Is The Powder River Basin The Next Central Appalachia? Peabody, Arch And Cloud Peak Hope Not

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Includes: ARCH, BTU, CLD
by: Peter Epstein

I follow global coal markets closely and have written numerous articles on SA about coal companies. I've learned at least two important things this year. First, thermal coal from the low-cost/high BTU Illinois basin is well positioned domestically and abroad through exports. Illinois basin coal will take market share away from higher cost Appalachian producers. In addition, there's A LOT of new Illinois basin coal production in the pipeline that will need to be exported, mostly through the Gulf.

Illinois basin coal is benefiting at the expense of both higher cost Appalachian and lower BTU Powder River Basin, "PRB" coals, which brings me to the second thing I've learned. PRB producers Peabody Energy, (NYSE:BTU), Arch Coal, (ACI) and Cloud Peak, (NYSE:CLD) are in big, big trouble. Of course, Peabody has a lot of coking coal exposure in Australia, but half of Peabody's earnings last year came from the U.S.

PRB coal is low sulfur and the lowest cost coal in the U.S., if not the world. As such, PRB coal was never at risk of coal-to-natural gas switching. However, with natural gas prices below $2.50 per MCF, even the lowest cost coal can become uneconomic at the margin. If this were the only problem facing PRB coal, then I wouldn't be writing this article. Most people believe that natural gas prices will rebound above $3 next year, which would alleviate the coal-to-gas switching issue in the PRB.

More pressing is that costs are rising despite falling coal prices. Lately, costs of diesel and explosives have remained relatively high compared to the decline in PRB coal prices. But it gets worse. PRB producers are also seeing their per ton costs rise as the number of tons they produce is slashed due to weak demand. If a rebound in PRB demand from more normal weather and perhaps a slightly stronger U.S. economy was the answer to the PRB's problems, then I wouldn't be writing this article either.

No, it gets worse still. The savior for the PRB was supposed to be exports to Asia through newly built west coast port facilities. These proposed facilities have been significantly delayed or canceled, and no one knows if meaningful export capacity will materialize. One thing that is clear is that there won't be a lot of new capacity in the next 2-3 years, which leaves PRB producers fighting for western Canada port allocations at Ridley and Westshores. How sustainable is that? PRB exports through the Gulf are feasible, but that route is also the main export venue for Illinois basin coal.

The bottom line is that in order to make a real difference, A LOT of PRB coal needs to find a new home, perhaps as much as 20%-25% of the basin's roughly 450 million tons of production. And, we know from Doyle Trading Consultant's recent report about coal plant retirements, that Arch and Peabody are at risk of a significant decline in regional demand, upping the ante even more. What other options are there for PRB coal?

In the past many believed that PRB coal would be railed to the east coast to displace Appalachian coals. Unfortunately, Illinois and Northern Appalachian coals are now better situated to play that role. I fear it's not a stretch to say that the success and rapid growth of Illinois basin coal is the PRB's worst nightmare. So bad, that it begs the question, is the Powder River Coal Basin the next Central Appalachia?

While a great deal has been written about the very warm winter, a lackluster U.S. economy, and record low natural gas prices, the resolution to these presumably short-term and one-off problems won't change the fact that PRB coal is largely stuck in the U.S. and west of the Mississippi. Until/unless a massive amount of new west coast shipping capacity comes online, PRB producers will be in a world of pain.

Disclosure: I am long ANR, CNX, WLT, NRP, OTCPK:CLNMF.

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