Last week the depressed coal names began announcing second quarter results. Investors already knew results would be poor and were looking for clues to spark a rebound in the sector. On Friday weak industry player Arch Coal (ACI) set off a huge sector rally. The coal supply rationalizations have arrived for a cyclical set up. Now the industry is waiting for natural gas to right itself.
The coal investment thesis stands on two legs. First, U.S. coal producers will at some point no longer be held hostage to the natural gas oversupply. Secondly, the global super-cycle is being driven by the industrialization of China and other emerging nations.
Hope continues to abound the U.S. coal market will return with vengeance. I am on the lookout, though I think a hairy natural gas should season must first be navigated. Peabody Energy (BTU) is well positioned for a U.S. rebound. Over the course of this cycle strong players like Peabody are taking market share from debt leveraged and high cost competitors.
Peabody kicked off the coal earnings season, and they showed their relative financial strength in using the downturn to buyback shares and retire their own debt at a discount. In Arch's conference call silent snickers could be heard when management was asked if they were considering doing the same. Of course not, as Arch is in a weak place and hopes be able to sell some assets into the depressed market to raise some cash.
Viewed from the U.S. and financial lenses, Peabody is in excellent shape. However, Peabody has structural problems with their Australian operations coming to the foreground. Peabody made a big bet on China driving worldwide coal demand when they bought Macarthur Coal in 2010. Yet China's recent economic slowdown is not the chief concern.
In Peabody's earnings release future expectations were drastically cut:
"..Australian conditions that include performance at contractor-operated mines, lower average realized pricing, a longwall move, timing of export shipments and the introduction of the carbon tax."
In Peabody's conference call the continued excuse of contractors was annoying. Weak international coal pricing is a more recent development than in the domestic market. For a company of Peabody's size to reference normal operations like longwall moves and shipment timing in this context is disconcerting.
However, Australia's carbon tax is the main problem. More accurately called the Mineral Resource Rent Tax, this government grab began on July 1 of this year after a long political battle down under. In short, I love the royalty business because it sucks in the economics of an asset. This tax does the same. Suddenly Austrailia is a higher cost resource producer for the long term.
Investors looking to play a recovery in the U.S. coal market should look elsewhere than Peabody. The Australian headwinds have only begun and are too strong.
Other strong, well capitalized and low cost producers are available for coal investors. Alliance Resource Partners (ARLP) actually increased their distribution. Suncoke Energy (SXC) had good profitability. Consol Energy (CNX) had good second quarter results, though Consol is not a pure coal play with their high quality natural gas division.
We will consider the other coal names in the future. Meanwhile, industry conditions will continue to be monitored.