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Industry Analysis: Coal
The Coal Industry is both cyclical and seasonal by nature, which can make the sector's results volatile. Members of this group derive the bulk of revenues by mining, processing, and marketing coal, though a small subset design and manufacture equipment used to extract the fuel and other bedded materials. The companies under our review are all based in the United States, and a few have extensive worldwide operations. Though most offer investors a regular dividend, coal equities are generally considered growth holdings. Our reports on this sector are presented in the standard industrial format.
Demand and Prices
The industry is highly dependent on worldwide energy demand and pricing. The majority of domestic coal production is consumed by electric power plants. In a challenging economic climate, during periods of warm weather, and/or when the prices of competing fuels are low, coal usage can quickly drop off, resulting in a rapid build up of excess inventory at power producers. If global economies are booming, shortages can disrupt the market, pushing up coal prices. Often, it will take several quarters for the coal market to revert back to a normal balance between demand and supply.
Demand for metallurgical, or hard-coking coal, is reliant on global steel production. A high-quality variant, met coal is the primary energy source fueling steel mills and serves as a key ingredient in the manufacture of the metal. This fuel has more direct ties to the economy than its thermal sibling, given the extensive use of steel in commercial and public construction and infrastructure projects.
Thermal coal competes with other fuel sources, mostly oil and natural gas. Historically, coal has enjoyed a solid cost advantage, but that gap has narrowed significantly in recent times. Economic, natural, and political events may cause the price levels of competing fuels to spike, especially in periods of peak demand, and the value of coal will rise in kind. Situations of oil/gas oversupply, usually temporary, will, to a degree, erode coal's allure as a fuel.
The coal mining sector is highly cyclical and capital intensive, thus earnings are difficult to predict. During good times, when asset utilization is maximized, margins are at their widest. The largest operators have the greatest leverage. However, in slack periods, margins will suffer considerably, with costly equipment sitting idle. Managements commonly hedge interest rates, foreign currencies, and fuel in an effort to limit earnings volatility; the benefits of such activity, though, are often limited. Income taxes are another important factor influencing net income. Companies have to accurately gauge demand, asset utilization, and mine depletion for a given year to make sufficient tax provisions in each quarter. Tax rates differ considerably across the group.
In addition to their core production business, several coal companies maintain brokerage arms. Of course, revenue and income from these secondary activities are rather unpredictable, since trading entails fast changes in demand and spot prices. Large positions can have a big impact on operating results.
Supply-and-demand imbalance is the biggest risk for the industry. Managements must assure that there are sufficient reserves available to meet short- and long-term production demand for various grades of thermal and metallurgical coal. Successful operators are proficient in forecasting demand, acquiring/developing mines, limiting excess capacity, and minimizing disruptions to output.
There are some factors beyond a company's control, most notably severe weather. For example, flooding can bring mine production and rail transportation networks to a halt, and storms can keep dry bulk ships sitting in ports. Lengthy delays hurt the bottom line. Another risk factor worth noting is the price of competing fuels, such as natural gas, which can have a deleterious effect on demand for coal.
State and federal regulations, environmental legislation in particular, also pose uncertainty for the industry. Coal combustion, especially at power plants, emits considerable volumes of nitrous oxide, carbon dioxide, and sulfur. Spending on environmental compliance reduces the cost advantage of coal over alternative fuels. A market for trading pollution credits could be a factor in coal's viability as a power source. Subsidies for alternative fuels (e.g., nuclear) can also have a significant impact on the demand for coal.
Coal production requires heavy investment in technology, equipment, land, and personnel to deliver bulk quantities and gain sufficient economies of scale. The industry's barriers to entry are quite high. Capital spending to maintain, improve, or replace existing facilities is continuous and considerable. Fixed costs need to be spread over a large operating base. During prosperous times, companies often use free cash flow to pare debt. In difficult times, characterized by low demand, weak pricing, modest capacity utilization, and unfavorable operating margins, coal producers may decide to merge in order to survive.
In most cases, managements prefer to use cash to enlarge the business. Internal expansion is generally more profitable, but it's also time consuming and may leave a company vulnerable to stepped-up competition from other producers of coal and new sources of energy. Acquisitions are an expedient route to growth, but can be costly, given the challenge of integration.
The stock of a coal company, structured as a corporation, is essentially a growth investment, paying a nominal, if any, dividend. Coal operators, set up as limited partnerships, offer meaningful distributions, with periodic increases, and high yields to those seeking more stability.