Powder River Basin Coal Prices Have Bottomed, All Clear For Arch Coal?

| About: Arch Coal (ARCH)

Arch Coal Stock Surges 40% on Friday's Earnings Release...

Judging by the moves in Arch Coal's, (ACI) stock price, up about 40% to $7.20, (vs. its low tick of $5.16) one would think that Powder River Basin "PRB" coal prices had spiked higher. One would be wrong. While PRB prices appear to have bottomed, the move upwards has been underwhelming. An uptick in spot prices is largely irrelevant, the forward curve is what matters. On that score the CY 2013 PRB 8800 price of $10.85 is below Arch's cost and the 2014 forward price of $12.90 is still $2 below what Arch needs to thrive. Only in 2015 does PRB forward pricing of $15.75 start to look attractive.

A problem with the forward curve is that there's a lot of "shadow inventory" in the PRB. Production cuts have been significant, but capacity can come back quickly due to the nature of the large surface mining operations in the basin. As demand increases due to the reversal of coal-to-gas switching, a rapid supply response might cap increases in coal prices. Increased demand is good as it lowers unit costs, but higher production levels at somewhat anemic margins will not save the day for Arch.

Analyst Views Vary Significantly

In earnings conference calls from Arch and Cloud Peak, (NYSE:CLD), management teams voiced optimism that the tide is turning in the PRB. Essential to this sentiment is the fact that natural gas prices have rebounded to above $3 per MCF, ($3.09 as I write this sentence). So far I get it, a hot summer, higher nat gas prices, coal stockpiles coming down, all is well for PRB coal producers. If only it were that easy.

As the summer heat fades and we move into the shoulder months, recent strength in nat gas prices may fade as well. Then the excitement about PRB coal producers might be difficult to sustain. I own Call Options in Alpha Natural Resources, (ANR), Walter Energy, (NYSE:WLT), Consol Energy, (NYSE:CNX), and the units of Alliance Resource Partners, (NASDAQ:ARLP) and Natural Resource Partners, (NYSE:NRP). I missed a nice move in Arch's stock since last Friday and I share the market's enthusiasm for Arch's cost cutting measures. But, now what?

Too Much Uncertainty to Have Conviction on the Stock

In order for me to consider going long Arch stock at $7.20 per share, I would need to expect a $10.00 stock within 6-12 months. A handful of analyst reports issued since last Friday's earnings offer price targets of $11-$12 per share, (with a firm named Global Hunter at $18). However, another batch of analysts issued price targets of $5-$7 per share. Collectively, the analyst community is not that bullish on Arch shares.

Looking at the big picture, nat gas prices headed into the shoulder months, PRB coal prices that have not yet moved decisively and a wide range of analyst opinions, it's difficult to have conviction in the name. But, the story doesn't end here. Based on next year's consensus EBITDA, Arch has a possible debt problem. It appears that the amendments Arch obtained earlier this year were much needed.

Arch Has A Possible Debt Problem That Shouldn't Be Ignored

Consensus EBITDA for 2013 is $739 million on an Enterprise Value "EV" of $5.6 billion. That's a fully-valued 7.6x EV / EBITDA ratio and a worrisome Debt / EBITDA ratio of close to 5x. The range of estimates for 2013 EBITDA is quite wide at $457 million to $967 million. Uncertainty on Arch's forward earnings is higher than that of Consol, Peabody Energy, (BTU) Walter and Cloud Peak. Unless nat gas and/or PRB coal prices move up more than expected in the next few months, I do not see Arch stock approaching $10 per share anytime soon. I'm sticking with WLT, ANR, CNX, ARLP and NRP.

Disclosure: I am long ANR, CNX, WLT, ARLP, NRP.