Last month, shares of Peabody Energy Corporation (NYSE:BTU) tumbled after the company posted a loss in its fourth quarter. BTU's revenue and sales volume declined on year-over-year basis, highlighting the weakness in the coal market. Although the stock has rallied in recent trading sessions, it is still down more than 8% for the year so far.
Peabody shares have fallen around 58% over the last one year, amid an extremely unfavorable state of affairs in the global coal market. While a fundamental imbalance in the coal market amid slowing economic momentum in China has sent prices down sharply, weakening prices of oil and natural gas have further weighed on the commodity.
Sea-borne coal exports hit their lowest level in a decade in 2014. Not only that, domestic demand has also been weak as utilities have switched to cheaper natural gas and oil. Prices of natural gas have fallen more than 40% in the last seven months. Benchmark thermal coal, which is used for electricity generation, has seen prices sink to almost a six-year low. Thermal coal prices, which traded at $56 per ton about a year ago, are now languishing at around $45 per ton. At the peak of the economic recession following the financial crisis of 2009, benchmark thermal coal prices plunged to $42.20 per ton. The prevailing depressed condition in the coal market raises a question: Will coal prices continue to submerge, thereby resulting in more sell-off pressure on Peabody?
In the short term, any drastic improvement in the coal market looks highly unlikely and therefore Peabody could continue to struggle. However, the stock looks a good long-term bet, when you consider following developments.
Supply Glut Could Ease
The U.S. dollar has been sharply appreciating vis-à-vis all major currencies over the last one year. As commodities are priced in dollars, a stronger dollar boosts earnings in local currencies -- spurring higher production in international markets. This in turn has resulted in a supply glut even as a stronger dollar negatively impacts exports from the U.S. Sea-borne coal supplies outstripped demand for the first time in nearly five years last year. However, rising supplies started to affect pricing in international markets. For instance, coal prices for Newcastle (Australia) plunged 26% in 2014.
In the backdrop of overcapacity and declining prices, coal producers would not have any other option but to cut their output. The U.S. market witnessed the same problem last year. A stronger dollar hurt exports and forced coal producers to cut production. The Financial Times, citing the Energy Information Administration, reported in January that U.S. coal production fell to its lowest level since 1993 in 2013. After a brief recovery in the output last year, it is expected to fall down to the same level this year.
Furthermore, falling coal prices have also hindered development of new supplies. According to Peabody's outgoing CEO, Greg Boyce, delays in supplies along with incremental increase in demand would help balance the supply glut over the course of time.
Improved Demand From India, China and the U.S.
In November, while on the sidelines of Asia-Pacific Economic Cooperation summit in Beijing, Greg Boyce said that the company envisions an improvement in the global coal market due to a "robust" growth in India and China in 2015 and stabilizing economic environment in the U.S. As a result, Peabody in its most recent conference call transcript noted that it expects seaborne metallurgical coal demand growth to outstrip supply increase for the first time since 2011 this year.
India, the world's third largest coal importer, saw its coal shipments increase 19% to 210.6 million tons in 2014. Thermal coal shipments rose 22% to 163 million tons in the same period. Coal shipments rose as domestic coal producer Coal India failed to maintain production amid growing demand.
Thermal coal demand is likely to remain robust as the Indian government focuses on providing 24x7 electricity to all Indians. A third of India's population have inadequate or no access to electricity. Reforming the power sector is one of the key goals for the Indian government. Although India's Prime Minister sees renewables as an important source of energy, coal will be a major part of the energy mix if the government has to achieve its goals. Indeed, despite the environmental impact and criticism from Western governments, India will continue to rely heavily on coal in the coming years. This is a very important long-term driver for coal demand, which the market seems to be underestimating at the moment. For all its appeal, renewables are still an expensive option and therefore developing countries like India will continue to burn coal.
Moreover, the macroeconomic picture of India shows tremendous improvement, thanks to the business friendly policies and reforms undertaken by the new government. Recently, both the World Bank and International Monetary Fund have upwardly revised India's GDP growth in 2015. In China, although electricity demand rose 4% in 2014, seaborne thermal coal shipments actually fell. Imports declined as China's hydropower capacity increased. Besides, uncertainty surrounding coal quality regulations also limited coal's usage. However, demand for coal could improve as hydropower growth is expected to slow down.
Furthermore, seaborne supplies are also anticipated to increase as domestic production is stabilized even as demand for high quality coal increases. Lately, China's economic indicators have been very disappointing. This could prompt the People's Bank of China to further ease its monetary policy and boost spending on infrastructure. All of these factors are positive for coal demand.
In the U.S., Peabody anticipates coal demand to fall between 50 million and 60 million tons due to declining natural gas prices. However, the company is hopeful that Powder River Basin (PRB) coal will remain cheap enough to compete with natural gas prices. Peabody expects PRB coal consumption to jump by 20 million tons in 2015. Besides, the company expects coal to account for about 40% of U.S. electricity by 2017 as utility coal consumption is projected to increase by 10 million to 30 million tons.
Cost Cutting Measures
Peabody is also focusing on cost-cutting measures even as it looks to increase its efficiency. For instance, in Australia, Peabody, has been reducing contractors in favor of in-house workers. In the third quarter of 2014, cost per ton at its Australian operations fell 5.6% to $65.7. The company is also focusing on increasing production at its low-cost mines even as it restructures four longwall mines to increase productivity.
Bottom Line
Despite the bearish near-term outlook for coal demand, Peabody looks an attractive stock. This is because of the factors I have discussed above. The company is taking steps to bring its costs down in the existing tough environment. This coupled with the long-term demand outlook, especially from China and India, makes Peabody an attractive long-term bet.
