PCX Patriot Coal Corp.

The rebound phase for the coal industry from the 2008-2009 turmoil continued in 2011. The global economic outlook started improving following the turmoil of late 2008. The U.S. economy came out of the recession in the summer of 2009 and has been in a recovery mode since then, though the pace of improvement appears to have weakened lately.

Like the other commodity sectors, the fortunes of the coal industry are closely tied to the health of the global economy. The post-recession demand recovery helped improve the group’s earnings power, with most coal companies solidly profitable in 2010. This uptrend in demand, largely driven by the improvement in the global economic activity, rebound in domestic power demand, favorable weather patterns and soaring coal demand from Asian countries, also continued into 2011.

Coal Fuels Power Generation: As we already know, coal as a major source of fuel for power generation dominates the Utility industry. Coal is used to generate about half of the electricity consumed in the United States, and is also the largest domestically-produced source of energy. Electricity generation absorbs about 93% of total of U.S. coal consumption. The reason is simple: coal is by far the least expensive and most abundant fossil fuel in the country.

In contrast, petroleum and nuclear power as a source of power generation have been losing market share displaced by the strong growth of renewable sources of generation and natural gas-fired generation. Petroleum is losing out to coal because it is becoming increasingly expensive.

The outlook for nuclear energy appears bleak at the moment because it has been dealt a severe blow by the current ongoing events in Japan. The chaotic situation in Japan that has created an uncertain future for the nuclear industry is also a net positive for the coal industry.

Coal as an Input for Steel Industry: Coal as a fuel source also contributes to the production of steel. The demand for metallurgical coal (coking coal), a key ingredient in the production of steel, has increased from 2009 levels based on the recovery of the global steel industry.

The rise in demand for steel in China, followed by India, acted as a major driver for global demand and influenced the pricing for coking coal in 2010. This was also seconded by a recovering demand in the U.S. and Europe. The U.S. steel industry operated at about a 70% utilization rate in 2010 compared to a 40% utilization rate for most of 2009.

Industry Trends

Demand for U.S. coal was strong in the first quarter. This was mainly driven by metallurgical exports but demand for thermal coals remains strong in both the domestic and international markets.

Demand Upsurge in Asian Countries: The global upsurge in coal demand has been the key price driver since the end of the recession. We expect this trend to continue in future mainly due to the growing energy needs of the world’s two largest coal consumers, India and China.

China, the world's fastest growing major economy, has massive coal reserves. But China's energy consumption in 2010 witnessed such rapid growth that the country’s imports for the year exceeded exports. China has overtaken the U.S. as the world's heaviest consumer of coal. In spite of the rise in China's coal imports and ample domestic coal production, the country continued to experience shortages in 2010.

Meanwhile, with the rising population and economic growth India witnessed in 2010, the country’s demand for coal has also risen substantially. Coal accounts for nearly 55% of the country's energy consumption needs. The last four decades has seen the country’s commercial energy consumption rise by about 700%. Going forward, India plans to double electricity generation capacity by 2012, which could see the country importing in excess of 200 million tons of coal.

U.S. Coal Exports on the Upside: Strong global demand for coal, particularly for metallurgical coal used to produce steel, resulted in sharp increases in U.S. coal exports. The earthquake in Japan may have been a short-term dampener on growth, but globally, the steel industry remains in full growth mode. China, the world's largest blast furnace iron producer, continued its strong growth in 2011 with over 58% of the world's production.

Supply constraints in key nations such as Australia, Indonesia, South Africa, South America and Canada, prices for metallurgical and thermal coal provide opportunity for more exports from the U.S. Thus we believe met coal companies like Arch Coal Inc. (ACI), Walter Energy Inc. (WLT), Alpha Natural Resources Inc. (ANR) and Patriot Coal Corporation (PCX) form attractive investment avenues.

According to the Energy Information Administration (EIA), the United States exported 51% more coal in the first six months of 2010 than it did for the entire 2009. While coking coal remains the primary export, exports of steam coal led recent growth, rising 160% over the same period.

The EIA expects U.S. coal exports to remain elevated in 2011, reaching an annual level of 98 million short tons (mmst). The EIA expects total coal exports to fall back to typical historical levels of approximately 80 mmst in 2012 as supply from other major coal-exporting countries recovers.

