U.S. coal stocks displayed a solid performance in H2 2013; however, since the start of 2014, stock prices have remained under pressure mainly because of decreasing met coal prices. The U.S. coal industry is mainly facing challenges in met coal markets, whereas thermal coal markets are improving due to higher natural gas prices, and as utilities are contracting of coal.
Last month, I downgraded Walter Energy (NYSE:WLT) from "buy" to "hold" over concerns of weak met coal prices; since then, the stock price has dropped by more than 25%. Met coal price for Q1 2014 settled at $143/ton last month, down 5.9% quarter-over-quarter, due to excess supply in the market and concerns over the health of emerging economies; met coal prices continue to deteriorate (met coal spot prices have declined to $125/ton). Also, I expect that as we move forward, WLT might have to opt for another credit amendment due to weak met coal prices. I recommend investors to remain cautious, and look for updates from the company regarding potential asset sales and sales volume guidance. I remain confident on the long-term outlook for met coal, however in the short term, met coal markets are likely to remain volatile due to excess supply.
WLT is among the leading met coal companies in the U.S. Its earnings are highly sensitive to met coal prices. The company's U.S. coal mines have relatively low costs as compared to its Canadian mines; WLT's coal mine 4 and 7 in the U.S. are cash positive even in the prevailing depressed met coal prices.
Met coal prices continue to weaken due to excess supply, depreciation of the Australian Dollar and an increase in Chinese met coal production. Also, high-cost producers like Arch Coal (ACI) are holding on to their production at high levels. Recently, BHP Billiton (NYSE:BHP) reported a 30% year-on-year increase in met coal production. Given the lack of met production cuts, I believe met coal prices will remain weak in 2014. I will recommend investors to keep an eye on the earnings releases of coal companies, which will be providing and updating their production guidance for 2014, which could have a material impact on the stock prices. Alpha Natural Resources (ANR) is among the leading met coal producers who have disclosed their production guidance for 2014; the volumes are expected to be flat year-on-year. I believe that in the upcoming Q4 2013 earnings releases, companies will announce to lower their future met coal production to address oversupplied markets. Also, the EIA anticipates coal demand to pick up in 2014, which will benefit coal markets. Coal consumption in the U.S. is expected to increase to 955 million tons in 2014, up from 924 million tons in 2013. I expect better coal supply management from coal companies will portend well for the industry in the medium-to-long term.
As met coal prices stay weak, I expect WLT will opt for another credit amendment, as it might be at risk of violating covenants in the latter half of 2014. Already in July 2013, WLT opted for a credit amendment for its $2.73 billion credit agreement to improve its financial flexibility; maximum net secured leverage covenant has been suspended through June 30, 2014 and also, minimum interest coverage ratio covenant has been suspended through March 31, 2015. Due to weak prevailing met coal prices, the company might face issues to meet its leverage covenants in H2 2014 and in 2015, therefore, believe the company can opt for a credit amendment in H2 2014. Also, the company is expected to provide more details on its target of generating $250 million through asset sales; in H2 2013, the company announced that it will opt for asset sales in H1 2014 to generate $250 million in cash. The potential asset sales will help the company improve its financial flexibility and lower its liquidity risk. Another tool available with the company to strengthen its credit outlook is to issue new equity, which will improve its balance sheet.
Also, the company is likely to update its operating cost and capital cost guidance for 2014 during the upcoming earnings release; the company is scheduled to announce its Q4 2013 results on February 20, 2014. Moreover, the company is likely to benefit from depreciation of the Canadian dollar, which will benefit WLT's cost structure and margins for Q4 2013.
I believe coal companies will opt for production cuts in the near future to overcome the problem of excess supply in markets. In the near term, met coal markets are likely to remain volatile and uncertain, however in the long term, I remain bullish on the industry, as production cuts will be observed and better demand will rationalize the market. I recommend investors to remain cautious and look for production and cost guidance from the companies in the upcoming earnings releases, which can have a significant impact on U.S. coal stock prices.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.