Quite a year it's been for the coal industry. Natural gas prices under $2/mmbtu, Patriot Coal's bankruptcy, new EPA regulations, and record low coal commodity prices have caused many to call for the end of the industry. This conclusion, under either presidential candidate, is wildly misguided.
Since recommending that investors begin looking into Peabody Coal (NYSE:BTU) in the wake of Patriot Coal's bankruptcy, the stock is up about 26%, while Arch Coal (NYSE:ACI), Alpha Natural Resources (NYSE:ANR), and a few other coal names have risen substantially as well. Improved investor sentiment within the coal space has largely been a result of the near doubling in natural gas prices in conjunction with record low coal prices, leading some market participants to believe that utilities companies will consume more coal this winter.
Natural gas traders have clearly not bought this thesis, as January futures contracts are trading near $4 in spite of record daily production and total supply.
As I outlined in a recent article, while I'm bullish on coal's upside this winter, and subsequently bearish on natural gas, most investors are probably far more concerned with the long-term outlook for coal than the outlook for this winter alone.
Let's take a look at a framework for thinking about the coal industry in general over the next decade:
- The Utility MACT, estimated to reduce mercury emissions by 90%, costs companies $1,500 for every one dollar reduction in mercury pollution.
- The Government Accountability Office found that two of the four major EPA regulations, CSAPR and MATS, will reduce the nation's coal-fired capacity by 12%. The EIA projects that 8.5% capacity will be gone by 2016 as a result of the regulations.
- Annual costs for compliance are expected to come in between $16 and $21 billion.
Competition From Natural Gas
- In ultraproductive shale regions, most producers are profitable when the price of natural gas is above $1.90. Given this fact, in addition to record daily production in spite of a rig count that has declined by nearly 50%, it's clear that the economics of gas production have been dramatically altered.
- As a result of these new economics, producers are likely to maintain record production at prices consistent with current values.
- Nat gas prices appear to have strong support from utility demand around $3
- Coal generates 12,500 Btu, or .0125 mmbtu per pound. One ton of coal produces 25 mmbtu, and at current prices around $60, one mmbtu costs $2.40. Given natural gas futures prices, coal is currently 114% cheaper on a energy-equivalent basis.
- Peabody Coal just announced that coal's share in the US electricity generation market rose to 39% over the past three months compared to 30% in the 2nd quarter, a result of the recent rise in natural gas prices.
Does Mitt Romney Have The Ability And Political Will To Reverse The Regulatory Landscape?
The first step would to appoint new EPA heads. Next, significant research would have to be conducted in order to refute the four major regulations that were imposed under the Obama administration.
NPR reports that Jeff Holmstead, the head of the EPA's air pollution policies under Bush, believes the repeal of the major regulations would occur over time. Granted, it would likely be a decently long process, but coal stocks should react very aggressively to a Romney election. Additionally, Romney could "starve" the EPA of the necessary funding to enforce the regulations.
Romney's recent remarks on coal appear to indicate that improving the regulatory environment for the coal industry will be of significant importance in his administration. The Republican base in general has run on the platform of cheap fossil fuel energy, and the coal industry has been a major talking point in debates.
Though the left typically argues that the EPA's regulations have a minimal effect on the coal industry, their argument is quite frankly nonsense. The aforementioned facts, courtesy of the EIA, are that current regulations are going to significantly reduce coal production. Increased costs of production in the order of $16 to $21 billion will push the marginal suppliers out of the market, and drastically reduce the profitability of the majors. Furthermore, when we take a look at the actual energy equivalent costs of coal and natural gas, coal is 114% cheaper. Total costs are the only thing utilities care about; if coal is cheaper than natural gas on an energy generation basis, then coal will be used. Simple stuff.
Now, even in the best case scenario, where a president Romney is able to repeal the vast majority of regulations (a tall order considering potential lawsuits from environmental groups, federal courts etc.), coal prices will have to remain depressed around $60/ton, and natural gas prices must remain significantly above ~$2.50. State pollution laws will remain in effect, and many utilities companies have already built the infrastructure for gas burning; without these specific commodity values, coal will have a difficult time remaining competitive. Fortunately, though I expect natural gas prices to decline in the intermediate term, the commodity seems to have a strong floor around $3/mmbtu.
Though the long-term outlooks for coal companies remain challenging, current industry valuations seem to reflect very muted expectations. A Romney election should have a significant effect on both investor expectations and actual fundamentals, given time.
My advice for longer-term investors is to make sure your coal companies do plenty of business in the international markets. The U.S. electricity generation market is unlikely to revert completely back to the days of ultra-friendly coal policies, and an investment made solely on the prospects for U.S. coal demand needs to be cushioned by strong demand elsewhere. Peabody Coal, for example, has an enormous Australian business and is ramping up investments in China, where policies favor coal and natural gas isn't competitive.
While coal stocks as a whole should do well in the event of a Romney election, the real outperformers during a Romney administration will be U.S. coal producers with strong international exposure and healthy balance sheets.