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Coal stocks 'not there yet'

By Kristen Gerencher
Last Update: 12/08/1999 2:18:00 PM

NEW YORK (CBS.MW) -- At this time of year, coal comes to mind as Santa's retribution for kids who made his "naughty" list.

"One should stay on the sidelines with the exception of Alliance, which we think is attractive because of its high yield." Wayne Atwell, Morgan Stanley Dean Witter

But coal stocks are taking the punishment as well, according to Wayne Atwell ,nonferrous and minerals analyst at Morgan Stanley Dean Witter.

Atwell briefed CBS MarketWatch on the outlook for stocks in his universe and discussed coal stocks in particular, observing that the industry has been beleaguered by low prices and a potentially crippling lawsuit, but that the stocks may get a boost out of sheer irreplaceability.

CBS.MW : How have the stocks been moving?

Atwell : This has been a fairly respectable year for the metal stocks. Aluminum in particular has done quite well: Alcoa (aa), Alcan (al), and Reynolds (rlm). Coppers did well for a while, particularly when the group was being consolidated. They haven't had as good a year as the aluminums, but they've done fairly well. Nickel has done quite well. Metal has doubled from its lows late last year.

It's been a tough year for coal. There has been no price relief except for very modest relief in the West. Prices in the East have headed down, and there was a court decision that was not very favorable. It's temporarily been stayed, but it has ominous overtones to it.

CBS.MW : What was the crux of the argument there?

Atwell : There was a decision by a judge in West Virginia concerning the enforcement of environmental rules. If it's interpreted in the strictest fashion, it could lead to a meaningful reduction in mountaintop mining and valley fill, which could have a very damaging impact on mountaintop mining, and in some cases open pit mining in the East could be severely restricted because of limitations in valley fill.

It has to do with filling in streams in valleys, and if you know West Virginia, all the valleys have streams. If you fill in a stream and you impede or eliminate its flow, that's not permitted by the EPA. So the court would essentially outlaw permitting mines that dump in valleys. It's temporarily been stayed and it's on appeal. T

here's a very detailed environmental study being conducted by a number of different agencies which probably will be a year or so before it's out which would probably be the guiding legislation in the future in terms of how this issue is resolved. But the issue is on the table and it could have a fairly meaningful impact on the industry.

CBS.MW: When you say valley fill, what do you mean?

Atwell: Let's just stick to mountaintop mining for a minute... When I say mountaintop mining, they literally take the top off a mountain and mine the coal and then they put the fill in the valley. One automatically says "Oh, gee whiz. They're dumping nasty things in the valley." But a lot of time it's just pure and simple rock that was mined to get at the coal.

But it does a couple of things as far as the human being is concerned. If you've grown up in a valley and your family's been there for several generations, people don't like to see their valley basically eliminated. There's a lot of memories and such associated with growing up in a valley and if it's full of rock, irrespective of whether it's good rock or bad rock, you're not happy. So there's a natural reluctance to see valleys filled in.

And then there's the question of environment... This would basically flatten out an area where you could put a school or a factory or something, but by the same token, eliminates a valley or a hollow by filling it in. The other thing is of course it would materially change the topography and the environment by filling in streams and eliminating the wildlife in that particular valley. Over time you'd have new wildlife and new streams, and presumably it'd be a lake or pond or something formed behind a fill....

It's something that's been going for some time. It's quite popular with some people and quite unpopular with others. It does create employment. Coal mining in West Virginia is one of the dominant industries. It provides a great deal of cash to the state and a lot of jobs, but it also tends to alter the profile of the land which makes certain people unhappy.

CBS.MW : How can coal companies mitigate their effects? Can they continue with their business and recover from the effects of the lawsuit?

"By continuing to improve productivity, they create a surplus which tends to press price."

Wayne Atwell

Atwell: The lawsuit has temporarily been stayed by the judge who made the ruling because of the potentially damaging impact it would have on West Virginia, and it could also be adopted by local states or states in general in the country. A couple things could happen. You either fill in a valley or you don't. There's no way to get around filling in a valley. If you're going to do mountaintop mining, you've got to put the rock somewhere so you've got to fill in a valley somewhere.

One compromise would be to gradually eliminate mountaintop mining but do it over a period of time so the coal miners could get their investment out of what they've already put in place and you would not dislocate employment in the state. If this were enforced, you could eliminate a third to a half of the coal mining in West Virginia, which would have a very damaging impact on both employment, state revenues, and power generation.

Fifty-seven percent of power in the country is generated by coal. West Virginia is I think 15 percent of the country's coal production, and I think it's the second largest coal-mining state. So it would have an incredibly damaging impact ... if it were to be enforced strictly.

I guess one compromise would be to eliminate mountaintop mining gradually but there doesn't seem to be a compromise in terms of living with mountaintop mining and not altering the environment because if you do mountaintop mining, you clearly have to put the rock somewhere and that would be in the valley.

