As gas heats up, coal sector burns less brightly

Fri Aug 3, 2012 10:48pm IST

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Aug 3 (IFR) - Coal is being overtaken by natural gas as the primary fuel source in the United States, and that is piling pressure on embattled credits in the US coal industry.

Analytics company StarMine places the 1-year default probability for the coal sector at 6% -- one of the poorest readings of any group -- and says several downgrades are expected.

Its data indicate that companies including Alpha Natural Resources, Walter Energy and Arch Coal are facing downgrades by the major rating agencies. Standard & Poor's currently rates Alpha Natural and Walter Energy at BB- and Arch Coal at B+; StarMine has them all at triple-C.

Current bond prices underscore the general sentiment, with several credits now approaching 9% yields. The Arch Coal 7.25% 2020 bonds are trading at 87.625, and currently yielding 9.45%. The Alpha Natural Resources 6.25% 2021 bonds are trading at 87, and yielding 8.36%.

And all the signs point toward more difficulties ahead.

OLD KING COAL

Coal was long the unquestioned king in the US power industry. As recently as 2010, it generated 45% of the nation's power, compared to just 24% from natural gas.

But cleaner, cheaper gas is catching up. It is seeing significantly lower prices than in the past -- and is much more environmentally friendly.

According to Department of Energy data, natural gas and coal each accounted for 36% of US power production in April.

Companies are converting coal-fired plants and building new natural gas-powered plants, which has weakened demand -- a problem compounded by the unseasonably warm US winter.

"Overall coal demand is running about 20% below its given year-average to-date in 2012," CreditSights said in a research note. "And coal inventories at utilities are 17% above the five-year average."

According to an EIA report, the demand for coal to produce power is likely to fall 10% this year -- and prices are down 25% over the past few months alone.

And without a major cut in natural gas supply, pricing pressures will persist. For 2013, Moody's expects average delivery prices of coal to decline at least 5% from 2012 levels.

STUCK IN IDLE

Arch Coal recently idled five mines to cut production, while Alpha Natural Resources announced it will produce 11 million fewer tons of coal this year -- a decline of 11%.

Meanwhile pending EPA regulations, which are more stringent on greenhouse gas emissions, are adding to the sector's woes. Older and dirtier plants are being forced to shut, as they will no longer be economical to run when the new regulations take effect.

Bank of America Merrill Lynch research analysts are expecting around 15% of the US coal production fleet to shut over the next five years "due to new EPA mandates and poor economics versus gas".

Furthermore, the sector's overall fundamentals have been hampered by unfunded pension liabilities and other employee benefit obligations.

"These obligations raise leverage from an average of 3.0x to 3.9x when they are treated as debt," CreditSights estimates. Patriot Coal's recent bankruptcy was mostly attributed to soaring pension costs, which were considerably more than the company's debt.

With rising leverage and oversupplied market conditions, credit ratios will continue to erode over the near term and weigh on operating results. Moody's is expecting operating margins for coal producers to deteriorate this year "as costs increase amid lower delivery volumes."

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