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Why Coal Isn’t Going Anywhere

Lior is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The coal industry has taken a beating in recent years. The discovery of natural gas in the U.S. has reduced the role of coal in the electric power industry: In 2012, the demand for coal has declined and coal companies, such as Arch Coal (NYSE: ACI), have suffered from this drop in consumption. So, is it time to count out coal? I think this sentiment is premature.

Consumption for Coal Fell in 2012

During 2012, the consumption of coal in electric power industry declined compared to previous years: in the first nine months of 2012, total consumption reached 615 million short tons; during the same time in 2011, consumption reached 722 million short tons. This represents a nearly 15% drop. Moreover, the share of coal in the electricity generating sector fell from nearly 50% in 2005 to 37.6% in 2012. Total consumption in 2012 is expected to reach 829 million short tons – the lowest since 1992. The drop in demand for coal is also reflected in the decline in revenues of major coal companies: during the third quarter of 2012, revenues of Arch Coal fell by 9.3% compared to the same quarter in 2011. The company's operating profit margin reached 13% as of the third quarter of 2012. On the other hand, revenues of Peabody Energy (NYSE: BTU) have slightly increased by 3.9% in Q3 2012 compared to Q3 2011, but its operating profitability has declined from 19% to 13% in the third quarter of 2012. This means the operating profit fell by nearly 31%.     

This decline, however, might change direction in the forthcoming years. According to the EIA outlook, the share of coal in the electric power industry is expected to grow to almost 40% by 2014. The expected rise in demand for electricity in 2013 is likely to push up the demand for coal.

The coal industry is not limited to production and electricity, transport companies also rely on the coal industry. 30% of CSX’s revenues are attributed to coal. Revenues of CSX (NYSE: CSX) have declined by 2.3% in the fourth quarter of 2012 compared to Q4 2011 and its operating profit has also fell by 4.4%. The company's profit margin remained stable at 28%. Therefore, if coal consumption will rise in the years to follow, this could also reflect in the revenues growth of transportation companies such as CSX.

The main factor that could determine the future progress of coal is the developments in the natural gas market,

Natural Gas and Coal

The big question will continue to be the role of natural gas in the electric power industry. The main usage of coal is in this industry. According to the EIA, nearly 90% of coal is used for generating electricity by power plants. Even though the demand for natural gas for the electric power industry has risen in recent years, coal is still a major player for many electric generating companies, E.g. FirstEnergy (NYSE: FE) generates 64% of its electricity via coal, 18% by nuclear, and 6% by natural gas.  American Electric Power (NYSE: AEP) generates 66% of its electricity by coal, 22% by natural gas, and 6% by nuclear. So the role of coal in some top utility companies is still significant and it will take time until utility companies will shift from coal to natural gas. For these companies, the low natural gas coal prices led to a rise in profitability during the first nine months of 2012, the profitability of FirstEnergy rose to 18% compared to 15% in the same period in 2011; the profitability of American Electric Power inched up from 20.9% to nearly 21.2% in the first three quarters of 2012.

Furthermore, the price of natural gas rallied during the second half of 2012 after it had reached a very low rate. One of the reasons for the low rate at the beginning of the year was the unusually warmer than normal winter. During the winter the demand for natural gas for heating purposes tumbled, which resulted in a decline in the price for natural gas. But during the summer as the demand for electricity spiked for using air conditioning the price bounced back. So where is the price of natural gas headed?  

Since natural gas and coal are considered substitute inputs, their prices are linked: during 2012 the linear correlation between the price of natural gas and coal was nearly 0.38. Because natural gas is more volatile and is used for other purposes than just generating electricity (e.g. heating purposes) it stands to reason that the price of natural gas is affecting the direction of coal. Nevertheless, during 2012 the price of natural gas rose by nearly 30% while the average monthly price of coal (Appalachian) declined by nearly 8%. If the price of natural gas will continue to rise in the months to follow, this could contribute to the rise in price of coal.

My guess is that the price for natural gas is likely to range between $3 and $4, which is historically low but not as low as it was at the first half of 2012. I think the demand for natural gas in the power sector will slowly rise in the years to come, but coal will remain the prime energy source for generating electricity in the U.S. This will keep the price of coal from further falling and thus maintain this industry in the years to follow.  

The drop in natural gas prices at the beginning of 2012 was the key factor for the decline in demand for coal, but if natural gas prices will remain higher than their 2012 low rates, this could pull up the demand for coal. Moreover, if the demand for electricity will also increase, this could contribute to the growth in demand for coal. This means the coal industry isn’t done, at least for the near future.

For further Reading:  

Will Natural Gas Remain Low in 2013?

Will Oil Prices break the $100 mark?

Disclaimer: The author holds no positions in stocks mentioned and does not plan to initiate positions within 120 hours of the posting of this article. This article is to be used for educational, research and informational purposes only and does not constitute investment advice. There are no guarantees, expressed or implied, of future positive returns in regards to the subject matter contained herein. Understand the risks inherent in investing before making the decision to invest or consult an investment professional for more information. Reasonable due diligence has been performed in regards to the information in this article. However, the author expressly disclaims any liability for accidental omissions of information or errors in fact.


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