Let's Talk About Coal

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Investors,

I wanted to spend the morning talking about coal. I received a lot of messages yesterday with coal stocks down across the board. To be upfront and clear, I am not an expert in any particular sector. I go where the busted and broken businesses live. Sectors that no one else wants to invest in. When I see a sector in distress I try to learn as much about it as I can.

That is how I found coal equities. At little over a year ago coal equities were trading under the liquidation value of the implied value of the mines. Every stock in the sector was sitting at a multi-decade low. A hated and unloved industry.

Twelve months ago it didn’t matter if you sold thermal or met coal. The market was giving the same value to each product. Today, that is still relatively the same case.

Take this case in point. Yesterday I received a lot of questions if CONSOL Energy’s (“CEIX”) 20% decline was concerning. If I was invested in thermal coal, yes, it would be concerning. But I am 100% invested in met coal which is a totally different product.

For investors new to the space:

  • Thermal coal, also known as 'steaming coal' or just 'coal', is widely used as the principle means of generating electricity in much of the world.

  • Metallurgical coal or coking coal is a grade of coal that can be used to produce good-quality coke. Coke is an essential fuel and reactant in the blast furnace process for primary steelmaking.

Thermal coal is a byproduct that is used to generate electricity. In a normalized environment thermal coal is used to generate cheap electricity. When natural gas prices spike, the demand for thermal coal spikes and electricity generators substitute cheap thermal for expensive natural gas. This phenomenon is happening now. Natural gas prices have spiked to record highs, leading to thermal coal prices increasing in anticipation of a cold winter and on the back of lack of supply from natural gas.

Metallurgical coal is mined to produce the carbon used in the steelmaking process. As of right now, if you want to produce steel in mass you need to mine metallurgical coal. There is no replacement for metallurgical coal in the steelmaking process and I don’t expect a breakthrough over the next three to five years.

TLDR: Metallurgical coal is tied to the global steel industry while thermal coal is tied to the global energy industry.

So what the hell is going on with our coal stocks? First, no one on Wall Street cares if you mine thermal coal or met coal. The case in point was the massive decline in all coal stocks seen today. From what I could tell, the reason for the decline in coal equities was:

  • CONSOL Energy reported poor results. There was a large derivatives contract entered on 2 million tons of API2 coal back when the price was at $79/metric ton. During Q3 that contract was selling at $152/metric ton. This large distraction generated an unrealized loss of $146 million on the income statement this quarter. Instead of generating net income, CONSOL reported a $113 million loss. For reference, EBITDA was positive at $61 million.

  • Thermal coal prices have also fallen, which has dragged down all coal equities. Thermal coal prices are down around 40-50% (depending on what port you use). This is mostly due to China attempting to limit price increases on thermal coal and rising energy prices. The Chinese government is looking to increase domestic supply and cap prices. I’m not sure how this will pan out but government intervention usually makes things even more messy, complicated and expensive.

Overall, if you own met coal miners, the selloff of thermal coal names is only a short-term distraction with no real meaning. Met coal prices are still at record levels and miners are announcing their contracted books for 2022 and beyond.

  1. Arch Coal announced they are selling 400,000 tons into 2022 at a contracted price of $230 per ton. I am expecting the 2022 contracted book to continue to increase going into the holiday season.

  2. Coronado Global Resources announced that 32% of their domestic met coal production would be sold at $187 per ton.

  3. Ramaco Resources announced that they will be selling 56% of their production at $196 per ton.

  4. I’m expecting the remaining miners who have not announced their 2022 contracts to drop them over the next few weeks, which could act as a catalyst for met coal miners.

I suspect that the met coal industry, which has been a beaten battleground filled with bankruptcies, combined with the lack of capital investment into building more supply, will severely hinder any additional supply coming into the market. No one is investing in building new mines at a large scale. Banks are not lending to the space. And woke ESG focused investors are long gone.

This sets the industry up well in terms of pricing. As world economies build back from the pandemic, they will be spending and stimulating the economy with large scale infrastructure projects. Large scale infrastructure projects require a lot of steel. A LOT OF STEEL.

It is extremely hard to forecast what the price of met coal will be in year three, let alone the end of 2022, but I would suspect demand for steel does not slow down. As the CEO of Ramaco Resources said so eloquently…

I view the current macro environment as it applies to us as somewhat like the four legs of a stool. First, on the demand side, all of the developed economies are rebounding from the COVID-19 impact at roughly the same time. Second, there has been fiscal stimulus injected into these economies on a scale we have frankly not seen before. More may indeed come. Third, this expansion of the world’s money supply has had the predictable effect of creating conditions for an inflationary impact that will no doubt affect pricing in hard assets like coal for an extended period. These three legs create a natural underlying demand for steel and, hence, metallurgical coal. The fourth leg is the supply equation. Perversely, coal as a commodity is in an existential period. Despite its continued strong worldwide demand, there are financial and regulatory forces that have created an arbitrary constraint on both new capital availability and, hence, new supply. We do not anticipate these conditions changing any time soon. Nor, do we sense there will be any near-term supply response sufficient to balance demand for the foreseeable future. - Randy Atkins, Ramaco Resources

Don’t worry about short-term price movements. All we need is one year of cash flows at this level of pricing and all met coal miners will come close to generating their market cap’s worth of free cash flow. Everything out is icing on the cake.

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