The War On Coal: Sell Arch Coal

| About: Arch Coal (ARCH)
This article is now exclusive for PRO subscribers.

Coal industry fundamentals remain notable for extreme volatility. Earlier this summer, Patriot Coal went bust as the effective canary in the coalmine. The coal industry now battles against the politicized "War on Coal" that is now a catch phrase encompassing declining coal prices, booming natural gas production, and alternative energy solutions. Amidst this ongoing malaise, energy analysts take care to break down specific coal portfolios in terms of geography and chemical composition. In this environment, the search for the alpha, or "best of breed" coal stock will likely prove futile. This strong sell call on Arch Coal (ACI) serves as an indictment against an industry that remains at risk of becoming outdated amid global recession.

The Coal Market

The United States and China are the two major bookends of the world's coal market. In terms of reserves and production, the U.S. and China headline a top-ten list that includes Russia, Australia, India, South Africa, and Indonesia. On the consumption side of the ledger, coal is obviously an important energy resource for China and the United States, the world's two largest economies. According to the Energy Information Administration, roughly 90% of U.S. coal production remains state side for power generation. Rapidly industrializing China, of course, is a primary destination for coal exports.

Lignite and sub-bituminous are low-grade classifications of coal primarily used as fuel for electric power generation. Bituminous coal is a mid-grade resource utilized for both electric power generation and coke, which is the primary fuel driving blast furnace steel production. As a premium fuel, anthracite coal is best reserved for domestic heating, due to its relatively high carbon content for clean burning and costly expense. In this political environment, access to bituminous and anthracite coal reserves alongside heavily trafficked trade routes to China are critical to the success of any mining operation.

Within the United States, coal mother lodes stretch through Appalachia and the Interior Rocky Mountain region. Wyoming, as the nation's leading coal producer, is home to the bituminous coal rich reserves within the Powder River Basin. Across the Mississippi, anthracite coal is a leading resource of Central Pennsylvania. Despite this abundance, U.S. Energy policy remains unfavorable to the maximum cultivation of domestic coal resources. Wyoming coal is effectively shut in and away from the international marketplace due to the lack of political willpower to build export terminals on the West Coast. Alternatively, Eastern Seaboard and Gulf Coast businesses often find it cheaper to import overseas coal, rather than transport this fossil fuel via rail.

Coal, of course, is always a convenient scapegoat for environmentalist groups. Coal emissions include sulfur dioxide, nitrogen oxide, mercury, and carbon dioxide. Until fairly recently, natural gas served as the more energy efficient, but expensive alternative to coal. Improved hydraulic fracturing, or fracking, technology to develop the Marcellus and Barnett Shale formations may effectively contribute to persistent natural gas gluts within the United States.

Over the past year, coal and natural gas spot prices have converged near $2.50 MMBtu. At this price point, utilities will convert to natural gas, at the expense of coal usage. As an energy resource, coal now accounts for a dwindling 40% share of U.S. power generation. Coal is losing the war.

Arch Coal Portfolio

Arch Coal classifies domestic mining operations according to geography, pricing, and energy quality. Arch mines are concentrated within Appalachia, Illinois, and the Interior Rocky Mountain region. Arch Coal management promotes a resource portfolio both rich in access to Appalachian metallurgical, or coking, coal for steelmaking, alongside the low-sulfur content coal of Wyoming's Powder River Basin for cleaner power generation. Going forward, access to Wyoming's Powder River Basin coal will prove critical to meet the inevitably tougher environmental standards proposed by Federal lawmakers.

Arch Coal's Appalachian region straddles the West Virginia, Kentucky, Maryland, Pennsylvania, and Virginia borders. Appalachian coal is notable for both its relatively high-energy output and sulfur content. For its 2011 fiscal year, Arch itemizes more than 500 million tons of recoverable coal reserves located within Central and Northern Appalachia. On average, Appalachian coal generates 12,778 Btus of energy per pound, while emitting between 1.2 and 2.5 pounds of sulfur content per one million Btus. For the sake of comparison, Powder River Coal generates 8,837 Btus per pound, and maintains sulfur content of less than 1.2 pounds per million Btus energy generated. Arch operates with roughly 1.5 billion tons of recoverable reserves within the state of Wyoming. Weak coal prices alongside tighter E.P.A. regulations will force the shutdown of underperforming mines throughout Appalachia.

The Bottom Line

Boom and bust scenarios are typical for all commodity plays. The coal industry is now deleveraging rapidly alongside both the aforementioned natural gas glut and lackluster economic forecasts throughout the Western industrialized world. Arch Coal profits are especially at risk, as this company ships the majority of its coal between the American and European continents. For Arch, the spectacular buildup of the Chinese marketplace is largely irrelevant. Indonesian and Australian mining operatives, such as BHP Billiton (NYSE:BHP) can easily undercut Arch on transportation costs to China. For 2011, Arch reports a mere $61 million in Asian revenue out of $4.3 billion in total sales.

During fiscal year 2012, Arch Coal's profitability has declined sharply. Although sales remain flat, $523 million in mine closing costs have contributed to $390 million in losses over the past nine months. Efficient cost cutting measures, rather than increasing coal production, pricing, and demand are largely responsible for the $46 million in Arch Coal Q3 2012 profits. Arch Coal stock was to decline from $8.48 to $6.50 for a sharp 25% loss over the three weeks following the release of this latest report. The steady deterioration in shareholder value will continue, as coal effectively goes the way of wood.

Conservative investors should sell Arch Coal 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.