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Is the Coal Market Catching Fire?

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In the past several months, the coal market has shown signs of recovery, mainly because of harsh winter conditions in the U.S. coal companies such as CONSOL Energy (NYSE: CNX  ) and Arch Coal  (NYSE: ACI  ) have benefited from these developments. But is the coal market heating up enough to augment their revenue and improve their profit margins in 2014? Let's take a closer look.

Boost in demand from weather 
The colder than normal winter has lifted the price of natural gas to higher levels. The rise in natural gas prices, mainly for heating purposes, has resulted in utility companies shifting back from natural gas to coal. On a yearly scale, the U.S Energy Information Administration expects that U.S. coal demand will increase by 4.6% to 966 million short tons. The rise in demand for coal should also boost coal production. The EIA estimates coal production will rally by 3.2% during 2014 to 1,028 MMst.

These changes are likely to reflect a higher level of production for leading coal companies such as CONSOL Energy and Arch Coal, especially in the first-quarter earnings reports. According to Arch Coal's annual guidance for 2014, the company still expects a 2% decline in its coal sales (in tons) from 139.6 million tons in 2013 to an average of 137 million tons. The improved coal market conditions could result in higher than expected coal production. Moreover, if the price of coal rises further, this could improve its operating margin and cut down the company's losses.

CONSOL Energy has also expanded its proved natural gas reserves by 44% to a record high of 5.7 trillion cubic feet equivalent last year. The increased natural gas operations came at the expense of the company's coal projects. In 2014, CONSOL Energy expects its coal production to decline by 44% (year over year) to 31.1 million tons, mainly because of the five West Virginia Longwall coal mines it sold during the last quarter of 2013. Therefore, the company is likely to benefit not only from the rise in demand for coal, but also from the rally in natural gas prices. 

Despite the recovery of coal in the first quarter of 2014, the coal market isn't likely to improve on a yearly scale. Further, coal companies won't increase their revenue or widen their profit margins for the following reasons:  

  1. Higher demand doesn't translate to higher prices: Back in 2013, the demand for coal rose, but this rally didn't pull up the price of coal -- it fell by 1.2% to $2.35 MMBtu. Moreover, in 2014, the price of coal is expected to remain low at $2.36 MMBtu. As a result, coal margins aren't likely to improve even if the demand for coal rises.
  2. Lower exports: The EIA estimates coal exports will decline to 103 MMst in 2014 -- a 13% drop, year over year. Further, coal exports are still a small portion of the coal market: They represent 13% of total demand for coal in the U.S. in 2013. Some suspect U.S. exports to Europe, which account for 50% of total exports, may rise because of the recent turmoil in Ukraine. Even if exports rally, the ongoing decline in coal trade prices is likely to reduce the margins on coal sales. This trend could eventually make it less profitable to export coal.
  3. Environmental costs: The U.S. Environmental Protection Agency has made it very expensive to operate coal-fired plants by enforcing its Mercury and Air Toxics Standards. This is why utility companies are slowly closing coal fired plants and not opening new ones. Case in point, back in 2013, FirstEnergy closed two of its coal-fired plants as they incurred $280 million in fines the company had to pay. 

The coal market has heated up in the past several months, but this rally won't be enough to improve coal producers' operating margins or revenues on a yearly scale. Even if exports start to pick up, they won't be enough to keep the coal market hot. On the other hand, if the price of natural gas remains elevated and higher than its normal levels, this could pressure up coal prices. Higher coal prices could be enough to improve coal companies' operating margins and increase sales. 

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Lior Cohen

Lior has been a contributor for the Fool since 2012. His main interests are in commodities, and energy and materials companies.You can follow him on Twitter to stay up to date with his industry analysis. @tradingnrg

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