Teck / Metallurgical Coal

The rumour mill has Teck (TSX: TECK.B) looking at selling or spinning off their metallurgical coal unit for $8 billion.

In the 3 months ended June 30, Teck’s metallurgical coal unit did $1.1 billion in revenues and generated $191 million in profit.

However, since June 30, metallurgical coal prices have exploded. Teck is going to be making a lot more money from this unit in the near term future. Hard coking coal, shipped to China, is nearing US$500/ton. Domestic is approaching US$300/ton.

Realized sales in Q2 was US$144/ton with 6.2 million tons sold. Costs were $64/ton plus $42/ton for transport (moving 6.2 million tons of anything, let alone across the Pacific Ocean is going to be expensive).

While the coal volume will drop slightly in Q3 (due to BC wildfires and such), the realized price is going to increase dramatically, especially with Teck having two points of egress (they are no longer hamstrung by having Westshore Terminals (TSX: WTE) being their only exit point for coal).

If Teck manages to get $8 billion out of this unit, they will be able to eliminate their debt and become that much closer to being a pure copper play.

I also thought they were going to get rid of their energy division, but clearly management is waiting for higher prices before pulling the trigger on that (likely in the form of a sale back to Suncor of its division).

This would be an interesting turnaround for Teck – their coal division was primarily acquired through the Fording River acquisition in July of 2008, and they paid US$14 billion for them, with the lion’s share (US$12.5 billion) in cash.

We all know what happened in late 2008 – the economic crisis really hit the fan. The acquisition was possibly the worst-time acquisition in Teck’s corporate history and it nearly bankrupted them.

So now we fast-forward 13 years later, and Teck is looking at getting rid of their coal division.

My question is – who would buy this? There’s no logical strategic buyer for the entity. Financially, perhaps some hedge funds want to make a gamble that coal pricing will be excessively high for a longer duration of time than the markets anticipate. One financial combination that would make some sort of faint sense is one of the British Columbia crown corporation pension plans (think about the regulatory protection that would afford the company), but one could imagine the political outrage of taking over a coal company in the era of climate change consciousness.

A spinout would be more likely, but I would see the Teck umbrella affording the coal entity much more regulatory protection than being a standalone entity.

As such, I do not believe they will take any real action on the coal entity. I could be wrong.

If they were able to dispose of the coal unit on acceptable terms, the financial engineering motive is pretty simple – by being seen as a more pure copper play, the company would receive a higher valuation. I know how my cautious investing colleague John Cole is feeling about Teck, but this commodity cycle is not at the point of peaking yet. Unlike lumber (where starting up and shutting down is a way of life and can be done with relatively quick frequency), other commodities have much longer cycles and activating coal/copper supplies is a matter of years and not months.

The other observation is that Teck is exporting 6 million tons a quarter, Arch (NYSE: ARCH) is going to do about 2.5 million tons of met coal a quarter now that Leer South is opened. While Arch has a geographical disadvantage (more difficult to ship the material to China from West Virginia), ton-for-ton would give them a US$2.6 billion valuation, which is about 60% higher than their current stock price, accounting for the moronic convertible debt financing they did a year back.

Hunting for ideas in this market

I’ve been noticing that certain sectors get hyped at certain periods of time. There are various influences out there (intelligent ones that, in general, are typically directionally correct and hence they gain a credible following over time) which form narratives and the digital financial wave decides to latch on until such a point they get washed away.

Today it appears that a bunch of hype is building up with uranium producers, the claimed narrative is that with Sprott opening up a physical Uranium ETF (TSX: U.UN) that this will suck up world supplies to a point where prices will rise and make all uranium miners spike. If storing vaults of gold and silver wasn’t enough to spike their respective commodity prices, surely storing yellowcake will be different!

The uranium market has been a cesspool for over a decade, which was not helped by Fukushima. In general, worldwide supplies of Uranium ore has been healthy to the point where Canada’s Cameco (TSX: CCO) decided it was easier to just buy than mine.

The claimed investment thesis is that an entity is essentially trying to corner the market on Uranium, so therefore you should buy the crap out of it before Sprott does. We also get a bunch of narrative about how China and India are building nuclear power plants, etc., etc. It’s a great narrative. The story is very easy to understand.

