Zacks Commentary: Industry Outlook

While production cuts will help prices from falling off a cliff, these will likely impact earnings in 2009 as higher unit costs and lower met realizations shrink margins. Until the economy and investors start to see the tangible effects from the late '08 and early '09 monetary and fiscal stimulus packages put in place on a global scale, there will not be any catalysts to move stock prices in the coal space -- thus trading flat through 3Q’09.

On a more positive note, while benchmark metallurgical prices for fiscal 2009 were recently set around $120/mt -- off markedly from the $300/mt level seen in 2008 -- this is still above historical met price levels. This could possibly be an indication of an implied floor due to the perfect storm of negative economic data.

U.S. producers have continued to cut production for 2009 in hopes of reducing oversupply at utility stockpiles to the tune of 50-60 MM tons thus far and will likely go up. As mentioned before, the production curtailment is in effort to offset the estimated 5% - 8% decline in domestic coal consumption in ’09.

OPPORTUNITIES

The larger coal players with strong balance sheets will be able to capitalize on the current market environment in the form of acquisitions. With asset prices coming down from mid-'08 levels and smaller producers feeling the strain on margins, this represents an opportunity to acquire reserves on the cheap. Additionally, many producers will generate a significant amount of free cash flow during 2009.

Also, if credit markets remain unfavorable, this would be an opportune time for management to either 1.) Strengthen its balance sheet, or 2.) Buy back shares of its stock. Both of these would likely have positive near-term effects on stock prices.

In particular, we like companies with exposure to the international coal markets as well as the Powder River Basin (PRB) in the U.S. Companies like Peabody Energy (BTU) and Arch Coal Inc. (ACI) look attractive currently. Both of which have recently engaged in long-term growth acquisitions.

Peabody is the largest pure-play coal producer, with significant leverage to the Australian export market. Due to the high quality of coal produced and its proximity to Asia (emerging markets) Australian seaborne coal trades at premium to all other coals. Peabody would benefit especially when China and other Asian emerging markets begin to rebound. The stimulus packages enacted by the federal government during the recent months should start to pay dividends toward the end of '09.

Arch Coal has a significant amount of reserves and is a top-three producer in the PRB. In our opinion, PRB coal will be in great demand over the coming years. The significant coal-fired power plant build-out will increase annual thermal coal demand by more than 60 MM tons; approximately 50% of this new demand will be met by PRB supply. Its likely acquisition of Rio Tinto’s (RTP) Jacobs Mine will increase ACI’s PRB market share while gaining operating synergies.

WEAKNESSES

Appalachian producers continue to face productivity problems via shortage of skilled labor, MSHA inspections, and other permitting and regulatory hurdles relating to the Clean Water Act. While the falling cost of steel and fuel will reduce the cost of direct materials, these other issues will more than offset. If the global economy -- particularly regarding its demand for steel -- is slow to recover, this could mean prolonged price suppression for CAPP and NAPP coal, which could lead to reduced production, idled mines and higher unit costs.

More recently there have been several debates regarding the effectiveness of "cap-and-trade." Basically designed to impose a per ton expense on carbon dioxide emissions, the coal and utility industries have been opposed to this system claiming that it will drive up the cost of coal, and put an effective tax to people living in the Midwest U.S. The cap-and-trade system may pose long-term problems for the coal industry as it would increase the cost of coal, thereby decreasing its competitiveness as an energy source (and decreasing demand for it) and would force businesses to use less reliable and more expensive forms of energy.

Assumptions for 2009 Average Prices:
Thermal Coal Prices: $60- $75 per ton
Metallurgical Prices: $100 - $125 per ton