Macquarie Research downgraded the U.S. coal sector to neutral from overweight as it believes that demand for seaborne metallurgical, or steel-making, coal in China is slowing.

Analyst Curt Woodworth said demand is slowing because Chinese domestic metallurgical coal production is increasing and China has built excess inventory of steel.

He also said Chinese steel production appears unsustainably high.

The analyst believes that steel production will likely decline moderately in China over the next several months following substantial increases in production levels experienced since April.

Woodworth noted that the fundamentals for thermal coal, used mainly by electric utilities to generate electricity, continue to worsen and said he expects producers to lower 2010 volume expectations this quarter.

Woodworth believes that the substitution of natural gas, instead of coal by electric utilities, has negatively impacted U.S. thermal coal demand by about 50 million tons.

This is significantly above the forecast displacement rates of about 20 million tons articulated by most producers earlier in 2010, the analyst said.

Woodworth expects thermal coal demand to remain depressed unless natural gas prices were to increase significantly in the short run. The analyst downgraded Massey Energy Co and Alpha Natural Resources Inc to neutral from outperform as he expects earnings to remain very weak over the next two quarters.

He also believes the market has become overly bullish on their ability to export met coal at higher prices in the second half of 2009.

Woodworth also cut Peabody Energy Corp and Patriot Coal Corp to underperform from outperform, saying that these stocks are now trading near the high end of historical valuation levels.

(Reporting by Hezron Selvi in Bangalore; Editing by Jarshad Kakkrakandy)