Uranium production itself is also a relatively small space in the publicly traded sphere (especially in North America) and there isn’t a lot to pick and choose from, hence it is a great target to hype up – a relatively small amount of capital will result in outsized price changes.

When I read these narratives from external sources (especially confirmed in multiple locations, which makes me suspect that there is a degree of inter-connectedness in these pronouncements) I get skeptical that I am behind the curve rather than leading it. I literally do not buy into these things.

I am sure there will be a decent price ramp (it is already occurring) but once the capital inflow dries up, it’ll be really interesting to see the conviction of these people that are looking for triple-digit gains in months when the geopolitical situation for this particular commodity will play out over years (specifically when fossil fuels get really expensive… come back later this decade for the resolution of this story).

My investment ideas have to be generated from non-narrative sources, and especially from sources that are not trying to sell subscription newsletters.

Unfortunately, this means that I tend to not pay much attention to various stories of hype – including the boom in marijuana companies in the second half of the last decade, the cryptocurrency boom, etc. I’m content with letting others gamble in that casino.

So when you are trying to be sold a story, ask yourself which stories are not being pitched to you, and look in that direction. It is much more difficult, cognitively, to look at a piece of information and then figure out what is not there, instead of fixating on the piece of information itself.

Stock screeners are great for generating a reasonable amount of random and obscure selections that can be subsequently mined for suitability. If one has views on specific sectors, selections can also be concentrated on that.

At present, however, my usual cautious approach to the markets has been getting even more cautious as of late. A chart of the S&P 500 or the TSX is not properly reflective of the level of fragility that likely exists out there.

Bank of Canada stopping quantitative easing?

Since the beginning of July, the Bank of Canada’s balance sheet hasn’t really gone anywhere. This is despite stating in the July 14th interest rate announcement that they would be continuing QE at a $2 billion/week rate.

Before COVID-19 began, the Bank of Canada historically has held about $75 billion in government bonds and $25 billion in (short term) treasury bills.

Today, the balance sheet consists of about $6 billion in treasury bills and $414 billion in government bonds.

The size of the Bank of Canada balance sheet is the same on August 11th as it was on September 1st. I would expect the balance sheet to increase slowly with QE but this hasn’t been happening.

For every asset there is either liability or equity, and in this case, the liability is the amount due to Members of Payments Canada (the big banks) – they collectively are owed about $276 billion as of the last September 1st snapshot.

We will see what happens on September the 8th when the next rate announcement is made. Given the ongoing federal election, there will be a lot of eyes on this report from non-traditional viewers.

On the US side, things still show no sign of stopping – it’s QE forever there.

This monetary froth, one way or another, ends up inflating the value of yield-bearing assets. The most obvious targets are government bonds themselves, but as money permeates up the risk spectrum, anything with a yield gets bidded up, making future returns on capital much lower, to the benefit of incumbent asset holders.

Short note – Coal

Market pricing for metallurgical coal is going nuts in China – right now it is north of US$400/ton cfr (and given how gong-showed marine transportation logistics are these days, freight is not a trivial expense). However, the point is that even with freight these are very, very, very high prices. This has impact on prices that Teck will receive on their met coal production (a good chunk of their met coal production goes over the Pacific). In addition, my briefing note and financial forecast I wrote on Arch Resources in June (cash generation of $15-20/share) is looking increasingly conservative.

In the current commodity price environment, both Teck and Arch will be cash machines. While both companies aren’t going to make US$400/ton on all of their sales (the North American market is much less pricier), the overall impact on pricing across the geographical spectrum is clearly up from where it was 18 months ago.

Teck will also have the supplement of its 70% owned QB2 project when it is completed in 2022. QB2, at US$4.00/pound of copper, will generate about US$1.7 billion EBITDA on a 100% basis and after baking in 40% taxes, Teck should be able to generate an incremental US$700 million/year in cash out of this project. Every 50 cents of copper above this will be about US$125 million more. On a consolidated company basis, it is foreseeable they will be able to pull in about $3 billion a year in cash. Once the capex on QB2 is finished (which is the primary cash drain for Teck at the moment), they will be able to begin a simultaneous debt paydown and dividend increase at the same time – my guess is they will ramp up their existing $0.05/quarter dividend to around $0.25/quarter once QB2 is finished and dump the rest into debt repayment. My guess is they’ll want to get below at least $5 billion net debt.

