The Oracle of Omaha has given the investing world many wonderful aphorisms. None are probably more well-known than "be greedy when others are fearful, be fearful when others are greedy." In theory, it is easy to practice Warren's advice. For example, if you were a budding childhood entrepreneur looking to get in the lucrative lemonade business and the kid down the block offered to sell you his rapidly growing stand for half price after a few rainy days, you would be overjoyed. He is fearful. You are greedy. Even kids know that weather patterns come and go. There will soon be another sunny day, and when the sun comes out, the lemonade drinkers will come back in droves. So that works if your counterparty is an eight year-old who doesn't like to stand out in the rain. We adults are far too smart to let the weather dictate the price at which we'd be willing to buy or sell a business. Or are we? I've been meaning to write this article for a while. When word surfaced last week that the Oracle himself was poking around the coal mines in hopes of finding buried treasure, I felt the time was ripe to break this down.
Coal and natural gas prices today are at unsustainably low prices because we are having a very warm winter.
Repeat: coal and natural gas prices are at unsustainably low prices because we are having a very warm winter. Yes, I am aware that there are other serious secular issues facing both industries that are also contributing to current price levels (as I will address below), but natural gas prices just aren't going to stay below the marginal cost of production in perpetuity. I don't know when they are going to rise again (the current NYMEX forward curve has them above $4 again by 2014), but two to five years seems like a safe bet. It is the gas prices (compounded with direct effects of the weather) that are driving down U.S. thermal coal prices at the moment, and with them, the valuations of coal reserves. U.S. producers have built some of the highest quality energy extraction facilities in the world, many with built in platforms for expansion. Those facilities are on sale right now for low, low prices. This is not a lemonade stand. It's a lemonade stand packaged with all the lemons in the country.
My thesis is that U.S. thermal coal prices are being driven by the convergence of four factors - (1) an abnormally mild winter, (2) a temporary oversupply of natural gas (exacerbated by that same winter), (3) a very real decrease in demand from old, inefficient coal plants being shuttered, and (4) a very real increase in demand coming from the rest of the world. (1) and (2) are temporary, and I think (4) trumps (3) over the medium to long term. If you disagree, I'd love to hear it. More detail below.
(1) An Abnormally Mild Winter
I'm flying to Chicago tomorrow and the forecast says a high of 80 degrees. In March. I used to have a long standing rule that I don't go to Cubs games in April for fear of snow, so the above should tell you all you need to know about the wild and crazy winter we are experiencing. As a data point, Hallador Energy (HNRG), a company I follow, states in their 10-K that heating degree days are down 17% from last winter and electricity generation is down 3.3%. Weather drives coal prices but it drives gas prices far more. Gas is the primary fuel used for heating in the US as well as a fuel for electricity generation. Coal is used primarily for electricity generation. Less electricity is being produced. And the electricity that is being produced is switching from coal to (cheaper-than-it-should-be-because-of-the-weather) natural gas. Coal inventories are building. Coal prices are coming down. Coal mines are idling. Reporters are overstating the impacts of (2) and (3) below. Investors are panicking.
It should probably be noted that a warm winter might very well lead to a warm summer which would, of course, increase demand for electricity and, consequently, coal and gas.
(2) A Temporary Oversupply of Natural Gas
I know some folks will criticize the word "temporary". I have a very simple thesis here. $2.30 is below the marginal cost of production. Yes, there is some natural gas that is being produced un-economically to hold leases and, yes, there is some that is being produced as a "free" byproduct of oil production, but - at the margin - it costs more than $2.50 to produce an mmbtu of CH4 (pipeline quality natural gas). Cost of production varies by producer and by region, but estimates I have seen are between $3 and $5 across a wide variety of production regions. It should be noted that the primary factors of production for natural gas (labor, rigs, equipment, services) compete with the lucrative oil industry. A few market responses that will enforce this before moving on:
a) Supply Responses: E&P companies nationwide are adjusting their drilling plan to oil vs. gas as the former is far more lucrative than the latter at current prices. Given rapid decline curves associated with currently drilled shale wells, the effects on supply should begin to be realized shortly. In a more dramatic move, the nation's largest natural gas producer, Chesapeake Energy (CHK) announced in January that 2012 production would be cut by 10%, a strong signal to their customers and competitors alike. It is hard to predict with certainty the price effects of these production cuts. They could be more dramatic than currently anticipated. Natural gas prices are historically volatile.
