As U.S. coal producers benefit from tight global markets for both steam and metallurgical coals, Fitch Ratings cautioned that high consumable prices and labor costs will constrain earnings growth over the new few months.

In the report, ‘Coal Outlook: Summer Burn, Supply Response', which was released by Fitch Wednesday, Monica Bonar, Director, Fitch Ratings, and analyst Sean Sexton noted that mining in new or challenging regions can amplify already high maintenance and capital costs.

Constraints to developing new coal mines include high capital costs, the need for sales contracts covering a high portion of new tonnage, and a lengthy permitting process, according to Fitch. While some producers are announcing new projects, the analysts noted that these have more than two years lead-time and may only replace declining production at existing mines.

While coal producers are benefiting from tight global markets for steam and metallurgical coal, regulatory uncertainty about carbon emissions has stalled plans for construction for many new coal plants, which Bonar and Sexton said, will cap domestic demand in the medium term.

Stocks are reportedly tight for Northern Appalachian coal, high for Powder River Basin coal, and comfortable for Central Appalachian and Illinois Basin coals, according to the report. However, the analysts predicted that coal company earnings growth will be constrained by cost increases. Coal producers are experiencing high prices for consumables such as fuel, explosives and steel in addition to high labor costs. Maintenance and capital costs have been on the rise, which can be amplified when mining in new or difficult areas.

While steam coal inventories are reported to be at comfortable levels, contract prices are up. Fitch expects steam coal realization growth to flatten out over the 12-18 months absent a new supply growth.

Meanwhile, metallurgical coal prices have blown through expectations on short supply. World growth in demand for metallurgical coal has not been met by a corresponding increase in Australian coal export infrastructure, particularly port and rail, the report said. Currently, prices are settling at $305/mt for the year ending March 31, 2009, with supply not expected to significantly ease until 2010.

The report noted that U.S. steel producers are benefiting from a weak dollar and high transportation costs. The U.S. metallurgical coal market also benefits from the growth of the Brazilian steel industry.

Fitch said it expects the metallurgical coal market to continue to benefit from tight supply and robust steel demand over the next 12-18 months. While U.S. metallurgical coal varies by quality, realizations may be up $100/ton on average for the period.

The Energy Information Administration (EIA) expects slow growth in domestic energy consumption, combined with projected increases in wind and hydroelectric power generation, will lead to virtually flat U.S. coal consumption in 2008 and 2009.

While new U.S. coal plants are being developed, the analysts noted that it is at a much more modest level than previously anticipated given uncertainties surrounding carbon legislation and capital costs. Fitch expects demand from newer efficient plants to match demand lost from shuttering inefficient plants over the medium term. The EIA's current Annual Energy Outlook does not anticipate incremental demand from net new coal plants until 2020.

The United States is increasingly benefitting from the international coal trade as European demand for high Btu U.S. steam coal is robust in the longer term as two- and three-year transactions are being completed, according to the report.

The weak dollar, combined with high freight rates, renders U.S. coal cheaper than South African or Australian coal. In addition, growing internal demand from transitional economic reduces exports from Russia, China and Indonesia, the analysts noted. Coal trade has been hampered by rail and port constraints in Australia, derailments and power outages in South Africa, and weather and rail constraints in Colombia and China.

Fitch expects the seaborne coal to remain robust.

While there are indications that European buyers are looking for multiyear transactions with U.S. suppliers, a modest export infrastructure and focus on large domestic demand limit how much exports can grow in the next 12-18 months, Fitch advised. If U.S. ports can sustain the March 2008 rate of 6.7 million tons, 80 million tons can be reached for the year.

The EIA's most recent forecast is that U.S. coal production will increase 1.1% this year and to remain relatively flat next year. The National Mining Association last month forecast a total demand of 1.218 billion tons of U.S. coal this year, including 80 million tons of exports.

Fitch forecasts that western coal production may be pulled east as Appalachian production to be pulled overseas. ...Appalachian production should fall given difficulties in gaining valley fill permits as well as changed mine plans associated with avoiding historic mining areas and safety concerns.

The analysts predicted that cost escalation for coal producers this year will range from 5% to 7%. They estimated that underground mining costs have increased between $2/ton and $4/ton in lost productivity associate with new federal mine safety regulations.

Nevertheless, while 2007 was a challenging year for U.S. coal producers and the financial markets, Fitch noted that most coal miners have worked to improve their liquidity.

Fitch expects the coal producers under view to continue to balance capital spending with free cash flows for the most part and maintain healthy capital structures. We note that companies with weaker capital structures are selling common stock or converting debt to common stocks and generally working to shore up liquidity.

The analysts expect coal mining company consolidation to continue on a modest scale and generally involve acquisition and sale of reserves.