Coal is predominantly used in the production of electricity and in the steel making process. The outlook for both of these end markets is different today. Although a diversified company like Peabody Energy (NASDAQOTH: BTUUQ ) provides exposure to both, more intrepid investors might prefer the finer focus that Cloud Peak Energy (NYSE: CLD ) and Walter Energy (NASDAQOTH: WLTGQ ) provide.
In the Clouds
Cloud Peak Energy is based almost exclusively out of the Powder River Basin (PRB). This area produces coal used for electricity that international coal giant Peabody Energy believes is competitive with natural gas priced at around the $2.50 to $2.75 per mmBtu range. That's about as cheap as it gets in the United States and is why Peabody generates about 37% of revenues from its Western U.S. division, which includes the PRB.
According to the Energy Information Administration (EIA), natural gas was in the $4 per mmBtu area at the end of June. In other words, virtually all of Cloud Peak's coal is price competitive today with its most-notable commodity competitor. That said, electric utilities have been burning coal from their stockpiles instead of buying new supplies, with stockpiles falling over 13% year over year in June according to the EIA.
That trend will lead to weak results for Cloud Peak in 2013 despite its cheap and currently competitive coal. For example, management is forecasting flat to slightly lower tons sold in the U.S. market in 2013. Add in weak coal prices and the year looks pretty grim. To management's credit, however, the company has remained profitable despite the deep market trough.
But once utilities start to pick up their purchases to replenish coal reserves, Cloud Peak's cheap coal will again be in demand. Looking forward, management is "optimistic that the steady coal burn and continued reduction in PRB inventories will lead to prices moving higher later in the year."
American Electric Power, for example, reduced its use of natural gas by 37% through the first six months of the year, but increased its use of coal by about 4%. And, within Duke Energy's Commercial Power segment, electricity generated by coal increased 26% while natural gas fired power fell by about the same amount. These types of shifts should set 2014 up to be a good year for Cloud Peak and its thermal coal focus.
Of course Peabody will benefit from that trend, too, but Cloud Peak's tighter end-market focus suggests that a U.S. coal recovery will have a more pronounced impact on the bottom line.
Steeling for a long fight
Walter Energy is focused on metallurgical coal, which is used in the steel making process. The company has mines in the United States, Canada and the United Kingdom. Unlike U.S. coal used for electricity which is driven more by domestic demand, met coal is heavily influenced by global supply and demand trends. Thus, Walter must compete with met coal producers from all over the world and in global end markets.
That's been a headwind of late. For example, the entire met coal industry has been focused on reducing costs and improving efficiency. While Walter was able to bring costs down to about $78.50 per ton in the second quarter from $102 per ton a year ago, those savings came along with a nearly 15% drop in tons sold and an over 20% drop in the price per ton.
Part of the problem is that Walter has to compete with global players like Peabody, which generates nearly 30% of its revenues from its Australian met coal operations. That area of Peabody is benefiting from a falling Australian dollar and its closer proximity to key Asian markets. Unlike Walter, Peabody sold more met coal in the first half than it did in the same period last year.
Walter lost money in the first half and is unlikely to turn a profit in 2013. However, it is continuing to invest in its business and was able to increase its production nearly 10% in the second quarter compared to 2012. Right now, that's just wasted capacity, but as the supply and demand of met coal balance out, it positions the company to prosper down the road.
Note that steel is a necessary component in the build out of the world's infrastructure. BHP Billiton is expecting the percentage of the world's population living in cities to increase from about 52% in 2010 to 60% by 2030. That's going to be driven by continued growth in China and India, where consumers are quickly moving up the economic ladder.
Although growth rates are likely to slow from their heady pace over the past decade or so, slow but steady demand for steel -- and thus met coal -- is BHP's expectation once supply and demand stabilize. Steel giant ArcelorMittal backs that up, noting in its 2012 annual report that overall steel demand is already back above pre-recession levels but that demand in developed markets isn't expected to regain those heights until late this decade. Emerging markets are clearly the driving force, but slow and steady is likely to be a worldwide phenomena.
So, Walter is a struggling company today, but it has notable turnaround potential once met coal markets right themselves. Unlike the U.S. electric market, however, the foundation for that turnaround doesn't yet appear to be taking place. And Walter's long-term debt accounts for nearly 75% of its capital structure, so it isn't a low-risk investment.
All of the above?
For investors looking to hone in on key coal end markets, Cloud Peak and Walter are two options to consider. More conservative investors, however, should probably stick to a diversified giant like Peabody Energy. It has exposure to electric and steel markets throughout the world.
Although 2013 is going to be a tough year for the company, just like it will be for the other pair, 2014 should be much better. And improving U.S. demand from electric utilities should help support the company's met coal operations which are likely to take longer to recover. That said, Cloud Peak is likely to see a bigger boost to its business from improved U.S. demand.