Your Very Own Canary in a Coal Mine

When canaries were guinea pigs, coal mining was even more perilous than it is today. Birds are no longer required in the mines, but I sent my own Foolish canary underground to be our fly on the mine shaft wall. After digging deep into earnings for several key U.S. coal producers, this is my canary's comprehensive coal industry status report.

The first pattern that our roving reporter observed was that operations remain profitable despite a broad and deepening set of challenges. Massey Energy (NYSE: MEE  ) revealed earnings of $43.4 million for the quarter, while last week Arch Coal (NYSE: ACI  ) eked out a $30.6 million profit next to CONSOL Energy's (NYSE: CNX  ) nearly $196 million windfall. The king of coal, Peabody Energy (NYSE: BTU  ) , kicked in a 80% increase in profit from continuing operations on net income of $170 million.

As I have reported over recent weeks, however, a confluence of indicators from throughout the American industrial sectors are sounding early warnings for persistent deterioration of domestic resource demand. Recognizing this increasingly glum outlook, the U.S. coal producers are again lowering expectations from already-reduced levels. They continue to strike a clear distinction between near-term demand disruption and a more bullish long-term picture for coal. But, to the frustration of investors, that near-term seems to drag on forever.

Hitting a Moving Target
Just a few months after forecasting a 1% decline in U.S. thermal coal demand for 2009, for example, Arch Coal now expects power generation to retreat 4% alongside the nation's worst reduction in power demand ever recorded. Peabody Energy predicted that overall U.S. coal demand will shrink by 90 million tons, but Arch Coal more recently suggested the decline would breach 100 million tons. Mirroring a domestic steel industry that has been sliced in half, Arch expects to sell 55% to 66% less metallurgical coal than it sold in 2008. To my canary's eye, it appears that the domestic economy has not yet stabilized to a degree that permits even near-term forecasts to stand the test of time.

Adding a much-needed bright side, Arch Coal's management suggested that production cuts during this period of weak pricing leave more resources in the ground to reap shareholder value once prices rebound. As I pointed out in the case of silver purchaser Silver Wheaton (NYSE: SLW  ) , miners can indeed become effective stores of shareholder value when they hunker down during price disruptions and permit reserves to gather market value. Arch Coal added an enormous resource with its purchase of the Jacob's Ranch mine from Rio Tinto (NYSE: RTP  ) in March, and the company's move to idle another dragline and shovel team at the adjacent Black Thunder operation suggests that Arch is very content to let this resource age like a fine wine. Since I share the industry's bullish long-term outlook for coal, especially as steelmakers like POSCO (NYSE: PKX  ) signal some thawing of Asian industrial activity, I consider such moves very much in the best interests of the long-term investor.

Massey Energy permitted my canary to fly through the electrical utilities of the southeastern U.S., where eye-popping data showed an 18% reduction in the amount of coal burned by utilities in that region during the first quarter. We can attribute part of that reduction to decreased power consumption, but a key factor involves utilities switching to natural gas to fuel generators in place of coal. Although coal prices have continued to slide, the percentage drop in natural gas prices has been cut far deeper. Natural gas prices have plummeted approximately 75% from their peak. With exposure to natural gas production as well as high-quality Appalachian coal, the clear advantage in the context of this fuel-switching goes to this Fool's No. 2 pick in the coal sector: CONSOL Energy.

CONSOLing Fools
I have built a case for Peabody Coal as a well-positioned global producer, but CONSOL Energy continues to solidify its position as this Fool's top domestic producer. I expect Arch Coal to thrive again one day, but by its own admission Arch faces near-term challenges involving backfiring fuel hedges and geological challenges. CONSOL, on the other hand, is thriving today. In fact, CONSOL managed an impressive 71% boost to operating cash flow in the first quarter on the strength of a 37% increase in realized prices. The company's operating margin surged 79% from $15.25 to $27.33 per ton.

With almost all production from underground mines, CONSOL is poised to skirt the heightened scrutiny of surface operations signaled by the Obama administration. The company could skirt much of this price weakness as well. Although CONSOL will likely be forced to revise contracts to permit clients to defer deliveries, this process would begin from a position of strength. CONSOL has contracted virtually all 2009 production at an average price near $60 per ton, or 23% higher than 2008 realized prices.

For all of these reasons and more, I continue view CONSOL Energy as a standout competitor within a domestic coal industry that is under growing near-term pressure from this deepening economic downturn.

Further Foolishness:

The "Coal" tag within the Motley Fool CAPS community lists 21 coal companies. Find out what other investors are saying about the stocks you're watching, or share your Foolish thoughts with us. CAPS is free and fun! Try any of our Foolish newsletter services free for 30 days.

Fool contributor Christopher Barker wishes he could squeeze coal into diamonds. He can be found blogging actively and acting Foolishly within the CAPS community under the username TMFSinchiruna. He owns shares of Arch Coal, Massey Energy, and Peabody Energy, and Silver Wheaton. Posco is a Motley Fool Income Investor recommendation. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool scrubs its disclosure policy before releasing it into the atmosphere.


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