How to Fight Stagnant Coal Prices

How to Fight Stagnant Coal Prices

Low natural gas prices and strict emissions regulations have led to a stagnant demand for U.S. coal. The uncertainties regarding future regulations have deterred investments in the coal production industry. Yet, firms such as CONSOL Energy , Cloud Peak Energy , and Peabody Energy could regain investors' confidence by taking advantage of their economic moats, forward selling, or the diversification of their production.

Taking advantage of natural gas
Apart from being an electric energy firm, CONSOL is one of the largest U.S. coal miners and an important natural gas producer. The company boasts an impressive portfolio, which includes natural gas production and undeveloped reserves. In 2010, the firm made its largest addition with the acquisition of Dominion Resources' natural gas assets, worth some $3.5 billion.

The interesting aspect of CONSOL's portfolio is the high correlation between demand for the Appalachian coal and the price of natural gas. Growth projects in the coal sector are being shelved, while the company's natural gas operations are expanding. Increasing the firm's shale gas asset portfolio will be achieved through the cash flow generated by CONSOL's coal division. This is a good move, since demand for Appalachian coal has suffered due to low natural gas prices.

The firm's coal assets are mostly located in the Northern Appalachian Basin, which benefits from relatively low production costs. However, the stagnant demand for coal has turned the company's attention to the area with the brighter outlook, the natural gas division.

The partnerships formed with Hess Corp (NYSE: HES) and Noble Energy (NYSE: NBL) in 2011 gave way to the development of CONSOL's unconventional natural gas acreages. With its position in the Marcellus shale, the firm has also gained access to a relatively low-cost natural gas production region.

CONSOL Energy is currently trading at 1.6 times its trailing sales, while the industry average stands at 0.98. The company has incurred a large amount of debt as a result of the diversification effort and has seen revenue decline as demand for U.S. coal remains stagnant.

Low-cost production and forward selling
Cloud Peak Energy is not only the lowest-cost coal producer, but also operates in the lowest-cost mining region in the world: the Powder River Basin. The firm has a production capacity of around 100 million tons, making it the third-largest coal miner in the U.S. The output generated by the company, along with low cash extraction costs, has helped Cloud Peak maintain an edge over competitors.

Cloud Peak has been able to deal with the stagnated demand for coal thanks to two factors: forward selling of production and extremely low production costs. Through the forward sale of the upcoming coal output of the next year or two, the firm can keep just enough workers and equipment it needs to fulfill current contracts. This allows the firm to focus on efficiently operating its assets to keep production costs at the lowest. The extraction costs on the other hand, are well below the $10 per ton mark, giving the company a narrow economic moat. The coal extracted from the PRB region not only beats natural gas prices, but also trumps other coal in terms of demand and price tag.

Additionally, Cloud Peak has achieved modest debt levels through moderate fiscal conservatism, accompanied by forward selling of coal output. I can only feel optimistic about this firm, which has reported healthy profits, despite the stagnated demand. Also, while trading at 0.6 times its trailing sales, Cloud Peak is valued at a significant price discount to the industry average.

High growth rates in low-cost regions
Peabody Energy not only has majority-ownership of 27 coal mines throughout Australia and the U.S., but also markets and brokers the resource globally. Stagnant demand for coal in the Asia-Pacific region and the U.S. has led the company to shift toward regions with lower costs and higher growth rates.

Like Cloud Peak, Peabody has also benefited strongly from producing coal in the extremely low cash cost region of the PRB. As the largest miner in the area, the company enjoys a narrow economic moat. Abundance, low cost, and low sulphur content of coal extracted from the PRB have pushed demand growth over the past decades despite elevated shipping costs. By leaving the Appalachian region and focusing on lower cost production, the firm has been able to continue generating healthy profits.

Furthermore, the company's mines in Australia generated significant profits from elevated met coal prices, yet stagnant demand is beginning to hurt the company. Hence, the firm might be risking too much by investing heavily in the region. The increasingly cyclical Asia-Pacific steel industry could be catastrophic for Peabody, particularly if China's economic rebalancing leads to a slowdown in steel production.

Although Peabody has an attractive domestic portfolio, its exposure to the Asia-Pacific region makes it vulnerable. Trading at 0.64 times its trailing sales, Peabody is available at a 38% price discount to its industry peers' average. Although steps have been taken in the right direction, I would hold on to this stock. The large investments made in Australia have yet to pay off and the Asia-Pacific demand does not seem to be on the rise. Also, the company has several operations outside the extremely low cash cost region of the PRB.

Waiting for coal demand to rebound
Firms such as CONSOL Energy and Cloud Peak have managed to deal with strict emission regulations and stagnant demand for U.S. coal. By diversifying into the natural gas sector, CONSOL Energy is simply adapting production to demand. Cloud Peak, on the other hand, continues to reap the benefits of producing at the lowest cost and forward selling production. I think the results on concentrating production in the PRB will be huge for Cloud Peak, and as a result I'm bullish on the stock.

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