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Improvement in domestic thermal coal demand

Electricity generated by coal is expected to increase to 40.2% this year compared to 39.1% in 2013, due to colder winters and rising natural gas prices. According to Tennessee Valley Authority (TVA), one of the three largest customers of Arch Coal (NYSE:ACI), with every 1 degree temperature drop below 20°F its electricity production rises by 400 MW. Many thermal plants switched to natural gas from coal in the past few years, due to the rising electricity demand. This increased consumption reduced natural gas inventory by about 42.8% since November 2013 to 2,193 Bcf. Since similar winter conditions are expected to prevail until March, natural gas inventory will reduce further. Low inventory increased natural gas prices to about $5.44 per thousand cubic feet as of the last week of January, which was below $4 per thousand cubic feet over the last four years.

This rise in natural gas prices has made coal comparatively cheaper for power generation. The following is the natural gas price range, at which prices of these basins' coal will be competitive:

Coal regions

Natural gas price range per 1,000,000 British thermal units (MMBtu)

Powder Red Basin (NYSEARCA:PRB)

$2.5 to $2.75

Illinois Basin

$3.25 to $3.50

Appalachian Basin

$4.5 to $5

Currently the natural gas price is trading around $5 per MMBtu, so switching to coals from all three basins instead of natural gas is attractive for thermal plants. Arch Coal can benefit from this scenario, as the company has reserves in all three basins. More than half of its reserve is in PRB, which is preferred by thermal power plants due to its low price, in comparison to the other basins. This year, PRB coal demand is expected to increase by 10%, or about 40 million tons. Furthermore, Arch Coal expects thermal coal sales of 124 - 134 million tons this year, and about 108 million tons is already falls under supply contracts.

Better equipped to face weak met coal market

Although the thermal coal market is improving, the metallurgical (NYSE:MET) coal market is expected to remain weak this year as well. In the past few years, global miners like BHP Mitsubishi Alliance (BMA), Teck Resources (NYSE:TCK), and Glencore Xstrata (OTCPK:GLCNF) increased their met coal production to improve their cash cost per ton. Due to the increase in production by these miners, the met coal supply increased by about 8.5 million metric tons, or 3% more than the global demand. Despite an oversupply, global met coal production is expected to increase this year as well. With increasing supply, the average price of met coal is expected to remain around $154 per metric ton this year, which is similar to last year's $153.41 per metric ton. However, it is significantly lower in comparison to 2012's average price of $210 per metric ton.

Due to global oversupply, Arch Coal reduced its met coal production last year; however, the company's production is expected to increase this year with incremental production at its Leer mine in Northern- West Virginia. In 2014, Arch Coal expects to sell about 7.5 million tons to 8.5 million tons of met coal in comparison to 2013's estimated sales of 6.8 million tons. About 4.2 million tons of the company's met coal production is already tied under supply contracts.

The met coal produced at the Leer mine is high quality, high volatile "A" coking coal, which is in demand in the steel industry because it emits less greenhouse gas and produces more heat. With lower met coal prices, the company's good quality met coal can displace low efficiency met coal. Along with better quality, the mine's location will help the company increase its supply to international markets since the Leer mine is close to East Coast ports. Better quality and locational advantage will help the company gain traction with customers.

Better cost structure than peers

In the Appalachian region, where Arch Coal has met coal reserves, it has lower cash cost per ton than other met coal producers in the region like Alpha Natural Resources (NYSE:ANR) and James River Coal (JRCC).

Company

Cash cost per ton

Arch Coal

$67

Alpha Natural

$73

James River Coal

$77

Arch Coal already has a better cost structure and plans to improve it further this year. It will reduce its selling, general, and administration expenses to about $124 million from $133.44 million last year. In addition, the company is expected to continue its cost reducing and process improvement initiatives, which are as follows:

1. Controlling consumable costs

2. Reducing contractor and overtime labor cost

3. Decreasing carrying cost of inventory

4. Right-sizing operations

Arch Coal reduced its cash cost to $67 per ton in 2013, from $69.46 per ton in 2012, and this year, the company expects to keep it in the range of $63 per ton to $67 per ton. With good quality met coal, the company's chances to sell its production will increase. In addition, improvement in cash cost will help the company offset weak met coal prices and improve its margin this year.

Conclusion

Due to weak coal prices, Arch Coal has reported losses over the last eight quarters. Met coal prices is expected to remain low this year as well and global supply is expected to remain more than demand. Unlike the met coal market, the thermal coal market is showing improvement this year due to increasing electricity demand and rising natural gas prices. I recommend investors to hold their position in this stock.

Source: Arch Coal: Thermal Market Improving But Met Coal Remains Weak