The demand for coal has been fading, and coal companies have been sent to the basement. Investors often argue that since natural gas prices rose significantly since May 2012, the demand for coal should increase. However, I believe the demand for coal will remain low in the near future for the following reasons:
Governments around the globe are imposing tougher measures to coal power plants to reduce environmental pollution.
China’s purchase management index reading shows signs of manufacturing contraction. The economy seems to be slowing down, which will cause a drop in electricity demand. Since coal is the fuel that produces 79% of the electricity in China, the demand for coal may deteriorate further.
Although natural gas prices have rebounded over the last 12 months, statistically, the price has remained relatively constant since 2009.
The effects of a dim demand for coal
Arch Coal Inc (NYSE:ACI) is the second largest coal producer in the United States. According to its most recent quarterly earnings statement, its revenue fell 21% to $826 million on a year-over-year basis. The company ended the quarter with a net loss of $70 million, compared to a profit of $1 million last year. Its cash from current operations fell by $12 million to $43 million. Its free cash outflow at the end of the period was $20 million, compared to $47 million last year. Although its free cash flow resulted in negative numbers, it was narrowed considerably. Analysts rate the stock a 4.0 on a 5-point scale where 5 is buy and 1 is sell.
However, I do not agree with these recommendations. Although the stock has fallen from $35 in early 2011 to just over $4 now, there is no reason to catch the falling knife. The company’s subsidiary Asia-Pacific Pte. Ltd. established operations in Beijing to increase its footprint in the world’s second largest economy. The company claims that it will be able to easily access neighboring coal markets such as India, Malaysia, and other Asia-Pacific countries. However, Indonesia is the world’s largest coal exporter, and the competition will be tough. Moreover, as China’s manufacturing decreases, the demand for coal should continue to remain low.
Peabody Energy Corporation (NYSE:BTU) operates mines in Illinois as well as in Queensland and New South Wales in Australia. The company has exited high-cost Appalachian coal basins and entered into lower-cost coal mining regions. According to its most recent earnings report, its revenue fell 15% to $1.74 billion. The company finished the quarter with a net loss of $23 million, compared to a net income of $173 million a year ago. On the bright side, the company’s free cash flow increased by $28 million to $198 million.
Although Peabody Energy Corporation (NYSE:BTU) has transitioned from high-cost mining regions to low-cost coal mines, the demand for coal will continue to put downward pressure in the company’s revenues. One advantage of Peabody Energy Corporation (NYSE:BTU) is that its increase in free cash flow should put investors’ mind at ease with respect to the safety of its 1.8% dividend offer. One imminent problem that the company faces is the China’s move to ban coal imports with high concentrations of sulfur. Why would this become a problem? The Illinois Basin coal contains more than 1% of sulfur. Before committing your money in this coal company, you should look for the outcome of the proposed ban from China, as it should have a direct impact in Peabody Energy Corporation (NYSE:BTU). Further, investors should look for improving signs in the coal markets.
Another aftermath of a weak demand for coal
Coal is also a fuel utilized in the steel industry. Weak demands for coal signal weak demand for steel as well. United States Steel Corporation (NYSE:X) recently missed analysts’ estimates by posting a first quarter net loss of $73 million, narrower than the net loss of $219 million posted last year. The net loss was mainly due to a loss of $13 million from its steel sector, compared to a net profit of $183 million over the same period.
I believe that the demand for steel should decline, which will hurt United States Steel Corporation (NYSE:X)’s revenues. China’s urbanization, although it is still expected to continue, will develop at slower paces reducing United States Steel Corporation (NYSE:X)’s exportation potential. One positive aspect is that the company should see lower costs of operation due to low prices in coke, the coal-based fuel used for steel production. As the demand for coal remains weak due to global economic concerns, the price of coal should not increase significantly. As long as the demand for coal and steel remains low, United States Steel Corporation (NYSE:X) does not present an attractive investment prospectus, and thus investors should steer to other directions.
Don’t get fooled!
The demand for coal remains weak, and coal-based companies are not appealing to commit our money in the sector. Investors should look for improvements in the overall world economies, particularly in China as it is the main importer of coal, to consider investing in any of these companies. Further, investors should wait until the proposal to ban certain coal imports in China is resolved, as it may affect US companies substantially.
The article Halt! Consider This Before Investing in Coal Companies originally appeared on Fool.com and is written by Robinson Roacho.
Robinson Roacho has a short position in X. The Motley Fool has no position in any of the stocks mentioned. Robinson is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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