The EIA also expects the strong global demand for coal to continue to suppress coal imports, with imports at levels below 19 mmst in both 2011 and 2012. U.S. coal imports averaged about 31 mmst annually from 2004 through 2009.

Given the growing demand from the fast-growing Asian economies, we find companies exporting coal to international locations attractive for investment. Some of the names having such exposure are Peabody Energy Corporation (BTU) and CONSOL Energy Inc. (CNX).

Thermal Coal Prices Stable: Demand for coal used in the electric power sector saw a modest rise in 2010 due to the higher electricity consumption during the hot summer. Over the last 10 years, the prices for coal delivered to this sector also have seen a relatively steady increase reflecting longer-term coal contracts initiated during a period of high energy prices, rising transportation costs and increased consumption.

However, the EIA projects the price of thermal coal used in power generation will remain stable in 2011 and 2012 as coal competes with natural gas for generation market share. The projected power-sector delivered coal price, which averaged $2.26 per MMBtu in 2010, averages $2.28 per MMBtu and $2.26 per MMBtu in 2011 and 2012, respectively.

The key thermal coal players in the industry include James River Coal Co. (JRCC) and Cloud Peak Energy (CLD). Apart from this, certain coal master limited partnerships (MLP) including Penn Virginia Resource Partners L.P. (PVR), Natural Resource Partners L.P. (NRP) and Alliance Resources Partners L.P. (ARLP) are also good investments for people seeking exposure in the coal sector.

Common Threats

Environmental Legislations: Coal has been losing its importance as a fuel source over the last few years, particularly in the U.S., vis-à-vis other sources that have a lesser impact on the environment. Concerns on the emission of greenhouse gases and global climate change have resulted in the formulation of new legislations and policies which emphasize on the use of environment-friendly fuel sources, particularly in the power sector.

This has considerably slowed the expansion of coal-fired capacity in the power sector, with utility companies now building new natural gas-fired plants and resorting to alternative sources of energy generation like wind, solar and hydro power. It remains to be seen what impact the Japan disaster will have on the industry’s fortunes going forward. But it has to be a net positive.

Natural Gas Substituting Coal: A major substitute for coal in energy generation is natural gas. Natural gas is usually an attractive choice for new generating plants because of its relative fuel efficiency, low emissions, quick construction timelines, and low capital costs. Cheaper natural gas and large coal inventories have greatly hurt the U.S. and European thermal coal demand in 2009. Looking ahead, we expect the thermal coal demand to remain slightly under pressure based on the expectations of lower gas prices.

Natural gas generation is likely to become more competitive over the coming years given its abundant domestic availability and the threat of regulation hanging over the Coal Mining industry. Not only coal, natural gas also substitutes the use of renewable and nuclear energy for electricity generation, as new natural gas-fired plant is much cheaper to build than new renewable or nuclear plants.

Competition from Alternative Energy Sources: Apart from natural gas, the coal industry has been losing a major share of its electric generation demand to renewable sources of energy like wind, solar and hydro power. Generation from renewable resources grows in response to key Federal tax credits, but it is expected to be lower in 2011 than in 2010 because of lower natural gas prices and higher costs for new wind power plants.

Growth in renewables has also been supported by the many State requirements which stipulate the installation of renewable sources of electricity generation as mandated by Renewal Energy Standards (RES). The share in energy generation of renewable fuels (including conventional hydro) is projected to grow from 11% in 2009 to 14% in 2035, as per EIA’s long-term outlook.

Conclusion

Though there is ample pressure from legislations and competition from natural gas and renewable energy sources, we believe the global power industry will continue to depend on coal for a large part of its generation. Coal as a fuel source will continue to power the growth in emerging nations like China and India, both for utility companies and steel makers. This trend gets a further boost from problems that Japan has been facing with its nuclear reactors following the earthquake and Tsunami.

With the discovery of abundant shale natural gas in the U.S. and the lower natural gas prices, the long-term competitive dynamics may have moved notably against coal. It is, however, far from certain or clear at this stage.

Moreover, coal and utility companies in the U.S. and across the world are adopting the development of clean coal technology to achieve near-zero emissions, which opens up avenues for potential long-term industry growth. Clean coal technology development in the U.S. has funding earmarked under the American Recovery and Reinvestment Act of 2009. This is an encouraging sign for world coal producers.
 
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