According to John Eaves, CEO of Arch Coal (NYSE:ACI), "If you think about the last 3 or 4 down cycles we've been through, one thing we know is we will correct and sometimes overcorrect." That's an important thing to keep in mind in the metallurgical coal market, which Eaves thinks is in an oversupply situation right now even though the future for demand looks bright.
The met coal problem
Arch Coal's CEO believes there is between 15 million and 25 million tons of excess metallurgical coal floating around the world. That's a big problem if you are a met miner because it keeps prices in the 325 million ton seaborn met market depressed. Arch Coal, for example, saw a nearly 10% year-over-year decline in prices in the Appalachian segment of its business, where its met coal is mined, in the first quarter.
It's no wonder the miner and met-focused peer Walter Energy (NASDAQOTH:WLTGQ) are bleeding red ink right now. And Arch Coal doesn't see a turnaround in this high-margin business until at least 2015, which means more red ink despite improvements in its thermal business (low margin thermal coal made up about 80% of revenues in 2013). Walter Energy, meanwhile, which gets virtually all of its revenues from met, could be in for a particularly rough ride in the second half.
So how is this pair of industry players adapting to the oversupply situation? In the first quarter, Walter sold less met coal and mined more of it, year over year. And the discrepancy was pretty big: coal sales volumes were off roughly 6%, but production increased 13%.
At the other end of the spectrum is Arch Coal. CEO Eaves commented to analysts that, "We're not the only producer electing to cut back production as you know, in fact with the settlement of the second quarter met benchmark announcements of production rationalization and idlings have grown from Australia, Canada and the U.S. We expect more to follow." troubled Patriot Coal, for example, recently idled met mines that produced 1.4 million tons of metallurgical coal.
Wouldn't it seem more logical for Walter Energy to have followed Arch Coal's lead and pulled in the reins instead of digging more coal? Maybe, maybe not. Although Arch Coal is clearly working to reduce supply, it openly discusses the future opportunity in the met coal market. CEO Eaves highlighted the need for steel in fast developing emerging markets, concluding that, "All this suggests that world steel demand should be on track for 3% growth this year, and as the world absorbs the current oversupply; we expect that met markets will recover."
In other words, the future is bright for metallurgical coal, which is used in steel making, even if the picture today is a little rough. No wonder Walter Energy is still mining. Indeed, while shutting high-cost mines makes sense, it takes more than the flip of a switch to open and close a mine.
Over and under
That's why Arch Coal's Eaves used the word "overreact" when discussing the met coal market. If low prices push enough met miners to close up shop, oversupply could quickly turn into undersupply. According to him, "it wouldn't take a whole lot to balance this thing pretty quick."
If met prices rise quickly, heavily indebted Walter Energy's troubles would disappear. And it would have the volume to capitalize via additional sales. Arch Coal and Patriot Coal, among many others, would have to ramp back up. That could leave them behind the curve. Arch Coal, for example, closed mines that were cash flow drains and has no plans to bring production back unless there's a sustained improvement in the market.
It's hard to say which miner is making the right choice, but neither can afford to lose money indefinitely. That said, keep an eye on the supply/demand dynamic in the metallurgical coal market because it will have a big impact on Walter Energy and Arch Coal. If things even out quickly, Walter will likely be quicker to benefit. If not, Arch will look like a survivor and Walter could be in for serious trouble.
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.