CBS.MW: What's the largest coal mining state?

Atwell: I'm pretty sure it's Wyoming.

CBS.MW: Do you have any picks in the coal sector?

Atwell: We're recommending Alliance Resource Partners (arlp). It's an MLP, master limited partnership. It pays no taxes. It pays out its cash flow in a dividend, which is about $2. Stock is under $13 right now, so it's a high yield. On the order of 70 percent of the dividend is tax-free to investors. It's primarily a retail stock....

With the issue outstanding of mountaintop mining, we're inclined to stay cautious. Alliance does not mine any coal in West Virginia, so that's not an issue.... They're in the Illinois basin: Illinois, Indiana, Kentucky, that region.

CBS.MW : Is this primarily a domestic business?

Atwell: This is primarily domestic business, but there are companies that own mines internationally.

Coal is a misunderstood industry. The coal industry in the U.S. is 1 billion tons. Let me put that in comparison to the steel industry in the U.S., which is roughly 100 million tons ... roughly one tenth of the size.

Aluminum is maybe 4 million tons domestically, so coal is major multiples of the aluminum industry. We produce 16 million cars in the country, but we mine a billion tons of coal, so it's a huge industry.... We export maybe 5 to 7 percent of our coal and we import maybe 7/10 of 1 percent.

The quantities are so massive that it's not an industry that lends itself to huge tradeflows. There's a lot of coal shipped from Australia to the Asian countries. Taiwan, Japan, Korea, those countries don't really have any resources. Australia has a huge amount, so that's where the majority of the coal trade is in the world. Coal coming into the Asian countries from either Latin America, the U.S., Canada, Colombia.

A couple companies have international coal operations. Rio Tinto (rtp) mines coal in the United States, Indonesia, and Australia.

CBS.MW : How has it changed over the years? Are there any innovations that have been particularly noteworthy?

Atwell: It's a fascinating industry in that respect. What's happening is the productivity has improved over the years. There's been new equipment installed. Equipment is getting bigger. We're getting better at mining coal. We're now using 300-ton trucks. years ago we used to use 25 ton trucks. The bigger the truck the more coal you can move. If you're using 25 ton trucks obviously you'd need 12 truck drivers versus one 300 ton truck and it costs just as much to maintain a small truck as a large truck.

Ironically enough, as we become more efficient and our productivity is improved, we've increased the amount of coal that is produced. Coal miners by nature like to sell the last ton. They think they're going to maximize their revenue.

As a result, we've seen coal capacity and coal shipments increase, which has tended to create an oversupply so we've had an oversupply of coal by virtue of the progress in productivity. The material improvement in productivity industry has worked as a real detriment to supply and demand and pricing, so pricing has been quite weak...

It's been a pretty tough industry to try to make a profit. The returns on coal are not very good. It's a business that they're sort of their own worst enemy. By continuing to improve productivity, they create a surplus which tends to press price.

Coal is generally not considered to be a very environmentally friendly product, and almost everybody who's environmentally aware is fighting coal. But by the same token, it provides the majority of lights in the country and power.

I think people aren't aware of just how important coal is. It's irreplaceable in a sense that we do not have the infrastructure to materially reduce coal production in this country. It provides a major part of the power. In that respect, it's irreplaceable and we have to learn to live with it.

CBS.MW : Is there anything else investors should know?

Atwell : Coal prices are coming down now.... Coal has been evolving at kind of a snail's pace, but the evolution could accelerate once the regulations are published. If they're enacted, then you could see a change in coal mining production around the country....

There are four sources of power: coal, natural gas, nuclear, and hydroelectric. Both hydroelectric and nuclear are peaked. No one will ever permit another nuclear plant to be built in this country. They're running at a fairly high level, but they're going to start being decertified over the next 10 years. Hydroelectric, believe it or not, is unpopular. A lot of people would like to see those shut down, these dams taken out. So you'll never see an increase in hydro, as far as I'm concerned. That will continue to decline.

Natural gas is only 8 or 9 percent of total. That will increase. That's where the majority of new plants are being built.... So coal is sort of the swing factor.

If hydro and nuclear decline at a fairly rapid rate, you'll have to see that picked up by coal. If natural gas can rise fast enough, it could eat into the coal market share as well. It's just that the other fuels are so small and natural gas being the only alternative, there' s a limit to how fast it can absorb other share. As a matter of fact, you actually may see coal volume increase to offset reductions elsewhere. Plus there's growth of about 1.7 percent or so in power consumption ... so some fuel's got to pick up that growth.

CBS.MW : So is coal good for a longer term investment?

Atwell: The fundamentals aren't in place to get people excited about coal right now. I think it could be a very exciting investment, but we're not there yet. So it's the sort of thing where one should stay on the sidelines with the exception of Alliance, which we think is attractive because of its high yield.

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