I’m a big contrarian investor at heart. I love the “hated” and “dying” industries. Those melting ice cubes that slowly lose revenue every quarter. The black sheep of Wall Street.
Recently I have been looking into industries that have environmental, social or governance (“ESG”) risk. You tend to find some interesting opportunities in these industries. Hated and disregarded. Companies that spit off cash flow but trade at basement level valuations due to the perceived notion that they are “bad” for society in some form or another.
My recent interest in these “bad” industries has lead me to research the coal industry.
For newbies, there are two types of coal:
Thermal coal: used in electricity generation
Metallurgical (“met”) coal: used in the production of steel
Both thermal and met coal get bad reps as they are pollutant to the environment in some form of another. In addition, there is a social factor as well given black lung disease, coal mine explosions, and an entire host of problems that occur when the large coal companies leave these small southern towns that have been the main employer for decades.
To make matters worse, outside of the not so great social and environmental issues, the coal industry is the epitome of the boom and bust. Bankruptcies. Total loss of capital. Restructuring. Rinse, wash, repeat. The entire industry is littered with lost investor capital to the wind. Billions have been made, and billions have been lost.
This ESG risk combined with the lack of investor capital has lead me down the path of researching and investing in coal names. So far, my entire focus as been on the met side.
As stated before, met coal is used in the production of steel. BHP provides a great overview how met coal is used in the steel making process:
Met coal is heated above 1,000ºC in a coking oven to create coke – a hard, porous lump.
The coke is then added to a blast furnace with iron ore. Hot air and PCI are introduced, creating a flame temperature over 2,000ºC.
The burning coal and coke produces carbon monoxide, which, along with the high temperature, converts the iron ore into a liquid.
This molten ‘pig iron’ is transported to a steel shop, where impurities are removed and alloys are added to make steel.
Currently there is no technology available to make steel at a large scale without the use of met coal. So if you want steel you need met coal. Unlike thermal coal which is used in the production of energy, there is multiple viable replacements. So no matter your political or social views, if you are a steel user, you are also a met coal user.
Why am I investing in the met coal industry? A few different reasons.
The demand for steel is extremely strong. Steel producers are running close to full capacity and everything they are making is getting gobbled up.
The strong demand for steel has lead to historically low levels of steel inventories and record pricing. Every piece of steel getting made is also getting sold. When you go an entire year without producing steel then magically turn the switch back on, record levels of demand combined with record pricing occur. This is happening in multiple industries across the world right now.
One of the best ways to get a boost to your country as a politician is to pass infrastructure bills. The United States passed a $550 billion infrastructure bill. India’s steel demand is forecasted to increase exponentially through 2025. And a host of other countries are spending their way out of this pandemic. Demand for steel should continue to remain strong outside of any global recession or another pandemic.
The increase in spending across the world has lead to analysts predicting we are entering a new commodity super cycle. Goldman Sachs recently put out a research note stating that we are entering a new commodity super cycle that could last years. Going green, Goldman Sachs contends, “has the potential to create a capex cycle on par with the emerging markets-driven cycle of the 2000s”.
The advent of a future commodity super cycle has caused met coal pricing to doubled (or more depending on the type) from the January 2021 lows. Pricing continues to increase everyday off the back of strong steel demand, record low inventories and a tight supply chain.
Despite the increase in pricing, met coal producers are still trading at basement level valuations (30-50% forward free cash flow yields) due to the ESG concerns highlighted above, along with the boom and bust history investors in these companies have endured throughout the years.
But with pricing having more than doubled, these met coal producers are on pace to post record revenues and profits in the coming quarters and years. Indeed, most of these companies are so gun shy from the previous commodity boom and bust cycles that all cash flow generated will be used to deleverage balance sheets, providing investors more long-term terminal value.
In fact, if pricing holds at the current level (most of these producers think it continues to increase heading into the back half of 2021) these companies will generate enough cash to pay off their debts entirely in less than a year. This phenomenon has already been seen with the steel producers which has lead to record level stock prices.
But what makes this most interesting is the lack of investor capital in the space. Investors have been burnt too many times in the coal space. Billions have been lost and the cost of capital has increased. In addition, new ESG concerns have forced many of these companies to struggle to get outside funding for new capital projects. So despite the saying that high pricing is cured by high pricing, it appears as if it may be different this time around. Thus, the lack of capital in the space, combined with debt and legacy liabilities is forcing coal companies to focus on balance sheet moves instead of investing in new projects and bringing on additional production.
So, the increased demand for steel (which appears to be a multiyear cycle), combined with basement level valuations, higher met coal pricing and lack of investor capital has piqued my interest to start investing in the coal industry. Because if I am directionally right, there is potential to make a significant amount of money as operating leverage kicks in, leverage ratios come down and cash flow is ultimately generated and used in shareholder type returns.
I have begun to advantage of this “commodity super cycle” by purchasing met coal miners that Wall Street seems to be totally ignoring.
This new miner that was recently highlighted to subscribers appears to have asymmetric upside to downside ratios. There is a significant amount of debt and other legacy liabilities on this company’s balance sheet so any directionally correct bet could result in considerable upside.
In addition, if pricing holds for the next three months production volumes will be locked in at record pricing that could make the company debt free by year end 2022.
The future for this company looks bright. I have made this miner a “top position” in my portfolio and will continue to buy more shares on any weakness in the market price.
If my thesis is correct, I think the stock price will re-rate to the $40-50/share range over the next 6-12 months and if pricing is indeed locked in at current rates, notwithstanding any operational issues (this is mining), the share price could go to $100/share by the end of 2022.
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