The Bull Case on Powder River Basin Coal Producer Arch Coal
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While I don't own shares of Arch Coal (NYSE: ACI), shareholders are increasingly excited about its prospects. I wish I HAD owned it three weeks ago when the company announced 2nd quarter earnings. The stock was up 29% that day alone. Arch's earnings were nothing special, but better than feared. Peabody Energy, (NYSE: BTU) had kicked off earnings season a week earlier with a big miss, causing its share price to dive 18%. The relief rally in Arch stock was sparked by good cost control and cautiously optimistic commentary.
The spike in the stock was largely due to short covering. I'm fairly certain about this because Arch was heavily shorted heading into earnings. The stock hit $7.76 intra-day the day after earnings, before falling back to $7.0 at the close. With short covering presumably out of the way, Arch closed at $7.46 on Friday. That's 42% above its low of $5.26 on July 26th.
Since Arch has rebounded more than any producer except James River, I have trouble committing to it now. The company has $4.5 billion of debt and substantial interest payments stemming from last year's ill-timed $3.4 billion acquisition of east coast producer Intl. Coal. Arch managed to top-tick the market on that deal.
Still, there's reason to be bullish over the longer-term. Although over paying, Arch acquired approximately 1.1 billion tons of coal reserves, taking the company to an impressive 5.5 billion tons, the second largest reserve base in the U.S. Roughly 40% of the acquired tons are high-vol "A" and mid-tier high-vol "B" and PCI coals. Arch plans to accelerate the key coking coal projects it inherited. Despite adverse market conditions, the company plans to keep moving forward on its promising Leer coking coal project.
The Leer project is ambitious and importantly is just the first of up to two additional mines in the same area. First coal is expected next year, ramping up to 3.5 million tons of mostly high-vol "A" coking coal a year later. This is very good coal that will earn very attractive margins when coal prices rebound.
Arch is perhaps better known as the 2nd largest producer of coal in the country after Peabody. A large majority of Arch's production is thermal coal from the Powder River Basin, "PRB." Arch has a higher cost structure than Cloud Peak, (NYSE: CLD) , but it successfully kept costs in check in the 2nd quarter. Like Cloud, Arch is actively pursuing export alternatives for its PRB coal. It's worth noting that Alpha Natural Resources, (NYSE: ANR) is the 4th largest player in the PRB. Alpha acquired PRB producer Foundation Coal. This segment will not be a meaningful driver of earnings anytime soon. Alpha is almost entirely a coking coal story.
No matter who's first among Arch, Cloud and Peabody to export significant PRB tonnage, PRB prices will increase as supply exits the domestic market. The forward curve for PRB coal shows a material up-tick in 2015 vs. 2014. PRB exports will likely increase by 10 - 15 million tons per year. In addition to planned new ports on the U.S. west coast, PRB producers are already shipping more through the Gulf coast and Ridley Terminals in western Canada. Ridley has signed deals with Arch and Cloud Peak and Peabody is teaming up with Kinder Morgan increase its capacity to 5 - 7 million tons through the Gulf.
The bull case on Arch will take patience, but when PRB coal prices reach the mid-teens in a few years and Arch's Leer mine is up and running, the company will be in very good shape. In the meantime, Arch is hunkering down to ride out the storm in the coal markets.
MockingJay2011 owns shares of Alpha Natural Resources. The Motley Fool has no positions in the stocks mentioned above. 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.