Waiting On Coal: Dynamics And Theory

| About: The United (UNG)
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This weekend in Arch Coal: Walking Dead, the precarious position of Arch Coal Inc (ACI) was noted. Arch's limited liquidity and options were discussed in relation to coal's depressed fundamentals. Based on comments, perhaps a review of the industry trough is necessary.

U.S. domestic demand for thermal coal in 2012 will be down over 100 million tones in 2012, from a 2011 level of 920 million tones. Inventory levels are piled high. Producers have responded by cutting 100 million tones in supply to balance the market.

If coal demand returns modestly, the sector would soar from the current depressed valuations. The industry is capital constrained, which would delay a supply response and bring forth a stronger-for-longer cycle.

The thermal coal market has been crushed by the natural gas (The United States Natural Gas ETF, LP: UNG) supply glut. Until this glut is rectified, coal prices will continue to be depressed.

To this point, natural gas has shown no indication a decline in production has begun. The fall shoulder season looks to be difficult with Marcellus production higher by 82% over 2011, with another 500 mcfd backlog being brought on line in September. Perhaps most coal-to-gas switching is permanent.

Until natural gas production shows signs a meaningful decline in production is to occur, most U.S. coal stocks are not investable. Investors ought to continue to monitor associated gas production and the backlog of wells in light of the natural gas rig count.

While speculators wait for a possible cyclical rebound in the U.S coal market, the secular decline must be observed. New power generation is largely natural gas and even wind. Coal plant retirements are going to be an industry problem, especially in light of tepid demand growth.

Meanwhile, the international coal super-cycle is compelling, driven by China and India. For the hundreds of millions of rural poor in emerging nations to obtain a better life electricity will be needed. Vast new coal supply will be required.

In addition to the international thermal coal demand story is steel-making coking coal as a basic ingredient to industrialization. Emerging market economic growth has slowed markedly in 2012, creating gluts in both thermal and coking coal. Until economic growth in these markets re-accelerates, coking coal producers such as Walter Energy, Inc. (NYSE:WLT) and Alpha Natural Resources, Inc. (ANR) ought to be avoided.

Often the robust growth of U.S. coal exports is noted as a savior for producers. Coal exports are an excellent long-term industry opportunity, growing from a small base, as infrastructure is built by those such as Kinder Morgan Energy Partners L.P (NYSE:KMP). But the scale of exports is tiny next to the current industry carnage. Note: 2012 U.S. demand will decline by the size of the entire U.S. export market.

The opportunity in the coal sector may be spectacular. However, investors would do well to wait on the coal sector. Stubbornly high natural gas supply must first decline.

The winners will be low cost producers such as Alliance Resource Partners, L.P. (NASDAQ:ARLP) and Cloud Peak Energy, Inc. (NYSE:CLD) at the expense of high cost and leveraged industry participants. Join me as I monitor developments.

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.