b) Demand Responses: Besides the fuel-switching in electricity alluded to above, there are a number of good examples of both foreign and domestic industrial companies starting to manufacture and build plants in the US again. South African multi-national Sasol (SSL) has announced plans to build two multi-billion dollar facilities in North America to upgrade abundant natural gas to higher value hydrocarbons. And Businessweek just nicknamed the U.S. the "China" of gasoline given our ability to produce the refined product cheaply and dump onto world markets. That cost advantage is due, in part, to cheap domestic crude, but also to even cheaper domestic gas. Expect to read more articles like that until natural gas trades anywhere near its global energy value.
c) Direct Exports: I keep expecting U.S. politics to de-rail the U.S. export LNG movement, but it hasn't yet. Cheniere (LNG) seems to be on track to move forward (as evidenced by its meteoric stock price rise), other projects such as a massive BP/Conoco project in Alaska seem to be announced with increasing frequency. Even if U.S. politicians block the export of this cheap domestic fuel, I think our neighbors to the North will get it done, which will soak some additional gas out of the North American market.
(3) A Very Real Decrease in Demand from Old, Inefficient Coal Plants Being Shuttered
Score one for the environmental community. After years of resistance, the tide has broken and my RSS feeds are now full of story after story of coal-fired power plants being retired. No matter where you stand on the politics of the issue, this is a real driver of demand going forward so it is important to understand the magnitude. It is hard to quantify (though if you have a good source, I'd love to know about it), but I have a source very close to the issue that tells me that 43 GWs of capacity are expected to retire in North America by 2016. That's mostly coal and mostly U.S. It's also a lot of plants that frankly weren't using much coal anyway because they were old, costly and inefficient. By a lot of back of the envelope math, that gets me to somewhere between 50 and 90 million tons taken out of the U.S. market. U.S. coal market is ~1 billion tons/year, so not an immaterial amount. For a variety of reasons, I think that estimate is skewed high, but let's go with it for now and compare it to (4) below.
(4) A Very Real Increase in Demand Coming from the Rest of the World
To put the above 43 GWs into perspective, world coal-generated electricity capacity is set to increase by 370 GWs over the same period. And those are new, efficient coal plants expected to run 90% of the time, not old coal plants running 10-40% of the time like those being shut down here. Like it or not, global demand is overwhelming. Coal is also much more expensive at ports of call around the world than in the U.S. From Europe to Australia, South Africa to China - coal is more expensive elsewhere than it is in the U.S. where coal is plentiful and abundant. I will not delve into a dissertation on global seaborne coal markets (although a tempting and interesting subject), this article is about the US market and what matters in the U.S. is exports.
Currently, coal exports are constrained by U.S. export capacity. Every major publically traded coal company is doing everything it can to increase exports and terminal developers are responding. Announced new terminals under construction or expansion on the U.S. Gulf Coast are expected to raise gulf exports from a record 22 million tons in 2011 to 50 million by 2015. There will be another 12 million tons of increased capacity at the Ridley terminal in Southern Canada. On the West Coast, there are two mega announced terminals with an expected combined 120 million/tons year of capacity, though both terminals are being fought rabidly by the environmental community and may not move forward. Even if those last two terminals are never built, the announcements on the Gulf and at Ridley will soak up a great deal of excess supply and new terminals continue to be announced monthly.
The jury is still out in the battle between new exports and reduced demand at home. I continue to monitor the subject closely. In the bull case for coal, new exports win by a mile (see West Coast terminals referenced above). In the bear case, exports lose by a little bit. Either way, sprinkle in a few new U.S. coal plants, and the recent weather and natural gas driven plunge in coal prices might not survive a warm summer. I plan to cautiously dip my toe into the choppy water by buying high quality names with exposure to the Illinois and Powder River Basin. I am also looking at Consol Energy (CNX), a high quality low-cost producer with exposure to natural gas prices and a very attractive sum-of-the-parts valuation.
Although the more I think about it, I better make sure I jump in with two feet before the summer. It just might be a hot one.