Coal has an image problem. It's under political and regulatory assault for being a "dirty" form of energy as well as being an unsafe industry. The Massey Energy mining disaster a couple of years ago that crippled the company and led to it being sold to Alpha Natural Resources (NYSE: ANR ) became emblematic of what was wrong with coal mining.
Because of regulatory actions as well as competitive reasons (and sometimes the two are inextricably linked), coal has gone from producing 50% of this country's energy to less than a third. Alpha says the central Appalachian region went from producing 300 million tons of coal annually at its peak in 1997 to 160 million tons today. According to the Energy Information Administration domestic coal output in 2012 will fall 7.4%, or by 81 million tons.
The switch to metallurgical coal -- the kind that is used to produced steel -- that was supposed to prop up miners like Alpha, Peabody Energy (NYSE: BTU ) , and Arch Coal (NYSE: ACI ) has also become more complicated as financial ruin spreads in Europe (where half of U.S. met-coal exports go) and China sees its economic expansion slow to the lowest rate in three years. Steel output there has fallen for two consecutive months now, and met-coal prices have fallen by a third to $192 a ton.
Analysts don't expect pricing to rebound next year and predict that if metallurgical coal stays below $200 a ton and thermal coal doesn't find some catalyst to drive it much higher, coal miners like Peabody and Walter Energy will turn cash flow negative. A Bloomberg analysis says Alpha, Peabody, and Arch were already cash flow negative in the second quarter of 2012, though only Peabody was able to generate any free cash flow over the first half of the year.
Cliffs Natural Resources (NYSE: CLF ) has its feet firmly planted in the steel industry. While it owns one thermal coal mine in West Virginia, Cliffs is also the largest producer of iron ore pellets in North America. Along with five met-coal mines it also operates five iron ore mines in Michigan and Minnesota, and two more in Canada, that provide iron ore for the Asia-Pacific region. It also has an interest in an iron ore mine in Brazil.
Some analysts are putting great faith in the new round of stimulus spending by the Federal Reserve to pull coal away from the brink. Coupled with China's intention to spend $150 billion on infrastructure improvements, the hope is that it will prop up pricing.
Unfortunately, I think it's a temporary salve. The president of the Fed's Philadelphia bank said the other day that Ben Bernanke's new round of quantitative easing will have a negligible impact on interest rates, the economy, or employment. China's new spending program seems only to confirm that its own prior massive stimulus wasn't successful at expanding the economy so there's little reason to think new spending will be generated. The country's purchasing manager's index was below 50% yet again, indicating that the economy is still contracting.
I believe the lack of confidence in the ability of government to spend our way out of this morass is priced into valuations that coal miners currently sport. You'll find most trading at less than 10 times earnings, but analysts think Cliffs might have a unique opportunity as it begins production of a premium grade ore from its Canadian mine at Bloom Lake, which ought to attract new customers while providing higher margins.
Others have taken a different tact altogether, actually embracing their "enemy." Consol Energy bought gas-producing assets from Dominion Resources in the Marcellus shale region two years ago while met-coal producer Natural Resource Partners (NYSE: NRP ) recently bought oil and gas fields in the Mississipian Lime region. It could be considered a hedging move, but it also suggests they see a long way to go before there's a recovery.
Scarcity of opportunity
Despite the risks, I continue to like the better prospects for Cliffs. Asian markets beyond China are still recording strong demand, and with its focus on Asia I think it comes out better than most players in the space. Global iron ore sales volumes jumped 13% last quarter even though lower pricing pushed revenues down. The stock is down 49% from its highs, but it's up 20% from the lows it hit just last month.
There's little doubt that both the coal and steel industries are difficult plays right now, but I see Cliffs geographic diversity cushioning the blow and putting it ahead of its peers, while its dividend yield of 6.5% seems sustainable. The overall industry, though, seems headed for worse times; it will be up to investors to pick and choose their entries, but let me know in the comments box below if you disagree that Cliffs Natural Resources can dig its way out of the hole.
Ready for a rubber match
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