Friday, October 12, 2012

Coal Market Prospects

It’s been a tough year for coal related stocks and I think this is likely to continue. You could spend a huge amount of time pouring over every facet of coal related stocks  operational metrics or evaluation compared to historical numbers and none of it would matter in the slightest. In my humble opinion, there are two things that will drive the sector. The first is sentiment over US coal production and the second is China’s fixed asset investment. Neither of which are particularly strong right now. In summary, I think tough times remain ahead.


Joy Global’s Latest Results

Mining machinery play Joy Global (NYSE: JOY) gave results recently and they weren't particularly positive.  Legacy sales were up 10.6% but the real story is with the bookings. Underground mining machinery bookings were down 25.5% and surface mining equipment orders fell 38.5%. These numbers are hardly surprising given the drop in capital expenditures announced by leading coal miners such as Alpha Natural Resources (NYSE: ANR) or Arch Coal (NYSE: ACI). Both companies have cut back investment in the face of rising coal stockpiles and the onslaught of shale gas. Only last week mining giant BHP Billiton (NYSE: BHP) announced plans to cut back $50 billion from planned investments including delaying the expansion of a huge coal mining project in Australia.

With regards to the US, natural gas prices have fallen and gas is taking market share from coal in terms of electricity production. In terms of China, the slowdown is due to the weaker economic growth and, in particular, slowing fixed asset investment.

The question that investors need to answer is whether these cutbacks are a natural part of a cycle which will see coal stockpiles run down and demand rise again or part of a sustained downturn.


US Coal Demand

The demand for coal in the US largely comes from its use in electricity generation. The calculation is simple. As long as the shale investment boom is in place and natural gas prices are falling, then coal will be pressured.  Throw in emissions regulations (coal is known as the dirty fuel) and you have the perfect recipe for declining demand.

That much is known, but how best to monitor developments?
I think a good way would be to look at what the Association of American Railroads is reporting in terms of coal rail carloads. Unfortunately, what they are saying isn’t pretty. US coal carloads were down 6.7% in the last reported data and on a cumulative basis in 2012 they are down 9.3%.

On a more positive note, natural gas prices have perked up a bit lately and according to Joy Global, coal has taken back some share in power generation. However, longer term the structural decline looks set and it’s hard to see coal making a comeback. We are still in the early stages of technological advances in shale gas technology and I would bet on its advancement worldwide rather than on coal.


China’s Fixed Asset Investment

Joy Global gave some interesting ‘color’ on China by pointing out that coal stockpiles in the main transfer point (Qinhuangdao) have come down 25% since early July. In addition, electricity demand seems to have picked up in the first month of the third quarter. Put together, coal prices have stabilized a bit in China. This is the good news.

The bad news is that the economic data on China has gradually weakened and those (including myself) that are very concerned about the bursting of a housing bubble have plenty more datasets to worry about.

For example, according to the official statistics, industrial profits actually decreased from January to July. Chinese manufacturing PMI is now at a multi-month low and the new orders component is at 49, which indicates a recession. As for the crucial construction sector, the land area being purchased by real estate developers recently declined by 24% on a yearly basis. Not a good sign.

Frankly, everything we have learned about property bubbles in the last 30 years from countries as far afield as the UK, US, Dubai Spain or Sweden suggests that they do not correct themselves quickly and without pain. I see no reason why China will not be same. Moreover a lot of hope is being pinned on China’s ability to stimulate the economy via spending. I am not so sure and have discussed some of the issues in an article linked here.


Where Next for the Coal Plays?

As discussed above, there are some reasons to believe that in coal prices have hit a temporary bottom and some better looking news will likely tempt investors into the stocks. However, I won’t be one of them.

The challenges are structural in the US and I’m skeptical about China being able to return to previous growth rates in coal production. Coal is an industry that is going to have to deal with ongoing structural challenges and it may pay to be cautious here.