America West Resources, Inc.(fka AWSRQ)

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Standard & Poor's outlook on coal prices

Wednesday May 11, 2011 (02:00 PM EDT)
SECTORS: KING COAL TO LOSE ITS CROWN

Negative Potential Implications: ARCH COAL INC. (ACI30.90 **), CONSOL ENERGY INC. (CNX49.13 **).

We recently downgraded our fundamental outlook on the Coal&Consumable Fuels sub-industry to negative from neutral. This is due to our belief that pricing for both industry metallurgical and thermal coal is too high. Our opinion is largely based on our belief that factors that have caused the run up will subside over the near-term. Also, we think industry coal prices are likely to decline moderating supply/demand dynamics.

Since September 2010, commodity coal prices have increased significantly. For instance, prices for coal in storage at the port of Qinhuangdao in China have increased by nearly 24%. We also note that prices for coal originating from Newcastle, Australia, a major international coal port, have increased by more than 36%. In addition, benchmark coal prices out of South Africa, another major supplier of internationally traded coal, have risen 42%. Coal prices in the U.S. have also reacted. For example, prices for coal originating from the Eastern U.S. have risen by 20% over the same period.

We believe global price increases have occurred for a number of reasons, which also includes improving demand. However, we think a great deal of the price increase since late 2010 is from other factors. For instance, coal market disruptions, following the Australian floods, have limited the supply of coal in seaborne coal markets, leading to higher metallurgical and thermal coal pricing globally. In addition, we also think that coal prices have moved upward in the wake of the Fukushima crisis in Japan, as markets have anticipated a push away from nuclear and toward power from coal. In turn, markets have reacted to the potential for increased coal demand. Another factor in rising coal pricing, in our opinion, has been the increase in inflation expectations, as exemplified by the spread between interest rates on Treasury bonds and Treasury Inflation Protected securities (TIPS). Our analysis shows that higher inflation expectations imbedded in this spread are a gauge for coal pricing.

For several reasons, we think these catalysts will prove to be temporary and are likely to lead to a pull back in pricing. For one thing, coal production that was curtailed by the floods in Australia has already shown signs of coming back online. In addition, we believe initial negative sentiment surrounding nuclear incident in Japan has toned down as we believe that the world realizes that nuclear power is needed in the future mix of energy production. Lastly, we think that price increases resulting from necessitated safety reviews of nuclear power plants is temporary.

Another dynamic aspect of coal pricing, that is rarely discussed, is weather. To our thinking, weather is a major determinant that drives changes in both supply and demand of coal. Hence, it effects industry pricing. To that end, we note that the air temperatures experienced during the summer of 2010 were far above normal. According to the National Oceanic and Atmospheric Association (NOAA), degree cooling days, a measurement reflecting the demand for energy used to cool properties, was 23% greater than the 30-year average in the summer of 2010. This drove demand and pricing. However, NOAA forecasts that degree cooling days will decline by nearly 20% during the summer of 2011. Should this forecast prove true, we think this will restrain weather-driven demand for coal this summer and reduce prices.

While factors such as the build-out of coal-based power plants in China and India, or the theory that global coal production will eventually peak suggest a positive long term outlook, we think prices will weaken in the near term for the reasons mentioned above, which suggests that the Coal and Consumable sub-industry will underperform the broader market. Coal companies that we have sell recommendations on include Arch Coal (ACI 31 **) and Consol Energy (CNX 49, Sell).

MATHEW CHRISTY, CFA, S&P Equity Analyst

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