Is This the Right Time to Buy Coal Stocks?

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Weak US demand hammered coal stocks last year. American coal producers were forced to boost their exports while trying to cut back on costs. Will this strategy help coal producers win back investor confidence? Here's why, in the short term, it probably won't.

Weakness in the US Market

Coal stocks were among the worst performers in 2012. Arch Coal (NYSE: ACI), among the largest coal producers in the US, saw its stock tumble nearly 50% last year. Alpha Natural Resources (NYSE: ANR) shares fell more than 50%. Peabody Energy Corporation (NYSE: BTU) shares fell nearly 20%. The weakness in the domestic coal market resulted in Patriot Coal filing for bankruptcy nearly a year ago.

Coal's lackadaisical performance was mainly driven by natural gas prices, which fell to a record low in April 2012, as the shale boom in the US boosted production. Although prices recovered, they still remained cheap.

According to the US Energy Information Administration (EIA), the average wholesale price for natural gas at Henry Hub in Erath, Louisiana, was $2.77 per million British thermal units (MMbtu) in 2012. This prompted several utilities to switch from coal to natural gas. At one stage in 2012, natural gas nearly equaled coal for power generation in the US. Not surprisingly, coal stocks tumbled.

Boosting Exports

The sharp drop in domestic demand forced several US coal producers to consider overseas markets having robust demand for coal. Rapid industrialization in China has made it the biggest consumer of raw materials, including coal.

India, another major market, has one of the largest global coal reserves. However, low mining investment makes it a net importer of coal.

Robust Asian demand led Arch Coal to increase its profile in China to meet growing global demand for metallurgical and thermal coal.

Coal demand in Europe has been robust as well. Peabody recently noted that European coal generation remained strong in response to high international natural gas prices, falling nuclear generation, and reliability and cost challenges of renewable power.

Adapting to Changing Market Dynamics

Given the difficult market conditions, US coal producers have had to implement cost-cutting measures and restructure operations.

In September 2012, Alpha Natural Resources outlined a plan to restructure its asset portfolio and administration to become more competitive. These measures seem to be paying off; costs and expenses during the first quarter of 2013 was $1.5 billion, down from $2 billion in the year-ago period.

Both Arch Coal and Peabody remain focused on containing costs. Arch Coal maintained its thermal coal guidance range of 125 million to 135 million tons, but reduced its annual cash cost guidance range for two of its largest operating regions.

In the first quarter, Peabody’s costs were lower than expected -- a sign that its cost-cutting measures are having an impact. In the first quarter of 2013, the company’s adjusted EBITDA stood at $280.1 million, significantly below the $511.5 million reported for the same period last year.

The significant decline was mainly due to lower Australian Mining adjusted EBITDA, which was negatively impacted by approximately $250 million related to lower pricing, but partly offset by cost reduction.

US Demand to Rebound

In its recent report on short-term energy outlook, the EIA said that total coal consumption in the US is expected to rise 7.1% in 2013, driven by higher electricity demand and higher natural gas prices. Indeed, the rise in natural gas prices has once again boosted coal demand.

According to Peabody, coal demand rose 8% in the first quarter and accounted for nearly 40% of total electricity generation. The company expects 2013 US coal consumption for electricity generation will grow by 60 million to 80 million tons over 2012 levels. Arch Coal CEO John Eaves expects domestic coal market fundamentals to improve in the second half of 2013.

However, the trend is not expected to continue, as higher gas prices would lead to increased supplies in the future. Not surprisingly, the EIA said in its report that coal consumption will grow at a more modest pace of 1.8% in 2014.

Long-Term Positives, Near-Term Bearishness

The outlook for coal producers has certainly improved. Cost-cutting measures, robust overseas demand, and a rebound in US coal demand are good signs. However, some concerns still remain that make coal stocks unattractive, at least in the near-to-medium term.

The biggest is China, which is planning to reduce coal consumption in some industrial regions due to pollution issue. In April, Goldman Sachs cautioned that China’s imports of thermal coal could contract in 2013. This means that any improvement in the US demand would be offset by weakness in China.

Demand in India is expected to remain robust; however, the country imports most of its coal from Indonesia. In addition, mounting current account deficit may force India to boost domestic production.

Given these factors, I am still bearish on US coal producers in the near-term. I would wait for the coal market to further stabilize and US coal producers’ cost cutting measures to take full effect before taking a long position.

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Varun Chandan Arora has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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