Why Coal Prices Might Be Set for a Rebound

Though the coal sector continues to struggle due to plunging prices, the news isn't all bad for the sector. In fact, the confluence of information from Peabody Energy (NYSE: BTU  ) suggests that a turn is all but certain.

For domestic coal investors, Peabody Energy provides the best insight into the global commodity with mines in both the U.S. and Australia along with customers on six different continents. The industry news is consistent with the information doled out by Arch Coal (NYSE: ACI  ) a few days ago.

As with any commodity, the supply/demand equation depends as much on supply scenarios as it does the demand side. In the case of coal, the global demand equation remains robust, but the supply remains abnormally high considering the downdraft in prices. Typically, the long-term nature of constructing mines can cause new supply to come online just as prices plunge. This scenario has set up some incredible numbers from Peabody Energy this quarter.

Dwindling domestic inventories
The company reported that the domestic coal stockpile had the largest withdrawal in 36 years. Additionally, the Southern Powder River Basin inventories stand at only 44 days. The amount is already 50% below the peak levels of two years ago. No surprise that Powder River Basin-focused miner Cloud Peak Energy (NYSE: CLD  ) has already soared to multi-year highs and is approaching all-time highs. The stock trades at an expensive 40 times 2015 earnings, suggesting that investors have already priced in the rebound in that segment.

In the global markets, the news hasn't changed much for the positive long-term demand picture. China continues working toward closing low-quality mines to the tune of 1,700 small mines. Global demand is expected to grow by 250 gigawatts of new coal-fueled generation in the next three years. In total, the expectations are that 750 million tons of thermal coal will be needed to meet the forecast utilization demands. As an example of scope, Peabody Energy expects to sell around 255 million tons of coal in 2014.

Capital spending plunge
Possibly the most stunning number from the first quarter is that Peabody Energy spent the lowest amount on capital investments in the last 10 years. The miner only spent $24.4 million during the first quarter, allowing for operating cash flow of $54.1 million to exceed expenditures by $30 million.

Peabody Energy further reduced annual capital spending targets to $250 million to $295 million with the focus on sustaining existing projects. Though one of the largest miners continues to forecast a strong demand scenario over the next three years, it isn't spending any money to develop new mines and expand capacity.

Arch Coal forecasts spending around $185 million on capital projects during this year. The company spent $297 million in 2013 and nearly $400 million in 2012. In total, capital expenditures will drop 50% within two years for Arch Coal.

Debt hurting
Despite the weak results, Peabody Energy actually produced an operating profit of $6 million. The major problem is that the nearly $6 billion of debt commands $100 million in quarterly interest payments.

Cloud Peak has mostly maintained profits during this period, suggesting the Powder River Basin area at least provides a more stable investing environment. Also, it doesn't provide the same level of snap-back rally.

Unlike Peabody, Arch Coal isn't close to generating an operating profit. The company saw its operating profit plunge to a loss of $73 million, suggesting the company needs a meaningful rebound in coal prices to regain an acceptable financial performance.

Bottom line
With domestic inventories shrinking at alarming rates and international demand set to soar, the lack of capital spending in the coal sector sets up a strong scenario for prices. Unfortunately, it also highlights the cyclical nature of the industry with the current trough leading to another peak in a few years. With Cloud Peak Energy trading at an expensive earnings multiple and Arch Coal showing substantial losses, Peabody Energy remains the best way to play a snap-back rally in coal.

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