Coal Price Weakness to Linger Longer

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Hard to Know How Soon and How Far Coal Prices Will Recover

There are a lot of moving parts driving the coal market, including: production strategies, industry costs, natural gas prices, utility inventories and the relative attractiveness of the country's coal basins. However, where the rubber hits the road is the key measure of coal market health, coal pricing. Foolish investors who follow coal stocks know that this is a cyclical industry. A rebound in coal prices is sure to come next year...right?

It's far from clear that a meaningful and sustained rebound in coal prices is coming anytime soon. Why? Three reasons: shadow supply, freight costs and exports. Shadow supply is an unofficial figure; it represents coal production that could easily and quickly come back into the market as coal prices recover. We are already seeing this occur in the Powder River Basin, "PRB." There have been widespread reports from Peabody Energy (NYSE: BTU), Arch Coal (NYSE: ACI) and Cloud Peak (NYSE: CLD) that coal demand from their mines in Wyoming and Montana has increased.

The increase in demand is largely attributable to power plants that can burn either fuel, switching back to coal from natural gas. News of this has been circulating since July/August as the U.S. experienced a very hot summer. However, while U.S. thermal coal prices (coal burned to generate electricity) have bounced off of multi-year lows, they have stalled lately and remain at unfavorable levels.

Despite Higher Demand for Coal from the Powder River Basin, Prices Are Still Weak

In the PRB, forward coal prices for 2014 rallied to above $16 per ton, but have since fallen back below $15 per ton. That's because the PRB has ample idled capacity it can bring back online as demand firms. Don't get me wrong, an increase in demand is a good thing, and the market will have to work through the overhang of shadow supply at some point. I just think it could take a long time for this to happen.

2013 is shaping up to be another bad year. Producers have locked up a significant portion of their thermal coal at poor to mediocre prices and have cut back on production. In other words, weak pricing and flat to higher per ton costs are coming. To be fair, PRB producers demonstrated good cost controls in their respective third quarter earnings reports. I would like to see that continue in the fourth quarter. Remember, the ongoing costs of permitting, regulations, environmental work and safety measures are not going down and are probably going up. Those costs will be spread over fewer produced tons. And, diesel prices are not down nearly as much as coal prices.

There's Nothing Particularly Good Happening....

Inventories at utility customers remain high and the 2012-13 winter does not appear to be off to a good (cold) start. Natural gas prices have stalled / fallen recently. Another factor worth discussing, not found on many investor radar screens, are the railroads. Railroads carry most of the coal in the country, both domestically and to a number of ports for export. Barging and trucking are the other two transportation options. Many people may not realize that the railroads have temporarily cut freight rates to grease the wheels of commerce. That has enabled the strong export year that the U.S. is having.

However, in recent months the rate of exports has slowed. It's very possible that exports next year will be weaker than the strong showing this year, which comes after a strong 2011. That would be a drag on domestic coal demand and weigh on pricing. As coal prices recover, the railroads will raise freight rates, mitigating the margin benefit for coal producers. Turning back to utility stockpiles, not only do they remain high in absolute terms, but on a days of supply basis they are even higher. Why? Because the country is burning a lot less coal than it used to. Utilities are likely to bring stockpiles down below historical levels because they don't need as much to match the days of supply they've traditionally held.

The Bottom Line

The Foolish bottom line is that just because coal prices and coal stocks are at depressed levels, doesn't mean they are especially likely to bounce back anytime soon. Housing is cyclical also. How many years did it take for housing to recover, 4-5 years? Most investors are aware of what's known as a value trap. I think the coal stocks are trapped. Traders are loving the volatility. For me, I am staying away from the coal stocks except for Alliance Resource Partners (NASDAQ: ARLP) and Natural Resource Partners (NYSE: NRP). Please click the links here, herehere and here for my views on Alliance and NRP. Hint: I like them both.

 


MockingJay2011 owns shares of Alliance Resource Partners, L.P. and Natural Resource Partners LP. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Alliance Resource Partners, L.P.. 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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