As Europe demands coal, Peabody Energy can supply (NYSE:BTU)
Today, the factor that has the most impact on the markets is the global shortage of energy. The shortage of key fossil energy products began long before Russia invaded Ukraine, though it certainly exacerbated the problem. In November, I discussed energy issues regarding capital investment, or lack thereof, in the U.S. natural gas and oil markets and how this issue could lead to a significant decline in energy production in United States this year.
In fact, the current energy crisis began in late 2014 when commodity prices experienced extreme declines. This led to years of negative cash flow for most energy producers around the world, giving them low investable capital by 2020. As oil prices crashed that year (2020) , most oil companies cut production drastically and, given low cash (and labor) levels, struggled to normalize production. This problem has been compounded by massive oil and gas divestment and regulatory measures which, while restricting domestic supply, fail to reduce demand for fossil fuels (thus creating no environmental benefit and simply increasing prices and foreign energy dependence). Add to that the impact of a drop in global exports from Russia, and we have a recipe for an extreme increase in energy prices.
With soaring energy prices, the price of virtually all goods is expected to rise as transportation costs soar and create new pressures on the supply chain. In my opinion, this type of situation, marked by a probable destruction of demand mixed with high uncertainty, leaves very few “safe” stocks in which to invest. Obviously, oil and gas producers are a decent option, as discussed in “XLE: How The Russian Invasion of Ukraine Could Impact Energy Markets.” However, other options may be better today or allow investors more portfolio diversity. A notable example is the world’s most controversial and abundant source of energy, coal.
I’ve been particularly bullish on coal companies Alliance Resource Partners (ARLP) and Hallador Energy (HNRG) since 2020, which have delivered returns of 451% and 206%, respectively, since last coverage. As expected in 2020, the price of coal has soared worldwide as declining natural gas production and supply chain constraints have led to a shortage of coal. Coal is back in the headlines as Russia, the third-largest coal exporter, is set to experience supply disruptions. This prompted Indonesia, the world’s largest coal exporter, to limit its exports to ensure stable domestic supplies. This creates a huge opportunity for the few remaining US coal exporters, such as Peabody Energy (BTU).
Why Peabody Energy can keep rising
Coal is a notoriously polluting energy source, but it should be pointed out that this can be partially mitigated by carbon capture. As such, there have been significant coal divestment trends that have likely reduced coal supply. Divestment efforts do not change the fact that coal still provides around 40% of the world’s electricity and is one of the few cheap energy sources available to developing countries. So, instead of reducing fossil fuel production, the trend of coal divestment has led to the chronic undervaluation of many coal stocks. More importantly, the trend has led to a massive increase in coal prices due to the global shortage.
The potential significant drop in coal exports from Russia and Indonesia, which collectively represent half of total world coal exports, will likely turn the formidable 2020-2021 coal shortage into a relatively extreme one. In my opinion, if coal exports from Russia and Indonesia drop significantly, coal could rise much more than oil and gas. It should be noted that, unlike oil and gas, coal can be transported more dynamically (without pipelines or complex LNG requirements) and is easy to store, making it an attractive fuel source in Eurasia (which usually faces huge natural gas reserves-string breaks). As such, the European Union is looking to dramatically increase coal consumption this year due to the huge disruptions in the natural gas supply chain.
Overall, we have a golden loop situation for US coal exporters, marked by low supply through 2022, a significant increase in potential demand, and a lack of competing coal exporters. Although the US natural gas supply is low, it is likely sufficient to support an increase in US coal exports at record prices. To illustrate, see Newcastle coal futures prices:
The price of coal has fallen from ~$145/T to ~$405/T so far in 2022. Coal was historically expensive, even at the start of the year, as it generally traded between $50/ T and $100/T over the past decade. . Peabody’s production costs range from $10 to $99/T across its business segments, with most unit sales coming from its lowest cost mining facility. As such, the company should make extremely large profits with coal prices where they are today.
Unfortunately, Peabody is on the wrong end of a coal price hedge bet. As of December 31, the company had a derivative hedge position of 1.4 million tonnes in 2022 and 0.7 million tonnes in 2023. Considering the approximately $250 increase in coal prices since then, total losses from these contracts are likely between $300 million and $500 million, depending on management decisions since then. That said, we do know that the company recently entered into a $150 million unsecured credit facility at a high 10% interest rate and posted a total of $534 million in cash to meet margin requirements. .
While this was undoubtedly a significant loss for the company given its market capitalization of $3.5 billion, the company had $950 million in total cash and $870 million in net working capital at the end of last quarter, which gave it decent momentum after the shock. Based on its 2021 10-K (p. 61), we know the company’s revenue per ton and the mining cost per ton differs significantly depending on its mining facility. Keep in mind that it produces ~132 million coal per year and could increase production given the attractive environment. As such, I expect his profit gains from rising coal prices to be considerably higher than the losses derived. See below:
Based on this table, I calculated that the company had a weighted average revenue per ton of $25.9 and a WA cost per ton of $19.4. Assuming no change in costs, 130 million tons of sales and a 50% to 150% increase in revenue per ton, we arrive at an EBITDA outlook of approximately $2.6 billion to $5.9 billion. of dollars. This would represent a 210% to 610% increase in EBITDA over the 2021 level. After subtracting approximately $1.25 billion in expected interest, taxes, D&A and derivative losses, this brings us to an estimated total revenue of $1.35-4.65 billion or EPS of $10-35. This estimate is significantly higher than the consensus-expected 2022 EPS of $7.1 (likely based on outdated estimates).
I use a huge range due to the many uncertainties regarding the impact of the military conflict and its repercussions on the coal market during the year. Additionally, there are many intricacies in Peabody’s business that would alter its marginal costs and realized prices. That said, it seems very likely that the company is trading at a forward “P/E” of at least 2.22X and potentially below 1X, depending on how the coal situation develops. Such valuations are virtually unheard of outside of certain segments of the stock market, such as coal.
Peabody for the long haul?
Just looking at the situation today, Peabody looks incredibly cheap with substantial upside potential. The company is a slightly speculative short-term bet that will carry significant volatility. The stock would still be fairly affordable today, even if coal falls back to 2021 levels. Despite this, the stock still has an 8.4% short interest, which is a bit high and could lead to a short rally. term if it continues to increase.
Of course, the situation becomes less clear when we consider Peabody as a long-term investment. As the world becomes more unstable, the potential of foresight seems to be getting shorter and shorter. It is unclear how today’s many events and instabilities will impact coal in the long term. Indeed, I expect record fossil fuel prices to give renewables a much-needed boost as they become relatively attractive. At the same time, extreme global inflation and instability are making it difficult for businesses, households and governments to pursue the costly investments needed to generate renewable energy. It remains true that coal is the main source of energy in emerging markets and still powers many developed countries. Coal is also very abundant compared to other fossil fuels.
So while it can be argued that high fossil fuel prices will cause a “green revolution”, it will likely take decades yet. Meanwhile, natural gas, the main source of energy in the United States, is proving less stable and less accessible than many had hoped before the “coal crumble” of 2010-2020. All in all, if we take a realistic view as opposed to an idealistic one, it really seems unlikely that global coal demand will decline anytime soon. Coal production has declined, so prices may remain high for many years, allowing Peabody to continue to generate substantial profits for years to come. Again, I see Peabody primarily as a short-term “undervaluation” bet, but the “coal is dead” argument against the company (as a long-term bet) may prove to be as correct as past predictions of “peak oil”.