The coal industry's product is not coal. It is energy. And the power-generating industry has become the chemical processing plant for the coal industry. Each year, utilities are forced to install more equipment to sort out the waste that comes with coal.
In the face of these challenges, the coal industry sends more, not less, waste along with its energy. The winners will be the coal companies that find ways to ship more energy and less waste to their best customers, the electric utilities.
Nothing is more telling than the reports published by the Energy Information Administration (EIA) that suggest that utilities are buying lower-quality coals. Year over year, the quality seems to deteriorate.
As my last article argued, growing volumes of waste products are causing utilities to incur higher production costs and increased regulatory oversight. That combination is making coal-fired power plants uncompetitive in the new power markets.
The power markets will force a change. The trend of using progressively lower-quality coals is unsustainable. The growing costs of managing wastes and declining prices for wholesale power will cause a new equilibrium to be established. This new equilibrium will likely reject low-ranked coal and reward high-quality fuels.
Without states approvng rate cases to benefit their local mining operations, the utility industry is putting the brakes on the coal industry. Faced with growing coal processing costs, utilities will either retire power plants that depend on low-Btu coal, modify plants to deal with growing waste issues or modify plants to use higher-quality fuels. For the present, it appears that utilities are considering all three. In the future, retirements will evaporate, and only the best in breed will survive.
As utility customers cull out struggling power plants, the coal industry will be forced to do the same. The winners will be the low-cost producers. But in the energy industry, the low-cost producers must also consider the total costs of the entire value chain. For coal-to-electric industry, the value chain begins with the mine mouth and ends with the utility's meter.
The winners will likely be the coal companies that provide the highest value for the least cost to electric utilities. That suggests that winners must have access to coals that have high-energy content, low-waste content, low mining costs and low transportation costs.
Coal companies that have assets in Northern Appalachian Coal Basin seem to fit the bill. This area includes western Pennsylvania, western Maryland, West Virginia, eastern Ohio and northeast Kentucky, and it is near the nation's major power markets. While significant amounts of the low-hanging fruit have already been harvested, some coal companies that operate in this region are doing well. In all likelihood, they will continue to do well.
An example is Alliance Resource Partners (ARLP). According to its profile, Alliance is the nation's first publicly traded master limited partnership involved in the production and marketing of coal. It began mining operations in 1971 and since then has grown through acquisitions and internal development to become the third-largest coal producer in the eastern U.S.. Alliance has a market cap over $2 billion, a price-to-earnings ratio over 10 and a dividend of over 6.5%. Year-over-year revenue and net income are growing. Cash flows and balance sheets are strong, and investments are growing.
Rhino Resource Partners (RNO) is another master limited partnership operating in the same region and serving the same customers. In addition to its coal interests, Rhino invested in oil and gas mineral rights in the Utica Shale and Cana Woodford regions, which began to generate royalty revenue in early 2012. Rhino has a market cap over $400 million, a P/E over 17 and a dividend over 11.5%. Year-over-year revenue and net income are recovering. Cash flows and balance sheets are strong, and investments are growing.
In contrast, Natural Resource Partners (NRP) also has a substantial footprint in the same region. But it owns low-ranked coal resources (lignite) in the Gulf States. Natural Resource Partners has a market cap over $2.2 billion, a P/E over 17 and a dividend over 10.4%. Year-over-year revenue is growing. On an annual basis, National Resource's net income vacillates. Its cash flows are strong, but its balance sheets also vacillate. The vacillations suggest a moderate level of risk for coal investors.
In the U.S., coal is not going away anytime soon. Nevertheless, in 2012, coal as a percentage of the overall power production mix fell below 40% for the first time. Last year, coal fell below 35% for three months. There was not a single month in 2012 when coal exceeded 39%. Yet Alliance and Rhino did well.
Focused cost leaders will survive, and they will prosper.