Is U.S. Coal Overhyped?

There are big issues in the global mining industry. Mining equipment producers Joy Global (NYSE: JOY  ) and Caterpillar (NYSE: CAT  ) have both reported falling equipment purchases, signaling that miners are still being pinched. It's nice to think of an imminent turnaround thanks to increased 2014 production, but these increases must be taken in context of previous production cuts. In 2014 and beyond, turning a profit on high-cost coal in the face of limited export capability is a huge challenge.

The canary in the mine
In the first quarter of 2014 Joy Global reported that its underground mining machinery sales fell 24.7% and its surface mining equipment sales fell 13.8% from Q1 2013. Caterpillar is facing a similar situation where its Q4 2013 resource industry's sales fell 48% from Q4 2012.

Caterpillar knows that miners are trying to do more with less. They are increasing production while cutting back capex and thus equipment purchases. Joy Global tries to put a positive spin on the U.S. coal market by highlighting that production is expected to increase 35 million tonnes to 45 million tonnes in 2014. These numbers are true, but they obscure the fact the EIA only expects a 3.8% increase in 2014's total coal production over 2013 levels. A 3.8% increase only brings the industry 1.8% above 2012's total coal production, a paltry increase. 

Export constraints pose a big challenge 
America is leaving coal in for other fuels like natural gas and renewables. This means that for U.S. coal miners to see substantial growth they need to export. The problem is that getting the required export facilities approved is a huge political controversy. Many people have come out against the proposed Gateway Pacific Terminal and its 54 million annual tonnes of dry bulk commodity export capacity. Just look at the Keystone XL pipeline to see how political opposition can drag out an approval process for years and years.

Alpha Natural Resources (NYSE: ANR  ) was recently hit with a $27.5 million EPA fine and will have to pay around $200 million to upgrade its waste water treatment facilities. In addition to these fines Alpha Natural Resources' fundamental problems remain. In 2013 its Eastern Coal cost of sales was $72.51 per ton while its respective revenue was $77.46 per ton, leaving a very thin margin.

Its Powder River Basin (PRB) operations have better margins, but export constraints make it very difficult for its PRB operations to erase its Eastern challenges. Arch Coal (NYSE: ACI  )  is in a similar position. Arch Coal did recently sell 38 million tons of Kentucky thermal coal reserves for $26.3 million, but the company still has thin or negative margins. 

In 2013 Arch Coal's Appalachia cash per ton margin as a percentage of average sales price was a small 8.3% with a negative operating margin, while its PRB posted a comparable margin of 14.4% with a positive operating margin. Alpha Natural Resources and Arch Coal are stuck with unprofitable, older deposits, but its profitable operations cannot erase losses due to export constraints.

The future for equipment manufacturers 
Coal miners are still holding on to expensive Appalachia assets, putting a lid on their profits and enterprisewide production growth. At the same time Alpha Natural Resource's total debt-to-equity ratio of 0.84 and Arch Coal's total debt-to-equity ratio of 2.29 limit their ability reorganize their operations.

The end result is that Joy Global and Caterpillar should not expect to be saved by the U.S. coal industry anytime soon. In Q4 2013 Caterpillar's Resource Industries segment was only 21% of its consolidated sales and revenue, showing that Caterpillar is sufficiently diversified to weather any downturn in the U.S. coal industry. Joy Global is in a tougher situation as underground and surface mining equipment are its only two business segments. The upside is that Joy Global's $610.4 million in service revenue accounted for 70.9% of its total Q1 2014 revenue.

Be cautiously optimistic
Coal is one of America's biggest fuel sources, but until expensive mines are shut down and more export capacity is built Arch Coal and Alpha Natural Resources will have low margins and small capex budgets. The market will rebound eventually, but for now expect low or zero growth for U.S. coal miners and little help for equipment manufacturers like Joy Global and Caterpillar.

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