Monday, July 18, 2016

The Coal Turnaround

I've taken positions long thermal coal companies. I've gone long CNXC and increased my positions in the defaulted debt of US coal companies. I'm also considering South32. I am not buying the commodity itself.

Times are very very bad for the US coal industry. I think readers of this blog will know why:
- The new technology of fracking has led to much lower natural gas costs. Natural gas competes directly with coal as an input to electricity generation.
- The Obama administration has encouraged this switch in the hope of reducing CO2 emissions, although the percent of world emissions saved is miniscule.
- The industry itself increased its leverage in the years prior to the decline, and has not had the resources to retrench.
- The collapse of LNG prices in Asia, has hurt the coal export market. Here's a graph from the Wall Street Journal of the Asian price.

The result of this is that all coal prices have fallen sharply. Here's a nearest futures continuation graph from barchart.com of Eastern US coal:

And here is a similar chart of coal CIF Rotterdam area. This is a good proxy for the world export market:
I believe the little upmoves in the right hand side of these charts are not fakeouts, but are the end of the long declines. Here's my argument:

The US coal industry extended its leverage in the years leading up to the bust. For example in 2008, at the height of the financial crisis, Peabody Energy had a liabilities to assets ratio of .67. As of the last financial statement before Chapter 11, it was .92. Some of this was operating losses, but a large part was a 42% increase in debt. The company simply did not have the financial flexibility to hunker down when times got very tough.

The situation was exacerbated by the failure of the industry to cut back production when the writing was on the wall. The combination of declining consumption and stable production has led to a very big increase in coal inventories. Here's a chart from the US EIA of coal consumption and stocks. Note that this ends in March 2016. I explain below why I think this has since turned around. Data is in 000 tons.

OK. That's the bad news background. Here's why I think things are turning around.

Recent data on coal railroad loadings has gotten better. This chart is from the American Association of Railroads:


You can see how coal loadings finally turned down in late 2015 and early 2016. Recently it has moved up, although not to earlier levels. This is consistent with a story of production cutbacks to a level which start to reduce inventories. However, railcar loadings and production are not likely to get back to earlier levels for a long time, if ever.

Natural gas prices have moved up. This directly impacts coal since a large number of powerplants have dual fuel capability and will chose whichever is cheaper. Here's a chart of August 2016 gas futures:



Weather has a surprising effect on coal demand (surprising to me anyway, since I thought coal was mostly used for baseline generation). In fact, analysts I have read put part of the blame for low coal consumption on the mild winter. So far Spring has been hot in much of the sunbelt. It hasn't been cool anywhere.

The result of this has been strengthening in coal prices. We saw this in the earlier charts, but it is important to know that the futures market is forecasting even higher prices for some coals, particularly eastern US.

      ICE CSX Coal
Aug 2016    40.20
Aug 2017    47.25

Since production costs may actually decline a little over the next year, this will be a big boost to cash flow.

So it looks to me like a typical commodity "cobweb" turnaround is happening right now. There is one big risk however. The Obama administration has proposed a new set of rules, the Clean Power Plan. This would sharply limit how much coal can be burned. They did this by regulatory action since they know that it could not be done legislatively. Much like the recent administrative action on immigration, this is being challenged in the courts. It is currently before a Federal Appeals Court. If this is upheld, it will be a huge long-term negative for the industry and a short term blow similar to Brexit was to the Pound. The ruling could come soon.

If you are willing to accept this risk, there are many assets you could buy. Probably the easiest is the ETF KOL. This is an ETF of coal miners, suppliers and transporters. However, it is not US focused. Several of its largest holdings are Chinese, and its largest holding, Teck Resources (TCK), does a lot more than coal.

If your tax situation is appropriate, the MLP CNXC should be considered. It was spun out from Consol Energy. David Einhorn, who owns much of Consol, wants it to concentrate on its gas E&P operations. Einhorn still owns much of CNXC, but I would expect him to sell on strength. Right now it's dividend rate is about 20%. However, only about 40% of that is covered by income, so I expect some reduction.

Finally, if you are willing to take on high risk and you want upside optionality, consider the bonds of the defaulted coal companies. For example, Peabody Energy bonds are going for about twelve cents on the dollar. If the coal market does righten itself, and if the Chapter 11 proceedings are not closed too quickly, these could be worth much more than that.

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