The Coal Industry is Licking its Wounds but Will They Heal?

Overcapacity in an industry requires companies to close up shop and better operators to take over the weak—both are happening in the coal space, which is setting up an eventual recovery.

Jan 14, 2014 at 9:49AM

It's easy to hate the coal industry, but even the Energy Information Administration (EIA) expects it to be neck and neck with natural gas in the electric grid for the next 25 years or so. And while the industry is struggling now, unfolding events will eventually lead to a better tomorrow.

Not a buggy whip
You can't blame investors for looking at coal and thinking that alternative energy sources are going to make the fuel go the way of the buggy whip. But that's unlikely, and EIA projections support this—even while renewable energy options materially grow their share of the pie.

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That leaves an issue of supply. Growth in coal demand around the world will likely help take up some of that slack, eventually. But not all of it. That's where mine closures and bankruptcies come into play. According to global coal giant, Peabody Energy (NYSE:BTU), there were over 150 mine closures in the first half of last year alone.

Most of those closures were in Central Appalachia and Northern Appalachia, regions where it is more expensive to mine. So, high cost operations are being shuttered, leaving more room for the most efficient mines. That's a very healthy sign for the entire coal industry.

Getting bigger
And then there's merger and acquisition activity. For example, CONSOL Energy (NYSE:CNX) sold five coal mines to privately held Murray Energy for $3.5 billion. That included around 30 million tons of coal reserves mainly serving the U.S. power market. Given that Murray Energy is private, it presents the opportunity to operate the five mines in a responsible manner without the need to grow for growth's sake to impress shareholders. 

CONSOL kept coal operations that serve mostly foreign markets because it believes that's a more growth oriented business. And, with the sale, it is refocusing on its growing natural gas drilling business. Murray, meanwhile, vaulted itself into the big leagues of the coal industry, nearly doubling its operations and securing the fifth spot in the top-ten list.

The top four players have been entrenched for some time and aren't likely to be unseated. That means that Peabody, Alpha Natural Resources (NYSE:ANR), Arch Coal (NYSE:ACI), and Cloud Peak Energy (NYSE:CLD) will continue to supply around half of the coal used in this country. But the movement underneath this quartet is important to watch.

For example, privately held Westmoreland Coal just secured the sixth spot with its own purchase. And while the top four names are big players, two of them are on less than secure footings. Arch Coal took on notable debt to diversify into metallurgical coal at the peak of that market. Although that could turn out to be a solid long-term move, right now the debt overhang has the market concerned about the coal giant's future.

Meanwhile, eastern thermal coal accounts for about 45% of Alpha's business. That puts the company in the region being hardest hit by closures. As an investor you have to be concerned that these operations won't make it through the shake out, which would crimp the top and bottom line. Peabody and Cloud appear to be better positioned.

Don't look now, but...
So while the market is focusing on the negatives of dirty coal and resurgent natural gas, you should keep an eye on what's going on underneath those headlines. High cost coal mines are going away and consolidation is putting the remaining mines in the hands of, presumably, more efficient operators.

And while the big names aren't likely to change any time soon, that doesn't mean there isn't room for improvement in the other 50% or so of the domestic coal market. That said, even within the big names, there could be important changes that take place. CONSOL's coal sale, for example, was a huge business shift. If Arch or Alpha needed to shore up their balance sheets or shed unwanted assets, they, too, could wow the markets with big moves.

In the end, all of these changes will help get coal back on its feet. And now is the time to be looking for investment opportunities.  

While questions remain about coal, we are pretty sure about this investment

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Reuben Brewer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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