By now everyone is well aware that natural gas price has dropped some 34 percent so far this year and is hovering around $2.00 per mmbtu. What is less publicized is the impact that has had on the fundamentals of what used to be King Coal. As the chart below shows, coal MLPs have performed poorly this year compared with the MLP Index, which itself has lagged the S&P 500 by more than 9 percent year to date.
Coal MLPs have outperformed regular coal stocks year this year to date, year-over-year and so far in April. Coal MLP performance is skewed by Penn Virginia Resource Partners LP's (PVR) outperformance, which is tied directly to the midstream portion of its business that is set to more than double to represent 75 percent of EBITDA in 2013.
Coal corporations with substantial metallurgical coal operations, like Alpha Natural Resources, Inc. (ANR) and Walter Energy, Inc. (WLT) below, have outperformed the other coal companies so far in April. Even with that bounce, however, coal stocks have produced an average total return in the last 12 months of -59 percent.
Weak performance has some research analysts (notably at Citi and Deutsche Bank) and media (notably the Wall Street Journal and Barron’s) calling the bottom and for a rebound, particularly for coal stocks with export exposure. But exports are the only bright spot for an otherwise dark and dirty sector. That sort of wishful thinking is not going to change declining industry fundamentals. Just as it has been said millions of times “Don’t fight the fed”, it is very hard to fight natural gas production growth (and carbon regulation) these days.
Several factors are combining to put increasing pressure on coal companies, which I discuss below. Coal prices have factored in these headwinds, with Central Appalachian coal spot prices down 20-percent-plus YTD and Powder River Basin spot prices down 40-percent-plus YTD. Coal companies have caught a bid in the last few weeks (although sporadically), but that valuation-driven bounce won’t last long.
Major Coal Headwinds
Coal to Natural Gas Switching – According to the EIA, coal consumption by the U.S. electric power sector is expected to fall below 900 million short tons for the first time since 1996. Coal demand by the power sector is expected to drop 5 percent year-over-year. This drop is a result of increased adoption of natural gas as the fuel for power generation given its cost advantage, and a very warm winter reducing consumption of all electricity. 92 percent of the coal produced in the U.S. is consumed by the power sector, so if coal’s share of generation continues to fall, coal miners will face continued margin pressure.
At the end of 2012, the EIA expects coal’s share of power generation to drop to 40.4 percent and expects natural gas share to rise to 27 percent, continuing the multi-decade erosion of coal’s once dominant position with power producers.
Coal bulls make the case that coal to natural gas switching fatigue has arrived. In other words, power companies that can cheaply switch to natural gas have already switched. If natural gas stays this cheap, and the cost of mining coal grows with regulations, power companies will figure out a way to switch. Natural gas will continue to whittle away at coal’s once dominant market share and force recontracting of coal sales at lower prices.
- Potential Carbon Regulation – There is no pending carbon legislation right now, but if Obama were to get re-elected that would increase the chances of carbon regulation that would directly and negatively impact coal producers.
- Weak Economy and Conservation – Energy demand in general is on the decline in the U.S. Crude oil imports are lower than they’ve been in decades, vehicle miles driven are lower, car ownership and home ownership among young people are at historic lows. All of this implies minimal growth in the overall electricity pie, which as I mentioned above, is 92% of coal demand in the U.S., with the rest mostly exports.
- High Inventory Levels– As shown in the chart below, inventories of coal at power plants is at historically high levels, even with a drop in inventories in each of the last 2 years. High supply doesn’t usually result in high prices or extra demand, leaving coal producers with few options other than to continue to cut production.Coal production is already down 7 percent from its all-time high in 2008, and it looks like the warm weather and cheap natural gas will see that decline continue in 2012. Lower production all else being equal would lead to higher prices. But all else is not equal, the pie is shrinking as is coal’s share of it, which means actions taken increase the price of coal from today’s levels (like by cutting production) would only cause the cost advantage of natural gas to grow.
- Uncertain Transportation Costs for Exports – The problem with relying on export growth is that shipping rates can vary quite a bit, and those rates tend to increase when economic growth is higher. So, if China and India are growing at a rapid rate, that generally means coal export prices will be higher and export volumes will be higher, but it also means that transportation will cost more to get the coal there.
Emerging Markets Growth, Natural Gas Recovery, Switching Fatigue
Coal companies might be due for a bounce and worthy of a short term trade, but it’s hard to make a long term bet on coal at this point. Potential upside to coal prices this year could come from significant export growth, an extremely hot summer that burn off inventory, or some serious reduction in natural gas production that results in higher gas prices (unlikely). There is no doubt coal companies are cheap, but that in itself is not a catalyst. I like to go through my portfolio and determine what the positions say about my view of the world. In other words, what must go right for this particular portfolio to work out well? What am I betting on? A bet on coal is a bet that the rest of the world will continue (1) to grow and (2) to use coal, and (3) that shipping rates will remain cheap enough to justify exports from the U.S.
Also, for the coal bull case to work out, coal production and demand would need to stabilize, so you are betting on benign regulatory environment and rising natural gas prices. Tough bet.
If You Insist: Bet on ARLP
If you do feel inclined to bet on the turnaround of the coal industry, Alliance Resource Partners LP (ARLP) is the best choice among MLPs. ARLP is a very well-run, low cost, heavily-contracted steam coal producer. At year end, ARLP had 97 percent of 2012 production contracted and priced, and 67 percent of 2013 contracted and priced. The 67 percent is by far the highest of any coal mining company. ARLP has only 8 percent of its production in the high cost central Appalachian region, and most of its production is in low cost regions of Northern App and Illinois Basin. ARLP has not issued equity in more than 5 years, instead choosing to fund growth capex out of its massive coverage ratio (internally generated cash flow).
ARLP has the highest distribution coverage ratio of any MLP, which will allow ARLP to grow distributions by 12-percent-plus again this year. With 6.8-percent yield (yesterday’s close), combined with 12-percent growth, a very conservative balance sheet, ARLP is the best positioned coal name to own right now. So, if you have to own a coal name and you are somehow bullish on a coal recovery despite the above industry headwinds, ARLP is an excellent choice, as is its public general partner Alliance Holdings GP, L.P. (AHGP). I have no positions in ARLP or AHGP in personal or client accounts, because I don’t believe in the long coal story.
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