Does it make sense to short coal stocks?
The Trump administration vocally supports the coal industry and has made several aggressive moves to ease regulations on miners and coal-fired power producers. This friendly environment may have led some to renew their hopes for the industry’s prospects. However, the industry is in the middle of a long structural decline that is unlikely to be arrested by recent government actions and rhetoric. For those of us that believe the current favorable tone from the top is a red herring, can we uncover any promising shorting opportunities in coal-related stocks to make a contrarian bet?
Regulatory Actions
First, here is a summary of the significant moves to date by the administration to support the coal industry:
Targeting the Mercury and Air Toxics Standards rule, established in 2011, which requires coal plants to clean up mercury and other toxins they produce. The EPA is simply opening up a comment period about the rule; this would be likely be followed by plenty of lawsuits if the agency actually tries to rescind the rule.
Easing a constraint put in place in 2013 which placed a low cap on carbon dioxide emissions from new coal plants that effectively required them to install carbon-capture technology.
Revised regulations from 2015 related to groundwater monitoring requirements to make it easier for utilities and power producers to dispose of coal ash.
The DOE put forth a plan in 2018 that would have required grid operators to buy electricity from “fuel-secure” coal and nuclear plants. This plan was shelved after finding little support outside of the administration.
Successfully repealed a ban instituted by the Obama administration in Jan 2016 which temporarily banned new coal leases on public lands.
Successfully froze another rule from 2016 which increased royalty payments paid by companies mining on federal land.
The coal industry has stressed its gratitude for these measures. One mining company, Hallador Energy Company, even lists out President Trump’s election and his supporting measures at the top of the MD&A section of their last 10-K:
Market Fundamentals
However, the market outlook for the coal industry has been and continues to be bleak. Coal-fired power plants are typically used as ‘baseload’ generation, i.e., they are meant to run as much as possible and deliver all energy produced onto the grid for whatever price they can get. Given the energy stack, where the cheapest sources of energy are deployed first, the trend has been towards wind, solar, and nuclear energy being first in line to supply energy to the grid. These technologies are setting the wholesale price of energy which means that coal-fired plants, coming online after these in the stack, are often taking a price that is uneconomic for them.
Coal-fired plants cannot be configured to operate as ‘peaking’ plants, which are expected to sit idle for long stretches and then ramp up very quickly to meet surges in electricity demand. The simplistic reason is that coal takes too long to warm up to the required temperature to deliver power in response to market signals. For now, peaking services are primarily met by natural gas plants.
The recent supportive regulatory climate has not fundamentally change these realities. As a result of these unfavorable circumstances, coal plants have been closing at a fast pace, with closures likely hitting a new record in 2018:
Coal stocks
So would coal plant owners be the best place to look for shorting opportunities? It turns out there are not many good pickings because most coal plants are owned by utilities which are usually large, diversified beyond coal, and earn regulated rates of return on all of their owned assets. A subsidiary of FirstEnergy Corp (NYSE: FE) which owns and operates coal plants did declare bankruptcy in early 2018, but the business is separated and the parent company’s stock did just fine last year. There are some independent power producers which operate coal plants and sell the power to utilities, but they are also diversified in terms of energy sources (for example, NextEra Energy and NRG).
That bring us to the domestic coal producers. The stock performance of several publicly-traded coal miners over the last two years is shown below.
Source: Yahoo Finance
The worst performers are victims of the market conditions outlined above and clearly did not benefit from the change in regulatory climate. WMLPQ (Westmoreland Resource Partners), down over 90%, declared bankruptcy in October. CLD (Cloud Peak Energy) is also down over 90% and is currently trading at around $0.39/share. These are not good candidates for contrarian short bets.
METC (Ramaco Resources), SXC (SunCoke Energy) and HCC (Warrior Met Coal) sell metallurgical coal, which is used as an input in steel production. These companies are not exposed to the energy market fundamentals discussed here and so the bearish thesis does not apply.
FELP (Foresight Energy LP) produces coal from four mines in the Illinois basin. The company has cut its dividend multiple times since 2015, and it may be on the path towards liquidity issues with a current ratio at 0.70 and a quick ratio at 0.50. The stock has declined by over 50% over the last two years though, so a bad outlook appears priced in. Illinois basin coal has a cost advantage over the eastern basins - FELP has a cost per ton in the $23 range, versus $28-29 for operators in Appalachia. Versus the western sources such as the Powder River Basin, Illinois coal is reported to have better quality and it also benefits from shorter shipping distances to east coast markets and ports. There is very little port access for coal on the west coast. These inherent advantages may give FELP some staying power relative to other coal miners. FELP currently has a large majority (85-90%) of its production secured under long-term contracts, so even if market conditions deteriorate further in the short term it is unlikely to pull the rug out from under them. Not the ideal short candidate.
