Until very recently, it seemed like thermal coal producers couldn't buy a break. Utility inventories were well above historical averages, prices were barely sufficient to break even, and demand continued to decline (as seen in the traffic numbers for major railroads). That's taken the price of Arch Coal (NYSE:ACI), the country's second-largest coal producer) down more than 90% over the past five years. Now it seems like there are some signs of life in the thermal coal market, but will the recovery be strong enough to meaningfully improve the fundamentals for this struggling coal producer?
Inventories Heading Down And Demand Heading Up?
Coal stock investors finally have a little good news to celebrate, as March marked a meaningful decline in utility coal inventories. While inventory levels were still about 18% above the 10-year average, there is reason to hope that maybe, for the first time in many years, inventories will reach normal levels.
Helping matters, it looks like the big coal-to-gas switch that defined 2011 and 2012 is starting to reverse. With Henry Hub natural gas above $4.10/MMbtu, Powder River Basin coal is once again very cost-effective and Illinois Basin coal is at least close to competitive. At the same time, adverse weather seems to be compromising hydro-power generation and leading to more coal demand.
SEE: Green Energy: Why We’re Still Not Using It
There's A Big “But”...
Unfortunately, it may be a little premature to assume that coal inventories are going to normalize and/or that coal prices are going to start marching back up. For starters, industry sources have estimated that there could be as much as 100 million tons in latent capacity in Powder River Basin coal waiting for higher prices.
With Arch management expecting a U.S. consumption increase of just 50 million tons in 2013 (versus 2012), that's a problem. I don't expect Arch, Peabody (NYSE:BTU), or Cloud Peak (NYSE:CLD) to act irresponsibly with their production, but the reality is that there's plenty of capacity to absorb demand and that could well limit price improvements. To that point, historical cost parity analysis would suggest fair value for PRB coal above $20 per ton with natural gas above $4, but that clearly isn't the case right now.
It's also worth noting that the very profitable met coal market is still in trouble. Met coal sells for about ten times as much as PRB coal at present, and Arch very much needs a better met coal market to generate stronger EBITDA. Unfortunately, met coal prices have been quite weak lately, and the comments from steel producers like Arcelor Mittal (NYSE:MT) (which is largely self-sufficient in met coal) don't suggest a huge turnaround in demand any time soon. What's more, the same problem exists in met coal as in PRB – a sizable amount of curtailed production that could hit the market and push prices back down pretty quickly.
SEE: A Primer On Coal
Arch Coal Has Taken The Right Steps, But There's A Big Gap To Fill
Giving credit where due, I think Arch Coal management has handled this major downturn pretty well. The company made some nearly catastrophic mistakes back when the market was stronger (taking on a lot of debt to buy International Coal Group and its higher-cost Appalachian mines), but the company refinanced its debt back in 2012 and bought itself some time. Management also curtailed some of the highest-cost mines, and per-ton cash costs were down 11% for the first quarter of 2013. To that end, Arch Coal's cash costs for thermal coal and met coal are pretty solid relative to Peabody, Cloud Peak, Consol (NYSE:CNX), and James River (Nasdaq:JRCC).
The question, though, is whether there are many worthwhile levers left to pull. Over the long term, Arch Coal could perhaps benefit from cost reductions tied to technology and automation, but comments from companies like Komatsu (OTC:KMTUY) would seem to suggest that a lot of that innovation is still on the drawing board. In the meantime, I'm not sure there's a lot for management to do but wait and hope that the cyclical coal markets start moving back up and allow the company to generate the EBITDA it needs to repay debt and fund worthwhile dividends.
SEE: Evaluating A Company’s Management
The Bottom Line
With no significant debt repayment demands until 2016 (assuming Arch Coal can remain in compliance with covenants, which I believe it will), Arch Coal has breathing room. What's more, I do believe that a coal recovery is likely to be a “when, not if” situation – while I do believe the glory days of coal are past (and particularly for Appalachian thermal coal), there's likely to be enough electricity and steel demand to restore prices to a point where Arch can make real money.
The problem now is that valuing the stock feels like an exercise in hope. Using Arch Coal's historical multiples, the current EBITDA expectations would suggest the stock is worth no more than a couple of bucks. On the flip side, the stock is trading at only half of tangible book value, but I suspect the value of those coal reserves is overstated relative to the actual economic value.
If this recovery in U.S. utility coal usage continues, I do expect Arch shares to move higher. The problem for investors is that the best bargains in this sector come when things look worst and it seems all but impossible to generate a reasonable fair value for the stocks. While Peabody is almost certainly the safer bet, investors who believe in higher natural gas prices and a recovering U.S. economy may well want to consider Arch Coal as a very risky turnaround story in the making.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.
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