Arch’s net debt probably peaked out at Q2-2021 and at this point forward, it will be generating significant sums of cash. When examining coking coal statistics, the Leer South mine (pretty much finished) will be positioned to grabbing the lion’s share of this market. It takes years to get a coal project out of the ground and mal-investment has finally taken its course. In 2022 they will likely be able to pay off their net debt and then re-institute a dividend or share buyback (offsetting their near-disastrous capital allocation decisions of previous years post-Chapter 11).

The virtual investment prohibition (fueled by ESG and other environmentalism) has created an environment of impossible-to-get capital for coal projects – a perfect formula for elevated prices for those that have incumbency rights. Both Teck and Arch fit the bill for metallurgical coal in North America.

The question is when the party will end. As long as worldwide demand for steel remains red-hot, not anytime soon.

General Market Comments

The last two weeks of summer, psychologically speaking, are the two weeks before labour day weekend. Families are still on holiday (whatever types of holidays are still available with the myriad of Covid-related disruption around us), children are not at school, and the weather is usually warm enough that one wants to stay outside before the big Canadian winter freeze commences.

In the markets, this also means institutional managers are in the same boat – major policy decisions on how to steer the computerized program trading will likely be made after labour day.

So I do not put much stock in market action that is occurring, other than to observe that the TSX and S&P 500 is at an all-time high:

The Nasdaq 100 is also the same way. Both US indexes are a functional proxy for Apple, Microsoft, Amazon, etc. The S&P 500’s top 10 is about 28% of the index, while the Nasdaq 100’s top 10 is just over 50% of the index.

The TSX’s top 10 are: SHOP, RY, TD, BAM.A, ENB, CNR, BNS, BMO, CN and CP. They are about 40% of the index.

You would think the markets reaching all-time highs would generate some news headlines. It has been exactly the opposite. What do we hear about today?

1. Disaster in Afghanistan
2. Disaster in Covid-19 (take your pick: vaccines not working, variants, travel curbs, ‘fourth wave’, etc.)
3. Disaster in supply chains
4. Disaster in climate (take your pick: hurricanes, wildfires, droughts, heat waves, etc.)
5. Disaster in the Liberal Party of Canada (OK, OK, this was a joke – I will write about the Canadian election later)

The one thing that has clearly NOT been a disaster are people that have their capital in return-bearing assets. Indeed, it has been a disaster if you were NOT in the markets. The TSX is up about 17% year-to-date, while the S&P is up 21%. If you’re lagging this number, you’re effectively ‘falling behind’.

This rise in the stock market continues to be fuelled by monetary policy, with the USA and Canadian central banks still vacuuming up treasury bonds like no tomorrow; and also fiscal policy, with both governments spending like crazy.

The cash will circulate in the economy until the point where it ends up locked in bank reserves, which currently earns a very low rate of interest and will continue to do so for the indefinite future. Individuals that have satisfied their material needs have no other choice but to put their capital into the asset markets, lest they lose purchasing power.

This is the market we have been seeing post-COVID-19, until at such point we do not.

We are well into seeing the price ramifications in this monetary/fiscal regime. The front-row-center for many is the elevated cost of residential housing in urban centers. Indeed, even second and third-tier cities/towns have had an influx of capital just simply because of the people escaping the urban centres. Because of the elevation of such asset pricing, correspondingly, the cost of everything else rises to bake in the extra capital required to use the land.

We also see the impact on the stock market.

The physical world is where things get interesting with regards to the impact of monetary/fiscal policy. Although most of what happens in finance is a transaction of electrons, the physical world is messy. Primary industries produce the raw materials necessary for the functioning of society, and this includes food, energy and minerals. Somebody needs to produce this. As the debasement of currency continues, it stands to reason that the elevated cost structure will result in these commodity prices elevating.

Almost everything (with the exception of gold and silver) has risen since the start of the Covid pandemic.

The result of the increase in commodity prices will be a price transmission on the physical side of the economy that we will have not seen since the 1970’s. This will likely continue until we see a market dislocation event. I do not know what or how this will take place, but when it occurs, it will be like a 9.0 Richter Scale earthquake right next to where you live. And just like earthquakes, it will be very difficult to predict.

Until then, and especially as the conventional media has completely tuned the masses away from the rising stock market, the major indexes are most likely to continue their existing trajectories.