Over the last week I've had quite a lengthy debate with Mark Anthony and others over the prospects for coal (KOL). Basically I'm defending that there is a chance for a panic, and is thus risky to buy at the present levels, whereas Mark Anthony says that we're right at the bottom.
This discussion is relevant both for the coal and natural gas (UNG) (which is down 32% year-to-date), as well as for coal suppliers Peabody Energy (BTU), Alpha Natural Resources (ANR), CONSOL Energy (CNX), Arch Coal (ACI), James River Coal (JRCC) and others.
This article is a summary of the arguments in both sides.
The Long Thesis
Mark Anthony sustains that:
- There is little coal to natural gas substitution going on. He puts it at 20% of the drop in coal usage, attributing the rest to weather;
- Coal production is already down substantially year-on-year, so producers are responding to the lower usage and this will help stabilize and elevate prices;
- Coal exports are up substantially and will help mitigate lower consumption;
- There's extreme pessimism in the sector;
- Natural gas won't exhaust storage facilities this year, even though it entered the injection season with inventories at historically record levels. He sustains this based on his correlation between the bottoms of the cycles and the tops of injection cycles, saying that producers and consumers adapt to the need not to exhaust storage;
Outcome of the long thesis
The long thesis sustains that coal prices are already at unprofitable levels, and as such a rebound in coal prices and coal supplier share prices is imminent.
The Short Thesis
I defend that:
- What is happening in natural gas is a once in a half-century event, coal is used almost entirely toward power production and competes with natural gas. Coal is traditionally the cheapest fuel when compared to natural gas, so coal generators get dispatched ahead of natural gas generators. Such relationship has broken down due to the low natural gas prices, and now coal is being substituted for natural gas in generation, both through plants that can burn both fuels, and especially through the dispatching of natural gas turbines ahead of coal-fired generation. This is lowering coal consumption and prices (there are constraints to the substitution, some permanent, regarding the stability of the networks and the characteristics of the generators, some which dissolve with time, regarding supply contracts on coal and natural gas);
- Natural gas is seeing extremely high production due to the shale boom, and even with the said substitution inventories are at historical records for this time of the year. This production won't abate in the short term, even though rig counts are already dropping. This means that this year there's a high likelihood that storage facilities for natural gas will be exhausted and that can have unpredictable consequences for natural gas prices, and thus for coal;
- The EIA confirms the substitution in power generation that I describe both in their usual updates, and through theoretical work, thus lending credibility to the thesis (see: EIA Short‐Term Energy Outlook Supplement, "The Implications of Lower Natural Gas Prices for the Electric Generation Mix in the Southeast", May 2009);
- Longer term, the EPA's aggressiveness toward coal emissions is leading to decommissioning of coal-fired power plants and little investment in new units. This can mean lowered long-term consumption of coal;
- Also longer term, the emergence of more renewable energy can have an impact on the demand for coal, especially if rules requiring priority dispatch are implemented;
- Also longer term, a trend toward smart grids will favor the renewable share of generation; as such grids are more able to accommodate its less stable and predictable nature (especially wind);
- Regarding pessimism, the short interest is only high on a couple of stocks, such as JRCC with 40.5% of outstanding shares sold short, or ACI with 13.3% sold short. BTU is at 2.9%, ANR at 7.6% and CNX at 5.8%. These are levels that show some concern but not outright distress.
Outcome of the short thesis
The short thesis as defended by me isn't really a call to short, as much as a call to a defensive posture. The rationale is that the situation is serious enough that it might at some point generate a panic where much lower valuations will be attained by the stocks in the sector. This has repeated itself many times in the market even under less serious circumstances, so it cannot be ruled out today.
Panic/distressed valuations are usually much lower than the valuations the coal companies still trade for today. It's easy to see EV/EBITDAs in the 6.5 area still, and these are "normal" valuations, not distressed. Distressed valuations can imply drops of more than 50% for most coal stocks. Given the chance that these valuations might happen during 2012, I am cautioning people to not get in front of this possible train. At least not yet.
It's important to notice, in this case, that I too believe that these two sectors (natural gas and coal) will generate cyclical buying opportunities due to what is happening. The difference in opinion, that makes me defend the short thesis and not the long thesis, is one about timing and risk. I believe that the situation is serious enough that we will witness distress in these equities, and the downside that these equities can have under distress is almost the same today, as it was when all of these stocks were 100% higher or more.