What's Required for Coal Fundamentals To Recover?
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Plenty has been written about the, "perfect storm," that has caused coal markets around the world to crater. Much less has been written about what's needed for underlying coal fundamentals to improve in a sustainable way. Foolish investors need to know what to watch for if they're invested in coal equities or are looking to jump in.
What's Gone So Incredibly Wrong?
It all started mid-to-late last year when everyone was talking about a slowing Chinese economy and high inflation. At about that time, efforts to prop up European countries were unraveling, perhaps you've heard of a country named Greece? Next, the U.S. had one of the warmest winters on record, causing electricity demand for heating to fall. Then, natural gas prices plummeted due to the warm winter and increased supply from the new shale gas plays. Decade-low gas prices enticed utilities to switch from coal to gas in their power plants. By late last year, coal stockpiles at utilities started to rise rapidly.
Again, there's a lot of commentary on this. But, what's required to turn things around? Before the summer, analysts said that we needed a hot summer and a cold winter at the very least. So far so good, the summer has been hot, [September is a key month, if it remains hot that's bullish for gas and coal prices]. Next, gas prices need to move meaningfully higher, there's no recovery in coal without a coincident move higher in gas.
Coal-to-gas switching needs to reverse. Utilities need to fear the price of natural gas once again. They've been lulled to sleep by highly unusual natural gas prices, trading in a range of about $2-$3 per MCF for over 2 years now. When gas prices rise back above $3.5-$4.0, not only will utilities switch back to burning coal, they may start thinking about purchasing more coal for the 2nd half of 2013. However, there's not much thermal coal available because coal producers have curtailed tens of millions of tons of production, a lot of it permanently.
Bullish analysts point to supply constraints eventually becoming a catalyst to move coal prices significantly higher. We will see. Before that's possible, stockpiles sitting at the utilities need to come down a lot. This is probably the biggest headwind facing the sector. Typically, inventories are about 150-170 million tons. In June that number was roughly 200 million. It will be nearly impossible to get inventories down without a spike in natural gas to say above $4.5-$5.0 or a very cold winter.
Which Producers Will Benefit Most From an Eventual Recovery in Thermal Coal Prices?
Alliance Resource Partners, (NASDAQ: ARLP), Arch Coal, (NYSE: ACI), Alpha Natural Resources, (NYSE: ANR), Cloud Peak,(NYSE: CLD), and Consol Energy, (NYSE: CNX). Each of these producers has substantial upside to a recovery in coal fundamentals described above. At the moment, a recovery looks to be a 2013 event. But, Foolish investors will want to be invested before the crowd piles in.
Alliance is 100% thermal coal in the best 2 regions of the country, the Illinois Basin, "ILB" and Northern Appalachia, "NAPP." Amazingly, ARLP is still mining a ton of cash along with the coal. With its industry-low costs, an increase in coal prices would turn strong margins into monster margins and enable this MLP to increase its quarterly distribution rate substantially.
Arch Coal gets a bad rap from its large exposure to the Powder River Basin, "PRB." That is, until PRB coal prices rebound. Today, PRB coal is probably the most out of the money. Not until 2015 does the forward curve allow for a strong margin environment. However, even a moderate improvement in the PRB curve would move 2014 prices high enough to generate good, not great, margins.
I've written so much about ANR recently that Foolish investors should know that I'm bullish over the longer-term. However, my bullishness stems from the coking coal side. If thermal prices were to increase a lot, even Alpha could make some coin. Of the companies mentioned in this article, Alpha has the least earnings upside to a moderate improvement in prices, a large increase would be required.
Cloud Peak is 100% devoted to the PRB. It has an attractive cost structure, a very-long term reserve life and one of the strongest balance sheets. Due to Cloud's lower costs, it will be among the first to benefit from a sustained move in PRB coal prices. Cloud stock has fallen far less than its peers due to its balance sheet strength and consistent earnings through this down cycle.
Consol Energy may benefit the most because they have conventional natural gas, shale gas and coal operations. Importantly, Consol's coal assets are top notch. It has one of the best low-vol coking coal mines in the country and owns a port facility in Baltimore, MD for exporting it. Assuming as I have that higher natural gas prices is a pre-requisite for a coal recovery, Consol will be killing it with gas above $4 per MCF.
What to watch for? Natural gas prices, continued hot weather, a colder than normal winter, and a reversal of coal-to-gas switching. Keep an eye on these and wait to see what company managements say on their 3rd quarter earnings in a hopefully frigid October.
MockingJay2011 owns shares of Alpha Natural Resources, CONSOL Energy, and Alliance Resource Partners, L.P. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Alliance Resource Partners, L.P.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.