Coal Conundrum: Learning From Penn Virginia Resource Partners LP Q2 Earnings

| About: Penn Virginia (PVR)

Penn Virginia Resource Partners LP (PVR) owns and manages 804 million tons of coal reserves primarily in Central Appalachia, though the firm's portfolio also includes producing properties in Northern Appalachia, the Illinois Basin and New Mexico.

About 89 percent of the coal that Penn Virginia Resource Partners' properties produce is steam coal, the kind used in power plants. But the company's mines in Central Appalachia contain high-grade metallurgical coal, the varietal used in steel production.

Penn Virginia Resource Partners doesn't mine coal; instead, the master limited partnership leases coal-producing properties to mining firms such as Peabody Energy Corp (BTU) in exchange for royalties. These 10- to 15-year agreements usually involve a guaranteed minimum plus a fee based on the value of the coal mined on the partnership's properties.

Although these agreements somewhat buffer Penn Virginia Resource Partners' against weakness in the coal market, declining sales volumes and prices weighed heavily on the MLP's second-quarter results.

U.S. coal producers have felt the burn after the no-show winter of 2011-12, which elevated electric utilities' inventories of coal and further depressed the price of natural gas, making the relatively clean-burning fuel more competitive. With the price of natural gas plunging to record lows and offering superior economics to coal, utilities with the flexibility to take coal-fired capacity offline and ramp up gas-fired plants have eagerly made the switch.

The Energy Information Administration currently projects that the U.S. electric power industry's coal consumption will tumble 14.3 percent in 2012, to 796 million short tons. Electric utilities in 2011 accounted for about 92 percent of domestic coal demand.

Fuel switching has weighed heavily on coal producers' earnings, especially those with elevated production expenses or outsized exposure to Central Appalachia, a region where compliance costs have increased and incremental production growth is hard to come by because of depleted seams. At current commodity prices, producing coal in this region is uneconomic for many operators.

To worsen matters, reduced heating demand during the 2011-12 winter has elevated many utilities' coal inventories, prompting some power companies to sell excess supplies in the spot market (further depressing prices) or push to delay contracted deliveries.

But investors shouldn't assume that the recent bout of fuel-switching marks the end of King Coal. Natural gas prices eventually will rise to levels that make thermal coal more attractive to electric utilities. At that point, price-related fuel switching will reverse course.

Central Appalachian coal becomes more competitive in the Southeast when natural gas exceeds $3.50 per million British thermal units (mmBtu) to $4.00 per mmBtu, while utilities have an economic incentive to revert to coal from the Powder River Basin when natural gas tops $3.00 per mmBtu.

Penn Virginia Resource Partners' CEO William Shea summed up the coal industry's response to these headwinds in a conference call to discuss second-quarter results: "reduced shifts, extended vacations, idling of facilities and operator contract terminations," all of which seek to align supply with demand. The aforementioned actions are all voluntary, but bankruptcy should also appear on the list. Patriot Coal Corp. (PCX) on July 10 filed for bankruptcy protection, sunk by a major customer default and plummeting cash flow.

The MLP's management team likewise warned that U.S. steam coal prices were unlikely to recover in the back half of the year or in early 2013, as competitive natural gas prices and elevated inventories have prompted utilities to push back scheduled deliveries until next year. Although the summer heat has provided some relief in this regard, coal producers are hoping that a cold winter will help to alleviate the supply overhang.

These trends weighed heavily on results in Penn Virginia Resource Partners' coal and natural resource management division, which still accounted for 46.7 percent of the firm's adjusted earnings before income, taxes, depreciation and amortization (EBITDA) and meaningfully impacts the firm's overall results.

In the second quarter, this operating segment generated adjusted EBITDA of $26.7 million, down 37 percent from year-ago levels. Management attributed the majority of this weakness to a decline in coal-royalty tons, which tumbled 22.7 percent from 12 months ago, to 7.8 million tons. Meanwhile, the plummeting price of steam coal also reduced the firm's second-quarter coal royalty revenue to $3.76 per ton, compared to $4.40 per ton in the second quarter of 2011.

On the plus side, management disclosed that the firm's largest lessee, Peabody Energy Corp , has largely maintained its output, which is destined for the Southwest, a niche market where coal demand has remained relatively stable. At the same time, management disclosed that Patriot Coal plans to continue mining its leased properties in Central Appalachia, though some output reductions are likely.

Mid-Continent Challenges

Penn Virginia Resource Partners' midstream operations in the Mid-Continent region, which posted a 27.4 percent decline in adjusted EBITDA during the second quarter, also faced their fair share of headwinds.

Although throughput on the MLP's gathering and processing system surged to 453 million cubic feet per day from 422 million cubic feet per day a year ago, this increase in volumes failed to offset the massive decline in NGL prices at the hub in Conway, Kansas.

Penn Virginia Resource Partners also has some exposure to NGL prices in this region, as keep-whole agreements -- contracts in which the processor retains the NGLs as compensation for its services -- account for about 15 percent to 20 percent of throughput in a given quarter. Meanwhile, percent-of-proceeds contracts account for about 60 percent of processed volumes. In these deals, the processor receives a predetermined percentage of the proceeds from the sale of the natural gas and NGLs.

Management also noted that in mid-May -- the nadir for NGL prices -- some producers had opted to keep ethane in the natural gas stream rather than paying processors to remove this hydrocarbon for sale.

Looking Ahead

Despite this undeniably disappointing second quarter, Penn Virginia Partners' unit price has held up reasonably well in subsequent trading sessions, in part because management indicated that the firm would cover its full-year distribution by 110 percent in 2013, assuming it meets the midpoint of its forecast for adjusted EBITDA.

With volumes and pricing in the coal segment likely to remain under pressure in 2013, management has pinned its hopes on the firm's eastern midstream segment, which accounted for 31 percent of total adjusted EBITDA in the second quarter.

Management has noted that the expansion of existing infrastructure in the Marcellus Shale and the integration of assets acquired from Chief E&D holdings will increase the percentage of fee-based contracts to 80 percent of nameplate capacity.

This transition from a coal-focused MLP to one that generates the majority of its cash flow from midstream infrastructure was never going to proceed without a few hitches. That being said, I remain bullish on the company's long-term growth prospects, though investors may want to wait for a pullback to build their position in this high-yield dividend investment.

Disclosure: I am long PVR, BTU.