Coal Bankruptcy Fears Stoked, but China Risk Is Bigger (Update 1)

Updated to include additional analyst comments, sector data

NEW YORK (TheStreet) -- As coal giants limp into the second half of the year, there's still the prospect that things could get worse for the sector. However, a weak revenue outlook and debt-laden balance sheets won't prove to be the death knell for an industry whose troubles were highlighted by the recent Patriot Coal (PCX) bankruptcy.

"I think the second half of the year is not going to be a heck of a lot better than the first half," says Davenport & Co. analyst Christopher Haberlin of his outlook for the coal sector. However, the reasons for caution are shifting.

Instead of an existential crisis, coal players head into second quarter earnings with a potential reversal of demand indicators. Met coal, which was the primary source of health for coal companies in the first half of the year thanks to Asian demand, and in particular, China, which uses the coking product to produce steel, is at risk of slacking. Thermal coal, mostly used in power generation, slumped in early 2012 as natural gas hit decade low prices, but a rebound in natural gas prices amid a late June and July heat wave has driven prices above $3, making coal an economic alternative for utilities in some markets.

Indeed, as investors brace for an outlook shift in which met coal becomes the bigger industry risk and the prospect of stronger economics for thermal coal signal an upside opportunity, there may be little reason to move away from the beaten up shares of Peabody Energy (BTU), Cloud Peak Energy (CLD) and Teck Resources (TCK), which have outperformed peers including Alpha Natural Resources (ANR) and Arch Coal (TCK). (In 2012, coal outperformance means a 25% drop or less, compared to 50%-plus declines for many industry giants.)

The likes of Peabody Energy and Cloud Peak may continue to outperform because of their operational efficiency and exposure to more economic coal basins, notes Haberlin.

Bankruptcy risk hasn't left the coal landscape. After Patriot Coal's recent bankruptcy, Haberlin highlights James River (JRCC) as possibly the most at-risk company in the sector because of its high cost structure. However, the company also has nearly $200 million in cash and thermal coal contracts through 2013 that may outreturn extraction costs.

"Aside from JRCC, the remaining companies in our coverage universe are not faced with significant bankruptcy risks over the next several quarters," wrote Haberlin in a note to clients.

The prospect of slowing growth in China and lower steel demand removing the largest marginal buyer of met coal has Haberlin more concerned. Haberlin and other coal analysts recently cut earnings expectations throughout the sector. Nevertheless, investors may still focus on whether companies revise met coal guidance -- of if earnings will slump faster than expectations.

"Into earnings we think estimates are too generous for more met-focused Alpha Natural Resources and Walter Energy and too tough for Consol Energy (CNX), given its restart of higher profit low-vol met coal production at Buchanan," wrote Bank of America Merrill Lynch analyst Timna Tanners in a July 17 earnings outlook.

"Despite near-term met concerns, we remain convinced that the market remains robust longer term given limited supply globally and high production costs," adds Tanners.

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