This is part two of a three part series on Arch Coal Inc (NYSE:ACI). At present, Arch Coal is trading significantly below its book-value-per-share and appears to be somewhat of a value play. However, there are numerous headwinds facing the company, which could turn Arch Coal Inc (NYSE:ACI) into a value trap. In this series I’m trying to arrive at suitable conclusion as to whether or not Arch is a value play or trap.

Arch Coal

In part one, which can be found here, I covered the bull argument for Arch Coal Inc (NYSE:ACI). Within this part and part three, I’m going to take a look at the bear argument, in particular, the state of the coal mining industry.

Despite being one of the world’s most abundant and low-cost power sources, coal is rapidly falling out of favor with investors and governments alike. As I write, the price of thermal coal is currently trading around lows not seen since the depths of 2009 and it would appear that these low prices are here to stay. Obviously, this is not good news for Arch Coal Inc (NYSE:ACI) as the company relies upon coal for almost all of its income.

Coal provides 30% global energy; but trending down

According to the World Coal Association, coal provides around 30% of global primary energy needs, generates 41% of the world’s electricity and is used in the production of 70% of the world’s steel. However, a number of recent government initiatives around the world designed to reduce CO2 emissions have reduced the demand for coal.

The most recent of these initiatives was by China, which aims to reduce the amount of coal used to generate power within Beijing by 50% over five years. What’s more, the combination of low natural gas prices and regulations from the EPA within the United States have driven coal’s share of domestic U.S. electric power generation below 34%, the lowest level in around three decades.

With the world’s two largest economies slashing coal consumption, it is no wonder there is downward pressure on the price of the black mineral.

Coal still useful where other sources fail

Still, coal has its uses. In particular, based on numbers supplied by BP plc (NYSE:BP) (LON:BP) and the World Coal Association, global consumption of coal expanded 2.5% during 2012, a rise lead by non-OECD nations where coal consumption expanded 5.4%. The rise was also fueled by Japan’s demand for fuel as its nuclear reactors remain out-of-action. However, as noted above falling coal consumption within the U.S. pulled down the global average.

Having said all of that, possibly one of the most concerning factors overhanging the coal market is the fact that supply is rising faster than demand. Indeed, during 2012, global coal output increased by 2.9%, while as noted above, supply only increased 2.5%.

With demand falling and supply rising, coal prices are almost certainly going to continue their downward trend in the near-term. However, this presents Arch Coal Inc (NYSE:ACI) with another problem: how to combat rising costs of production.

Arch Coal Inc (NYSE:ACI), like many companies within the resource sector, has reported rising costs of production during the past few years when the commodity boom was underway. Now with the falling price of coal Arch Coal Inc (NYSE:ACI) is having to slash costs but the company is finding it hard to cut costs fast enough. Specifically, year-on-year to the nine months ending September 30th, the average price received per ton of coal sold by arch fell 24% but the company only cut operating costs 20%.

Collapsing operating margins and rising interest costs are the two main threats facing Arch Coal Inc (NYSE:ACI). Stay tuned for part three where I will explore both in detail.