Can the Coal Industry Survive the Shakeout?

Can the Coal Industry Survive the Shakeout?

The coal sector has been through a lot in the past three years. The spot price of thermal coal has fallen significantly as advances in horizontal drilling and hydraulic fracturing have unlocked cheap natural gas in North Dakota and Texas.

Metallurgical coal prices have fallen significantly as China's economy, which consumes around half of the world's coal , contends with a deflating credit bubble.

With the recent spill of a chemical used to clean coal in West Virginia, the coal industry now has to deal with unwelcome headlines and worries of increased regulation.

Can the coal industry survive the cyclical downturn?

Long-term headwinds
There is no question that the coal industry faces some long-term headwinds.

According to the National Association of Regulatory Utility Commissioners, about three-quarters of all U.S. coal plants are at least 30 years old. Since the average life of a coal plant is only 40 years, many coal plants will be nearing their retirement age in the next decade.

Because of new EPA regulations, it is highly unlikely that new coal plants will be built in the U.S. The EPA has a rule that requires all future coal plants to emit no greater than 1,100 pounds of carbon dioxide per megawatt-hour. The average U.S. coal plant currently emits around 1,700 pounds of carbon dioxide per megawatt hour. Unless new economical carbon sequestration technology comes in, we won't be seeing many new coal plants in the U.S.

In addition to coal losing market share, the overall demand of electricity growth is likely to slow as electrical appliances become more efficient.

Long term positives
There are still positives. Despite the dour outlook, the Energy Information Agency expects coal to make up around 34% of total U.S power generation by 2035 from the current 37% today.

Globally, the demand for coal is still going to be there. Poor developing nations will still use thermal coal for energy generation because coal is often the cheapest choice. Most nations don't have the luxury of cheap natural gas.

While Chinese coal imports have fallen significantly, India is picking up the slack. India's coal imports rose 21% in 2013 to 152 million tonnes and could rise another 12% in 2014.

In a lot of ways, India is where China was a decade ago. The country is entering a stage where it needs a lot of energy and infrastructure to grow its economy. Many experts predict that India will be the top importer of thermal coal in 2014 and will drive coal import demand in the decade to come.

The bottom line
Coal is currently in a low-growth mode. In a low-growth, challenging environment, the best companies are the lowest-cost producers and large diversified mining companies.

Cloud Peak Energy is one of the low-cost producers. The company is the only pure-play coal producer in the the Powder River Basin.

According to the Energy Information Agency, the Powder River Basin is the lowest cost producer of thermal coal in the U.S., with a spot price of around $0.50/MMBTU versus a spot price of $2.50/MMBTU for Appalachian coal.

Because of its low production cost, Cloud Peak Energy is one of the few profitable coal producers. With a total debt-to-equity ratio of only 0.74, the company is also not as levered as the other thermal coal producers.

While levered metallurgical coal companies such as Walter Energy and Alpha Natural Resources have seen their stock prices slump due to concerns over China, large diversified coal miners such as Rio Tinto have the financial strength and diverse income streams to last through the cyclical bottom.

The demand for metallurgical coal will eventually pick up. As of 2013, China is only 54% urbanized. Most developed nations have urbanization rates of over 80%. As technology improves, cleaner thermal coal technologies could become economical as well.

But until that time comes, the best bets in the coal space are the low-cost producers and diversified mining companies.

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