This demand slump will ripple through the coal industry well beyond 2009. For example, as demand precipitously declined, producers failed to match the market with production cuts. Unsurprisingly, inventories ballooned. Today, we estimate that there's at least 50 million tons of excess inventory in the country, the largest overhang we have ever encountered. The problem is especially severe in the eastern United States, whose more expensive coals were disproportionately displaced by natural gas and lower exports.

Although production gradually declined enough to check inventory bloat, the damage had already been done. In 2010, we expect continued anemic production. More importantly, thermal coal pricing has been kept down by the inventory overhang and still-low natural gas pricing. This means that contracts (especially in Appalachia) signed in 2009 will be less profitable than contracts signed in 2008 or even 2007. And because contracts often run for several years, the disaster of 2009 will blemish income statements for much longer.

The Way Out
That said, coal companies have generally coped very well with these significant head winds. Despite difficulties, we suspect that 2009 will be remembered as a transformational year for the entire industry. Perhaps fittingly, coal equities have done very well this year, with most coal firms in our coverage universe doubling or tripling off their spring lows.

Despite a reputation for fragmentation and irrational competition, the industry successfully cut production. This process became noticeable in February or March and accelerated through the summer and fall. Almost all of the large public companies did their part, and many remain very cautious heading into 2010. Moreover, we think many of the large companies, such as Peabody Energy (BTU) and Arch Coal (ACI), actually led the way in this endeavor, reinforcing our thesis that they are becoming more rational and disciplined over time.