How Did It All Go So Wrong For Patriot Coal?

| About: Patriot Coal (PCXCQ)

I imagine a few investors are feeling pretty confused now, with news that Patriot Coal (PCX) has declared bankruptcy. So how is it that a company whose assets ought to hold hundreds of millions of dollars worth of net value is going the route of bankruptcy?

Cue The Outrage

It is a pretty safe bet that we'll all hear from the anti-Obama contingent before long, and not without some reason. Notions like "Obama is trying to kill private enterprise" is garbage better suited to talk radio, but the fact remains that the Obama administration has made it meaningfully more difficult to be in the coal business. Whether it's OSHA regulations that cover underground mine operators like Patriot, Arch Coal (ACI), or Alpha Natural Resources (ANR), or EPA regulations that make it more expensive to burn coal for electricity generation, it's not easy to be in the Appalachian coal business (and not all that much better to be in Powder River Basin).

Gas On

More significant, at least in my view, has been the compelling price advantage of natural gas. Widespread shale gas exploitation, coupled with pipeline build-outs, relatively more favorable environmental rules, and much better gas-powered turbines from the likes of General Electric (GE) and Siemens (SI), have made natural gas a compelling option for many utilities. In the eastern part of the U.S., utilities have swapped from coal to gas almost as far as they can, and nobody seems in a big hurry to use any more coal than necessary.

A warm winter and spring only made that situation worse. Coal stockpiles at the utilities grew as electrical demand waned, and utilities started to pay to defer contracted coal shipments. A very warm summer may help coal demand, but it's not going to change the market fast enough to really help Patriot.

Steel Loses Its Sweetness

Patriot has also lost the nice little kicker that it was hoping would come from met coal sales. Met coal, the coal used in steelmaking, carries a substantial higher price than thermal coal and Patriot Coal was hoping to direct about 20% of its production to met coal. Unfortunately, the economic problems in Europe, the slowdowns in emerging markets like China and Brazil, and the sluggish steel prices in the U.S. have kept a lid on price and demand. The long-term market for met coal is still fairly appealing, but once again, that does not help Patriot today.

Where Are The Buyers?

Making matters worse, nobody is in any hurry to step up and buy coal reserves. Patriot declared bankruptcy in large part because the company could not adequately address its needs for a new revolver and term loan to deal with upcoming maturities in the first quarter of 2013.

Selling reserves, even at a bad price, would have appeared to be an option, but it just doesn't look like anyone wants to buy. I can't imagine Arch Coal wanting to go any deeper into Appalachian coal (as its most recent move to do so hasn't really paid off), and Peabody (BTU) seems more interested in Australia than Appalachia. While a company like Penn Virginia Resource Partners (PVR) would normally seem to be a reasonable candidate, this company has clearly bet its future on the natural gas side of its business, and has arguably stretched its balance sheet pretty far in the Chief Gathering deal.

Keep in mind, too, that bond indentures limited the company's ability to sell assets. In its filing, management said that its "existing capital structure prevents it from making the necessary adjustments to achieve long-term success." Said differently, bondholders saw little to gain in relaxing covenants to allow a fire-sale of the coal reserves that secure those bonds.

The Bottom Line

With Patriot in bankruptcy, equity investors need to get out. Even in the unlikely event that the company does some sort of warrant offering to give common shareholders something to hold on to after the bankruptcy process, it's not going to be much at all. The bonds might be a more interesting opportunity, but here too there is a real risk that long-term value of Appalachian coal reserves has been seriously and significantly impaired. This is severely stressed the company looking at a very long road back, even if its assets in the ground do still retail substantial theoretical value.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.