Until very recently, it seemed like thermal coal producers couldn't buy a break. Utility inventories were well above historical averages, prices were barely sufficient to break even, and demand continued to decline (as seen in the traffic numbers for major railroads). That's taken the price of Arch Coal (NYSE:ACI), the country's second-largest coal producer) down more than 90% over the past five years. Now it seems like there are some signs of life in the thermal coal market, but will the recovery be strong enough to meaningfully improve the fundamentals for this struggling coal producer?

Inventories Heading Down And Demand Heading Up?

Coal stock investors finally have a little good news to celebrate, as March marked a meaningful decline in utility coal inventories. While inventory levels were still about 18% above the 10-year average, there is reason to hope that maybe, for the first time in many years, inventories will reach normal levels.

Helping matters, it looks like the big coal-to-gas switch that defined 2011 and 2012 is starting to reverse. With Henry Hub natural gas above $4.10/MMbtu, Powder River Basin coal is once again very cost-effective and Illinois Basin coal is at least close to competitive. At the same time, adverse weather seems to be compromising hydro-power generation and leading to more coal demand.

SEE: Green Energy: Why We’re Still Not Using It

There's A Big “But”...

Unfortunately, it may be a little premature to assume that coal inventories are going to normalize and/or that coal prices are going to start marching back up. For starters, industry sources have estimated that there could be as much as 100 million tons in latent capacity in Powder River Basin coal waiting for higher prices.

With Arch management expecting a U.S. consumption increase of just 50 million tons in 2013 (versus 2012), that's a problem. I don't expect Arch, Peabody (NYSE:BTU), or Cloud Peak (NYSE:CLD) to act irresponsibly with their production, but the reality is that there's plenty of capacity to absorb demand and that could well limit price improvements. To that point, historical cost parity analysis would suggest fair value for PRB coal above $20 per ton with natural gas above $4, but that clearly isn't the case right now.

It's also worth noting that the very profitable met coal market is still in trouble. Met coal sells for about ten times as much as PRB coal at present, and Arch very much needs a better met coal market to generate stronger EBITDA. Unfortunately, met coal prices have been quite weak lately, and the comments from steel producers like Arcelor Mittal (NYSE:MT) (which is largely self-sufficient in met coal) don't suggest a huge turnaround in demand any time soon. What's more, the same problem exists in met coal as in PRB – a sizable amount of curtailed production that could hit the market and push prices back down pretty quickly.

SEE: A Primer On Coal

Arch Coal Has Taken The Right Steps, But There's A Big Gap To Fill

Giving credit where due, I think Arch Coal management has handled this major downturn pretty well. The company made some nearly catastrophic mistakes back when the market was stronger (taking on a lot of debt to buy International Coal Group and its higher-cost Appalachian mines), but the company refinanced its debt back in 2012 and bought itself some time. Management also curtailed some of the highest-cost mines, and per-ton cash costs were down 11% for the first quarter of 2013. To that end, Arch Coal's cash costs for thermal coal and met coal are pretty solid relative to Peabody, Cloud Peak, Consol (NYSE:CNX), and James River (Nasdaq:JRCC).

The question, though, is whether there are many worthwhile levers left to pull. Over the long term, Arch Coal could perhaps benefit from cost reductions tied to technology and automation, but comments from companies like Komatsu (OTC:KMTUY) would seem to suggest that a lot of that innovation is still on the drawing board. In the meantime, I'm not sure there's a lot for management to do but wait and hope that the cyclical coal markets start moving back up and allow the company to generate the EBITDA it needs to repay debt and fund worthwhile dividends.

SEE: Evaluating A Company’s Management

The Bottom Line

With no significant debt repayment demands until 2016 (assuming Arch Coal can remain in compliance with covenants, which I believe it will), Arch Coal has breathing room. What's more, I do believe that a coal recovery is likely to be a “when, not if” situation – while I do believe the glory days of coal are past (and particularly for Appalachian thermal coal), there's likely to be enough electricity and steel demand to restore prices to a point where Arch can make real money.

The problem now is that valuing the stock feels like an exercise in hope. Using Arch Coal's historical multiples, the current EBITDA expectations would suggest the stock is worth no more than a couple of bucks. On the flip side, the stock is trading at only half of tangible book value, but I suspect the value of those coal reserves is overstated relative to the actual economic value.

If this recovery in U.S. utility coal usage continues, I do expect Arch shares to move higher. The problem for investors is that the best bargains in this sector come when things look worst and it seems all but impossible to generate a reasonable fair value for the stocks. While Peabody is almost certainly the safer bet, investors who believe in higher natural gas prices and a recovering U.S. economy may well want to consider Arch Coal as a very risky turnaround story in the making.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

Related Articles
  1. Insurance

    Evaluating The Board Of Directors

    Corporate structure can tell you a lot about a company's potential. Learn more here.
  2. Bonds & Fixed Income

    Evaluating A Company's Capital Structure

    Learn to use the composition of debt and equity to evaluate balance sheet strength.
  3. Investing Basics

    A Primer On Coal

    With the right knowledge, investors can better understand coal and gain exposure with the investment vehicles available.
  4. Mutual Funds & ETFs

    Evaluating Green Equity Investments

    Learn how to find stocks that are both eco-friendly and profitable.
  5. Active Trading Fundamentals

    Evaluating A Company's Management

    Financial statements don't tell you everything about a company's health. Investigate the management behind the numbers!
  6. Investing

    How to Ballast a Portfolio with Bonds

    If January and early February performance is any guide, there’s a new normal in financial markets today: Heightened volatility.
  7. Stock Analysis

    Performance Review: Emerging Markets Equities in 2015

    Find out why emerging markets struggled in 2015 and why a half-decade long trend of poor returns is proving optimistic growth investors wrong.
  8. Investing News

    Today's Sell-off: Are We in a Margin Liquidation?

    If we're in market liquidation, is it good news or bad news? That party depends on your timeframe.
  9. Investing News

    Bank Stocks: Time to Buy or Avoid? (WFC, JPM, C)

    Bank stocks have been pounded. Is this the right time to buy or should they be avoided?
  10. Stock Analysis

    Why the Bullish Are Turning Bearish

    Banks are reducing their targets for the S&P 500 for 2016. Here's why.
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>
Trading Center