HNRG (Hallador Energy) mines in Indiana. The stock is down 42% over the last two years, despite the efforts of the Trump administration which they went out of their way to highlight in their 10-K. Commodity pricing for coal in this region is down significantly over the last 3-4 years, and their cost of production is at the high end at $29/ton. Thus the company’s margins are at historic lows. That is usually an indication of a poor entry point for shorting a stock; unpredictable commodity prices could easily swing profitability back up in the short term. The balance sheet appears healthy. These factors, in addition to the significant decline in the stock price to date, make me pass on this shorting opportunity.
ARLP (Alliance Resource Partners) mines in Illinois and Appalachia. It has a high production cost, but the business seems stable. ARLP is paying a very high dividend – the yield is currently at 11%. Although that doesn’t sound sustainable for the long run, the company currently generates enough cash flow to cover the dividend payments as well as capital expenditures. The expensive yield to pay on the borrow precludes me from shorting this stock at this point.
BTU (Peabody Energy Corp) is a large producer with 26 mining operations in the U.S. and Australia. It filed for bankruptcy in 2016. Since emerging and relisting in early 2017 the stock has done pretty well, which at least to some extent can be credited to having close ties to the DOE. They are poised to lose a key customer with the likely shutdown or conversion of the Navajo Generation Station in Arizona. These facts makes BTU an interesting candidate for a long-term short position. Short float is close to 5%, higher than average for companies of this size. Counter-arguments to the bearish thesis include a) BTU runs a diversified operation that won’t be totally hobbled by the loss of a power plant or two, b) the company has an improved balance sheet post-bankruptcy, and c) cash flows are currently strengthening largely on the back of export sales.
Like BTU, ARCH (Arch Coal) is a miner to recently emerge from bankruptcy. It filed in January 2016 and relisted in October of that year. The company turned a modest profit in 2017, the first since 2011, and the stock is up 10% over the last two years. It produces coal quite cheaply in the Powder River Basin. There seems to be a level of complacency or even optimism, which provides a basis for a contrarian short bet. A short float of 13% implies that I’m not the only one who thinks so. However, they get a fairly significant % of revenue from sales of metallurgical coal, and the export markets are providing a tailwind for the time being.
Lastly we have CEIX (CONSOL Energy) and CCR (CONSOL Coal Resources). CCR is a master limited partnership which owns 25% of a single mining operation in southwest Pennsylvania. CEIX owns the remaining 75% direct stake in that mining operation, 60% of the LP interest and 100% of the GP interest in CCR, a coal export terminal in Baltimore, and some undeveloped coal reserves in other areas. The concentrated bet on one mine makes for a very interesting short case. The production cost of this mine is $28/ton, at the higher end versus competitors. Duke Energy, a key customer, is planning to close or convert nine coal power plants by 2024. At least one of those plants (Asheville, NC) is supplied by CONSOL’s mines; several others within Duke’s fleet and supplied by CONSOL are of a similar age to the Asheville plant and could very well be on the chopping block too. The main counterpoint to the short thesis, as with other miners mentioned above, is the lifeline that these companies are currently getting from export markets. 31% of the coal produced by CONSOL in 2017 was exported (2018 numbers not reported yet but the trend likely continued).
The run up in CEIX stock could mark a nice entry point for a short position. Short float is at 3% so there isn’t much buildup of a bearish sentiment yet. CCR has been more or less flat, but the company is paying a large dividend currently (almost 12% yield) so it would be tough to hold a short position in CCR for a long run.
Disclosure: No positions opened in any of the aforementioned names yet.
Sources:
https://www.laboratoryequipment.com/news/2019/01/epa-orders-rollback-obama-mercury-regulations
https://www.nytimes.com/2018/12/04/climate/epa-coal-carbon-capture.html
https://www.nytimes.com/2017/08/06/us/politics/under-trump-coal-mining-gets-new-life-on-us-lands.html
https://www.eia.gov/coal/production/quarterly/pdf/t7p01p1.pdf