The U.S. coal industry is emerging from a period marked by painful change, bankruptcies, and a truly horrid public image of the fuel in question. Just because companies like Arch Coal, Inc. and Peabody Energy Corporation (BTU) have emerged from bankruptcy doesn't mean that coal is back on a growth path. That's why you need to read this before you buy thermal coal stocks... and stick to industry leaders like Alliance Resource Partners, L.P. (ARLP 2.98%).
Here to stay, for a while
The good news about coal is that it isn't going away. Coal produces around a third of the power in this country, and you simply can't replace that much production overnight. That's why the U.S. Energy Information Administration's (EIA) projections include coal as a major power contributor for at least another 20 years (current projections only go out to 2040).
In the base case, coal will slowly lose share in the electricity market over that span. In the best case, it will basically hold its own. There are a couple of key facts to remember. First, coal is a very cheap fuel option. Second, coal power plants are expensive to build and last a long time. These are economic factors that haven't changed, and unless there's a really good reason to shut down a coal power plant, electric utilities are likely to keep running them for as long as possible.
But here's the real issue for coal miners: No amount of regulation can change the past. The fact is that coal has lost material share of the electric grid over the last 10 years or so. The problem wasn't clean energy, it was economics: it's cheaper and quicker to build a gas-fired plant, and since gas prices have been low, gas-fired plants are cost competitive with coal.
Giant U.S. utility Southern Company (SO -1.45%), for example, got nearly 70% of its power from coal in 2008. That number fell to just 33% last year. Natural gas, meanwhile, went from 16% to 46% over the same span. Clean energy options only rose from 1% to 4%. Clearly gas has been the big winner.
The problem for coal is that there's little chance of winning back that lost share. Across the electric grid coal plants were shut down and gas plants were built. There's no reversing that, so coal producers continue to face an increasingly competitive market. That said, the oldest and least economic coal plants have largely been shut... so the trajectory of the decline is likely to slow from here. That's basically what the EIA projections show.
To be fair, the EIA's projections are just educated guesses. And it has underestimated the growth of renewables for a number of years. There is a risk that it's being too optimistic with its coal projections. However, if you believe, as I do, that you can't shut down a third of the power grid overnight, then coal is still an interesting investment play even if the outlook isn't as rosy as the EIA currently thinks. You'll just want to stick to the best companies, or in this case partnership.
How to play this
Arch and Peabody used the bankruptcy process to clean up their balance sheets, which is great. But they can't change the backstory in the thermal coal market. Not even proposed regulations that might reward power plants that can store fuel (such as coal) can push back the clock, though they might slow the declining trend.
This is why you need to stick with a coal miner that has proven it can survive, like Alliance Resource Partners. That's true even though the individual units have been clobbered so far this year.
For starters, Alliance made money every year through the worst of the coal downturn -- a feat its peers couldn't achieve. Second, it has a rock solid balance sheet, with long-term debt at just 25% of the capital structure and a respectable current ratio of roughly 1.1. This is not a company that's at risk of financial distress.
Perhaps most important, however, is that Alliance's business is largely focused on the Illinois Basin coal region. This is a big piece of the puzzle since this region has been gaining share in the coal market at the expense of other regions for years. That's a trend that the EIA expects to continue.
So Alliance is financially strong and well positioned in the market it serves.
A huge yield that's growing
There's no question that coal's future isn't great, but the declines from here should be less dramatic. Coal miners like Peabody and Arch are in better financial shape today than they were before bankruptcy, but they are still facing the same market issues that pushed them to the brink.
Investors would be better served sticking with Alliance, a partnership that has proven it can handle adversity and that remains just as well positioned today as it was before peers started succumbing to bankruptcy. And you can collect Alliance's fat 10% yield along the way. Which brings up one last point; Alliance just increased its distribution, suggesting that the worst may, indeed, be past in the coal market.