My Failure With Peabody Which Has Become A Speculative Position

| About: Peabody Energy (BTU)
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Summary

Peabody is the largest private coal producer with very poor performance along with most of the coal sector the last few years.

A brief analysis of what brought on the decline is presented. Australian asset purchase, coal pricing decline with natural gas competition is reviewed.

Bear and bull case are considered.

Those of us who violate Jack Bogle's advice to stick with buying and holding index funds will inevitably stumble in some of our stock selections. Most of us like to think about our multibaggers and in fact I plan an article about how I try to handle these. For now, a little humble pie is in order. The unprecedented expansion of the Federal Reserve balance sheet the last five years caused me significant anxiety about inflation. I wrongly assumed that overweighting natural resources such as mining and energy would protect against this. Instead, 2014 showed significant commodity declines in multiple areas with both ample supply and weaker demand leading to significant declines in price, revenues, and book value. Coal (NYSEARCA:KOL) in particular has been a disastrous investment the last few years due to several other headwinds. This has led to significant losses in that part of my portfolio. Let's look at Peabody (NYSE:BTU) as an example.

Peabody, headquartered in St. Louis, is the largest private coal producer and in 2011 with thermal coal prices strong, went heavily into debt to buy a large Australian mining asset. At the time, the hope was to sell coal to the voracious Asian market and particularly at a time when met (Metallurgical) coal used in steelmaking was in high demand. The price of met coal was likely artificially elevated in 2011 from massive flooding in Australia curtailing production. Unfortunately for BTU both thermal coal used for electricity and met coal prices began dropping as production came back online and demand softened. Peabody dramatically overpaid for its Australian assets at the very top of the market.

Peabody went from less than 3 billion dollars in debt to more than 6 billion at a time that Met coal demand from China began falling, supply increased, and the mainstay thermal coal business in the U.S. was undergoing a significant price drop as well.

In early 2012, I unfortunately decided that after a 50% reduction in stock price, it was time to sell some covered puts and was assigned at about $31 per share. I was aware that thermal coal in the U.S. was down slightly but it was a very entrenched dominant form of electricity generation in the U.S. (more than 40%) despite EPA and environmentalist objections. Some headwinds did arrive in the form of stricter EPA standards which have increasingly made some older coal utilities too expensive to improve. Gradually natural gas replaced some coal plants entirely, and the fracking revolution made gas so cheap that cleaner burning gas was not only preferred for lower emissions but for economic reasons too.

I did not realize the full impact of fracking in 2012 and my woefully wrong thesis was based on multiple ideas: 1. I believed that environmentalists may have hated coal but would come to try to ban fracking - all it takes is one significant drinking water incident to turn states against it. 2. I felt reassured by Peabody's size: surely if any company could survive and outlast competitors the largest private producer would. 3. Peabody has major thermal coal reserves in the Powder River Basin (PRB) which has substantially lower sulfur content and production costs per ton than traditional Appalachian coal. I felt their coal would outcompete other coal if the price dropped as it can be mined profitably at a lower cost; and does not require as expensive a retrofit of electric plants as higher sulfur coal. 4. Electric power generation has been very unreliable in India even for top tier cities; and I felt that a growing middle class there would demand more electric plants. Coal is the easiest, cheapest energy source to transport and fairly simple to set up new power plants and I felt that exports and coal prices would have to rise. Wrong!

graph of quarterly U.S. coal exports by type, as explained in the article text

Source: U.S. Energy Information Administration, based on U.S. Census Bureau data


I never abandoned my position and refused to take my loss even after the true abysmal nature of Peabody's position became clear. I sold a few call options on the way down as a stock repair strategy but essentially I am down more than 70% on this position. When reviewing the stock chart, there was an interesting spike (and in retrospect time to sell the stock) after the first presidential debate in 2012. Romney was considered the victor of that debate and Peabody's stock price spiked on the market's consideration of a Romney presidency and relaxation of EPA rules.

BTU Chart

BTU data by YCharts

Of course I wasn't the only investor to underestimate how powerful the American fracking revolution would prove. Here I think the facts about coal and price declines of a cheap, abundant, and unloved commodity are obvious in retrospect. Selling at $25 or even $15 would have made more sense. The big drop in 2014 is partially correlated to lower Chinese demand for met coal (see the iron ore decline this year). Thermal coal pricing will only significantly improve if natural gas prices rise and that does not seem likely in the short term unless we get another brutal winter here. A huge multinational could easily buy out Peabody for less than $12/share but there are no publicly known offers.

When natural gas supply runs lower during a cold winter and the prices rise, many plants can go back to burning coal. However, there are essentially no new coal plants being built in the U.S.; there is an effort in China to slow the production of coal plants given the horrendous air pollution issues there, and investors should not expect any quick improvement unless another cause drives up natural gas prices.

On a side note, the longtime CEO Greg Boyce made $9.4 million including various bonuses in 2012, and $10.7 million in 2013. So we can add outstanding corporate governance and a terrific board of directors to Peabody's assets.

Whether to buy or sell:

Bear argument: at the time of writing Peabody is under $8/share. One common investing mistake is "anchoring bias" and I am certain by buying at a higher level I was guilty of it. At this point the previous price of $60 or $30 does not matter. What matters is this: do you want to be a part owner of a 2 billion dollar market cap company carrying 6 billion in debt and selling an unloved commodity that competes with cheap natural gas? If coal prices continue to stay down here the dividend will be cut and eventually common stock holders will be wiped out.

Bull argument and possible reasons company could be a speculative investment. A J.P. Morgan report suggested that the oil price crash will shut down a significant amount of fracking for oil and therefore reduce production of natural gas, a major byproduct. This would eventually increase coal demand and pricing. Personally, I am hanging on to my shares as a very speculative stock but think there are many other factors to consider. There is enough liquidity to last another few years if coal pricing does not drop further. The weakening Australian dollar might help a little with the Asian market and help stabilize the balance sheet.

Assuming oil prices stay this low, many of the smaller E+P companies currently producing oil may go bankrupt or at least lose financing for further new drilling. However, oil production in the U.S. is not run by a cartel - in a Prisoner's Dilemma, this might trigger further production in an effort to generate revenue. Natural gas wells can be capped off but many of the leases are dependent on active production and American energy production is therefore not simply run on pure supply/demand economics.

Political outcomes are hard to predict and invest in - could a coalition of coal state politicians pass bills that roll back some expensive coal EPA mandates? I am skeptical and think they would be vetoed anyway. I suspect that the 2016 presidential election will go to another Democrat (Clinton? Warren? a moderate populist?) and I don't think there will be salvation from Washington for the coal industry. In fact, at natural gas futures at $3/MmBTU the coal industry will continue to suffer regardless of EPA.

Highly Speculative Buy - 50% chance of bankruptcy or asset takeover at much lower price next few years. 30% chance of a double or triple if coal can rebound in couple years and production from other companies is lowered. 20% of lingering at this level for years. 100% chance of new CEO if dividend is cut.

Disclosure: The author is long BTU.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.