prices rose to about $5.44 per thousand cubic feet in last week of January, which was below $4 per thousand cubic feet over the last four years. This rise in natural gas price has increased coal demand for power generation.

However, Alpha Natural is at a disadvantage because about two-thirds of its thermal reserves are in the North Appalachian basin and the Central Appalachian basin, which are less preferred by coal fired power plants due to the higher price in comparison to other coal basins like the Powder Red Basin (NYSEARCA:PRB). Although the company will benefit from its remaining thermal coal reserves in PRB, it may not offset the decline in overall demand.

The table below shows gross margin generated by thermal power plants based on usage of PRB Coal and Central Appalachian coal.

Assumption

PRB

Central Appalachian

Power price ($/Mwh)

$135.95

$96.25

Coal Price ($/ton)

$11.15

$63.10

Transportation Cost ($/ton)

$25

$12

Total Cost ($/ton)

$36.15

$75.10

Total fuel cost (per mmbtu)

$2.05

$3.13

Heat rate of plant (mmbtu/MWh)

10

10

Total coal cost ($/MWh)

$20.54

$31.30

Gross Margin ($/MWh)

$115.41

$64.95

The above calculation signifies that despite the higher transportation cost for delivery of PRB coal, it is still profitable for power plants. Due to higher profitability, PRB coal consumption is expected to increase by 10%, or 40 million, this year, but Central Appalachian consumption is expected to decline by 5%, or 20 million. With less demand for Central Appalachian coal, Alpha Natural reduced its 2014 thermal coal production volume guidance from the Appalachian region to 24 million tons - 28 million tons compared to 28 million tons - 30 million tons in 2013.

Long-term challenge

Alpha Natural's thermal coal production from the Appalachian region is expected to be affected in the coming years due to the retirement of about 300 thermal power plants of the region, which generate about 43 GW of power. These plants are expected to retire due to the EPA's anticipated new mercury and air toxic standards and air pollution rule. President Obama's Climate Action Plan instructed the EPA to draft regulations for modified, reconstructed, and existing power plants by June 1, 2014. Thermal coal from the Appalachian region contributed about 46% of Alpha Natural's coal revenue in 2012, but the plants closing may affect the company's supply from the Appalachian region basins in the long run, which will negatively impact the company's revenue.

Conclusion

As met coal continues to be oversupplied, global prices are expected to remain low this year too. With less demand, Alpha Natural is planning to reduce its met coal production volume for this year. In addition, the company is also taking initiatives to cut its cost of sales to improve its margin.

Along with met coal, the company's thermal coal business from the Appalachian region will also face challenges. Overall, I recommend investors do not take a new investing position in the stock.

Source: Alpha Natural: Can Cost Cutting Help Offset Market Challenges?