The Upside Of The "Unfavorable" Trends In Coal

The Upside Of The "Unfavorable" Trends In Coal

Eastern U.S. focused CSX is projecting that just two of its customer groupings will face difficult markets through the rest of the year: domestic coal and export coal. That said, digging into the negative outlook a little helps to show the difference between the state of these two broadly defined segments of the coal industry.

A positive undertone

CSX is projecting that about 13% of its rail volume will come from coal this year. That's down from about 20% last year. A 14% drop in first quarter shipments of domestic coal, and a 3% first quarter drop followed by a 16% second quarter drop in foreign coal volumes were the big numbers. They easily overshadow the 3% uptick in domestic coal volumes in the second quarter.

That's unfortunate because the U.S. thermal coal market was among the first to feel the pinch of a supply/demand rebalance. Mining equipment maker Joy Global , for example, stated in its fiscal second quarter earnings announcement that, "The U.S. coal market was the first to correct. Those corrections are mostly completed, and demand for coal-fueled power generation is improving."

It updated that projection in its fiscal third quarter release: "Stockpile depletion will continue in the second half and should reach a normalized level of around 150 million tons by year end. This should set the stage for coal delivery increases of 50 to 70 million tons in 2014."

That's good news for CSX's domestic coal shipments for next year. The slight uptick in the second quarter is early evidence of the U.S. thermal coal industry starting to get back to equilibrium. So, this segment, which accounted for around two thirds of the rail hauler's coal business, should shift back to growth mode next year after expected declines of between 5% and 10% in 2013. Look for positive trends here for CSX in 2014.

The coal maverick
On the coal front, this trend will also be good for Alliance Natural Resources which gets about 80% of its coal out of the Illinois Basin (ILB), which touches CSX's rail network. The ILB is the second most cost competitive coal basin in the United States when compared to natural gas. That said, Alliance hasn't missed a beat through the coal downdraft, actually increasing sales year over year in each of the last six quarters.

Volume increases have more than offset the drop in coal prices, leading to record performances and continued dividend increases. For example, the partnership sold nearly 20% more tons of coal in the first half of this year than it did in the same period last year. Volume increases will turn into a big revenue increase when coal prices start to move higher.

Although Alliance's units don't possess the upside potential of coal miners that have seen their shares fall up to 90% from recent highs, a combination of an about 6% yield, regular dividend hikes, and at least modest capital appreciation should make for a rewarding total return.

Foreign coal's a longer-term problem
Facing longer-term hurdles will be the third of CSX's coal segment that's destined for international shores. On that score, Joy notes "Seaborne coal prices have declined 17 percent since the beginning of the year..." With prices depressed, it just doesn't make as much sense for U.S. coal miners to send coal overseas.

Interestingly, demand in foreign markets like India and China has been heading higher. The problem is that there is an oversupply of coal. Until that oversupply works itself out, CSX's foreign coal volumes are likely to remain weak.

While Joy notes that, "Lower pricing is making higher cost mines uneconomic and will result in closures that will rebalance the market," that processes hasn't started in earnest just yet. Expect weakness in CSX's export coal volumes into 2014, with the second half of 2014 or early 2015 as a potential turning point.

Equipment sales will lag even more
Joy Global, meanwhile, will have to wait longer for any improvement in its equipment sales to the coal industry, among other currently oversupplied commodity markets. Management summed it up nicely when it stated that until the coal market rebalances, "there is little incentive to invest in new mine capacity." That's true of virtually all of Joy's end markets.

In fact, an uptick in capital spending may not take place until well after demand starts to outstrip supply to some extent. So even a nascent recovery in the U.S. coal industry won't be enough to push capital spending higher. That's why Joy is expecting weak sales through 2014. Investors should probably avoid the company until its end markets start to pick up. That said, watch U.S. coal capital spending for the first signs of a potential business turn.

An industry in flux
The coal industry is in a state of flux, and the impact extends beyond the miners. CSX's coal business has seen a notable hit, for example, as have sales at mining equipment maker Joy Global. As coal markets around the world rebalance, however, look for the coal industry's drag to start benefiting this duo. Continued strength in CSX's domestic coal volumes will be among the first signs that things are moving in the right direction. And, if that's true, Alliance will see continued improvement in its already impressive results.

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Reuben Brewer has no position in any stocks mentioned. The Motley Fool recommends Alliance Resource Partners, L.P.. The Motley Fool owns shares of CSX. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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