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PRB Auction Fail: A Sign That Coal Is Healing

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Seven years ago, Cloud Peak Energy (NYSE: CLD  ) asked Wyoming to sell it a tract of coal land. When the land auction recently came up, no one made a bid. That's a sign of how much the coal market has changed, but also an important step toward the industry healing itself.

Getting what you wished for
Cloud Peak, focused almost exclusively on the Powder River Basin (PRB), seemed like it should have been an obvious bidder on a piece of property that it basically asked to buy just a few years ago. However, management reviewed the sale "in light of current market conditions and the uncertainty caused by the current political and regulatory environment..." and chose not to bid.

One of the main reasons for this is the fact that the coal was of a lesser quality than the coal Cloud Peak mines from its other PRB operations. Thus, it would have to charge less for coal from the tract being offered. Not a good way to optimize profits in a tough market.

That no one bid at all was, in fact, a first for a PRB coal auction. That's a little surprising since the PRB has some of the cheapest coal around. Peabody Energy (NASDAQOTH: BTUUQ  ) , one of the largest players in the region, estimates that PRB coal is price competitive with natural gas in the $2.50 to $2.75 per million Btu range.

That means that despite the lower quality coal, it is most likely price competitive today with natural gas. The big problem is that there's no infrastructure in place to get at the coal. So, even if Peabody or Cloud Peak had bought the land, they wouldn't have seen the benefit for up to several years. And they would be footing the cost of the new mine's development at a point where preserving financial flexibility is paramount.

How long and how much?
Rhino Resource Partners (NASDAQOTH: RHNO  ) started construction of a mine in the Illinois coal basin in the first quarter. It expects the mine to start producing coal by mid-2014. That's well over a year of development. Just getting the mine up and running is expected to cost around $40 million.

That's a big expense and one that Cloud Peak didn't want to take on in the PRB with coal markets in their current state. Interestingly, Rhino didn't start work on its new mine until it had a committed sales contract for 800,000 tons of coal. In addition, the project is located near a river which will provide both low cost transportation and access to foreign markets. The new mine should be a notable growth catalyst for Rhino starting next year.

The PRB sale wasn't nearly as well situated and didn't have any contracts in place to support it. Meanwhile, Cloud Peak has over a billion tons of PRB reserves while Peabody controls more than twice that much coal in the region. So adding more coal wasn't exactly a necessity for either company.

A longer term trend
This is indicative of the larger trend going on right now in the mining industry. Both Joy Global (NYSE: JOY  ) and Caterpillar (NYSE: CAT  ) have been suffering as mining customers have pulled back on capital projects. Weak end markets forced Caterpillar to reduce its guidance for the year when it announced second quarter earnings. And the company has already had "temporary factory shutdowns," "rolling layoffs," and "reductions in [its] flexible workforce."

Management noted that "after several years of increasing capital expenditures customers have reduced spending across the mining industry." Moreover, it noted that its sales were down in every region of the world. The pullback in new projects is a bad sign for the rest of the year at Caterpillar and, frankly, for next year, too.

The outlook provided by Joy Global in its fiscal third quarter release was equally as glum. The company expects "the market will continue to be more challenging before it starts to improve." This is because long-term projects are being pushed out due to weak commodity markets. Interestingly, in its second quarter earnings release, Joy noted that the U.S. coal industry is furthest along in this industrywide correction.

A better future
Like Caterpillar, Joy is looking at a rough 2013 with little hope that 2014 will see material improvement. Investors should probably avoid the pair. However, the troubles here, coupled with the failed PRB auction are clear evidence that coal supply in the U.S. market is tightening. Only the best properties are being developed and that will lead to less supply.

Ultimately, supply and demand will balance out. And that will lead to a recovery for coal miners like Peabody, Cloud Peak, and Rhino. Note, however, that Rhino's new mine will enhance its growth prospects starting in the middle of next year.

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