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King Coal to Rebound? Don't Bet on It


The rise of natural gas means that coal's once dominant market share will likely erode over time.

By now, everyone is well aware that the natural gas price has dropped some 34% so far this year and is hovering around $2.00 per mmbtu. What is less publicized is the impact that has had on the fundamentals of what used to be King Coal. Coal Master Limited Partnerships, or MLPs, have performed poorly this year compared with the MLP Index, which itself has lagged the S&P 500 by more than 9% year to date.

Coal MLPs have outperformed regular coal stocks this year to date, year-over-year, and so far in April. Coal MLP performance is skewed by Penn Virginia Resource Partners LP's (PVR) outperformance, which is tied directly to the midstream portion of its business that is set to more than double to represent 75% of EBITDA in 2013.

Coal corporations with substantial metallurgical coal operations, like Alpha Natural Resources, Inc. (ANR) and Walter Energy, Inc. (WLT), have outperformed the other coal companies so far in April. Even with that bounce, however, coal stocks have produced an average total return in the last 12 months of -59%.

Weak performance has some research analysts (notably at Citi and Deutsche Bank) and media (notably the Wall Street Journal and Barron's) calling the bottom and for a rebound, particularly for coal stocks with export exposure. But exports are the only bright spot for an otherwise dark and dirty sector. That sort of wishful thinking is not going to change declining industry fundamentals. Just as it has been said millions of times, "Don't fight the Fed," it is very hard to fight natural gas production growth (and carbon regulation) these days.

Several factors are combining to put increasing pressure on coal companies, which I discuss below. Coal prices have factored in these headwinds, with Central Appalachian coal spot prices down 20%-plus YTD and Powder River Basin spot prices down 40%-plus YTD. Coal companies have caught a bid in the last few weeks (although sporadically), but that valuation-driven bounce won't last long.

Major Coal Headwinds

Coal to Natural Gas Switching – According to the Energy Information Administration, or EIA, coal consumption by the US electric power sector is expected to fall below 900 million short tons for the first time since 1996. Coal demand by the power sector is expected to drop 5% year-over-year. This drop is a result of increased adoption of natural gas as the fuel for power generation given its cost advantage, and a very warm winter, which reduced consumption of all electricity. 92% of the coal produced in the US is consumed by the power sector, so if coal's share of generation continues to fall, coal miners will face continued margin pressure.

At the end of 2012, the EIA expects coal's share of power generation to drop to 40.4% and expects natural gas share to rise to 27%, continuing the multi-decade erosion of coal's once dominant position with power producers.

Coal bulls make the case that coal to natural gas switching fatigue has arrived. In other words, power companies that can cheaply switch to natural gas have already switched. If natural gas stays this cheap, and the cost of mining coal grows with regulations, power companies will figure out a way to switch. Natural gas will continue to whittle away at coal's once dominant market share and force recontracting of coal sales at lower prices.

  • Potential Carbon Regulation – There is no pending carbon legislation right now, but if Obama were to get re-elected that would increase the chances of carbon regulation that would directly and negatively impact coal producers.
  • Weak Economy and Conservation – Energy demand in general is on the decline in the US. Crude oil imports are lower than they've been in decades; vehicle miles driven are lower; and car ownership and home ownership among young people are at historic lows. All of this implies minimal growth in the overall electricity pie, which as I mentioned above, is 92% of coal demand in the US, with the rest mostly exports.
  • High Inventory Levels– Inventories of coal at power plants are at historically high levels, even with a drop in inventories in each of the last two years. High supply doesn't usually result in high prices or extra demand, leaving coal producers with few options other than to continue to cut production. Coal production is already down 7% from its all-time high in 2008, and it looks like the warm weather and cheap natural gas will see that decline continue in 2012. Lower production, with all else being equal, would lead to higher prices. But all else is not equal: The pie is shrinking as is coal's share of it, which means actions taken to increase the price of coal from today's levels (like by cutting production) would only cause the cost advantage of natural gas to grow.
  • Uncertain Transportation Costs for Exports – The problem with relying on export growth is that shipping rates can vary quite a bit, and those rates tend to increase when economic growth is higher. So if China and India are growing at a rapid rate, that generally means coal export prices will be higher and export volumes will be higher, but it also means that transportation will cost more to get the coal there.
Bull Case:

Emerging Markets Growth, Natural Gas Recovery, Switching Fatigue

Coal companies might be due for a bounce and worthy of a short term trade, but it's hard to make a long-term bet on coal at this point. Potential upside to coal prices this year could come from significant export growth, an extremely hot summer that burns off inventory, or some serious reduction in natural gas production that results in higher gas prices (unlikely). There is no doubt coal companies are cheap, but that in itself is not a catalyst. I like to go through my portfolio and determine what the positions say about my view of the world. In other words, what must go right for this particular portfolio to work out well? What am I betting on? A bet on coal is a bet that the rest of the world will continue (1) to grow and (2) to use coal, and (3) that shipping rates will remain cheap enough to justify exports from the US.

Also, for the coal bull case to work out, coal production and demand would need to stabilize, so you are betting on benign regulatory environment and rising natural gas prices. Tough bet.

If You Insist: Bet on ARLP

If you do feel inclined to bet on the turnaround of the coal industry, Alliance Resource Partners LP (ARLP) is the best choice among MLPs. ARLP is a very well-run, low cost, heavily-contracted steam coal producer. At year end, Alliance Resource Partners LP had 97% of 2012 production contracted and priced, and 67% of 2013 contracted and priced. The 67% is by far the highest of any coal mining company. Alliance Resource Partners LP has only 8% of its production in the high cost central Appalachian region, and most of its production is in low cost regions of Northern App and Illinois Basin. Alliance Resource Partners LP has not issued equity in more than five years, instead choosing to fund growth capex out of its massive coverage ratio (internally generated cash flow).

Alliance Resource Partners LP has the highest distribution coverage ratio of any MLP, which will allow the company to grow distributions by 12%-plus again this year. With 6.8%-yield (yesterday's close), combined with 12%-growth, and a very conservative balance sheet, Alliance Resource Partners LP is the best positioned coal name to own right now. So if you have to own a coal name and you are somehow bullish on a coal recovery despite the above industry headwinds, Alliance Resource Partners LP is an excellent choice, as is its public general partner Alliance Holdings GP, L.P. (AHGP). I have no positions in Alliance Resource Partners LP or Alliance Holdings GP, L.P. in personal or client accounts, because I don't believe in the long coal story.

This article was written by Hinds Howard. See the original version here.

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