Tag: TECK

A few miscellaneous observations

The quarterly earnings cycle is behind us. Here are some quick notes:

1. There is a lot more stress in the exchange-traded debenture market. Many more companies (ones which had dubious histories to start with) are trading well below par value. I’ve also noticed a lack of new issues over the past six months (compared to the previous 12 months) and issues that are approaching imminent maturity are not getting rolled over – clearly unsecured credit in this domain is tightening. There’s a few entities on the list which clearly are on the “anytime expect the CCAA announcement” list.

Despite this increasing stress in the exchange traded debenture space, when carefully examining the list, I do not find anything too compelling at present.

2. Commodity-land is no longer a one-way trade, or perhaps “costs matter”. I look at companies like Pipestone Energy (TSX: PIPE) and how they got hammered 20% after their quarterly release. Also many gold mining companies are having huge struggles with keeping capital costs under control. Even majors like Teck are having over-runs on their developments, but this especially affects junior companies that have significantly less pools of financial resources to work with (e.g. Copper Mountain).

3. This is why smaller capitalization commodity companies are disproportionately risky at this point in the market cycle – we are well beyond the point where throwing money at the entire space will yield returns. As a result, larger, established players are likely the sweet spot on the efficient frontier for capital and I am positioned accordingly. I note that Cenovus (TSX: CVE) appears to have a very well regulated capital return policy, namely that I noticed that they suspended their share buybacks above CAD$25/share. The cash they do not spend on the buyback will get dumped to shareholders in the form of a variable dividend. While they did not explicitly state that CAD$25 is their price threshold, it is very apparent to me their buyback is price-sensitive. This is great capital management as most managements I see, when they perform share buybacks, are price insensitive!

4. Last week on Thursday, the Nasdaq had a huge up-day, going up about 7.3% for the day. The amount of negative sentiment baked into the market over the past couple months has been extreme, and it should be noted that upward volatility in bear markets can be extreme. This is quite common – the process is almost ecological in nature to flush out negative sentiment in the market – stress gets added on to put buyers and short sellers and their conviction is tested. Simply put, when the sentiment supports one side of a trade, it creates a vacuum on the other side and when there is a trigger point, it is like the water coming out of a dam that has burst and last Thursday resembled one of these days. In the short-term it will look like that the markets are recovering and we are entering into some sort of trading range, but always keep in mind that the overall monetary policy environment is not supportive and continues to be like a vice that tightens harder and harder on asset values – and demands a relatively higher return on capital.

I suspect we are nowhere close to being finished to this liquidity purge and hence remain very cautiously positioned. My previous posting about how to survive a high interest rate environment is still salient.

Can Teck unload their met coal operation?

Teck (TSX: TECK.A/B) had some interesting news yesterday – they dumped their 21% interest in the Fort Hills oil sands project for $1 billion to Suncor (the majority owner and operator), and they also released their quarterly report.

The Fort Hills project was the black sheep of Teck, primarily because it goes against their “wokeist” image they are trying to project and is clearly not in their strategic mandate to be a lead producer of “low carbon metals” (aren’t all metals non-carbon?). Once the Frontier Oil Sands project was shelved, pretty much the days were numbered for the Fort Hills division.

For Q3, Teck’s share of the project was 37,736 barrels of oil a day, and the consolidated project is 180,000 barrels – not a trivial size.

The project historically has been plagued by operational issues and, in my quick evaluation, the deal is good for both Teck (who wanted to get out) and Suncor (who is likely to consolidate 100% of the project in the near future). The Frontier project might get revived in a future decade when regulatory concerns get alleviated, but I would not hold your breath.

Of note is that both companies (Teck and Suncor) will be taking non-cash accounting losses on the disposition – in Teck’s case, the amount of capital dumped onto the project is less than the amount that they were able to get back from it with this disposition. The impairment charge on the books was $952 million. The conference call transcript indicated there was a ‘small capital loss’ on the transaction.

Teck’s major project in the works is the QB2 copper mine in Chile. One reason why their stock had a tepid response to the quarterly report is because of the usual announcements of delays and construction cost escalation, coupled with a decreased expectation for production in 2023. However, this is yet another sign that one cannot click a few buttons on Amazon and expect a mine to start producing – the scale and scope of these projects is gigantic and this one has taken about 5 years to get going from the “go-ahead” decision to when things will be materially completed. If this decision was pursued today, the costs would likely be even higher (not to mention the regulatory climate would be even worse than it is today).

QB2 is the example of their “low carbon metals” strategy, where apparently they can be dug up from the ground without emitting carbon, but I digress. The “to-go” capital expenditure on QB2 is anticipated to be US$1.5-$1.9 billion from October 1, and once this is completed, Teck will be a free cash flow machine barring some sort of total collapse in the copper market (beyond the 30% drop from half a year ago).

The balance sheet is very well positioned, with $2.6 billion in cash and no major debt maturities until 2030 other than a US$108 million bond due February 2023, which they can easily pay off. As a result, Teck will be in a position to either buy back stock or issue increased dividends later in 2023.

But the focus of this post isn’t about QB2 or Teck’s future prospects, it is about their metallurgical coal operation.

Their met coal operation generated $1.24 billion in gross profits in Q3, and $5.55 billion year-to-date. It is single-handedly the reason why Teck is in such a fortunate financial position to be able to dither on QB2 and not get terribly concerned about it.

However, it flies in the face of their “low carbon metals” strategy and this reminds me of last year’s article which rumoured that Teck was looking at getting rid of, or spinning off their met coal operation.

My question is still the same – who would buy this? It is making so much money that even if you paid 2x annualized gross profits (an incredibly generous low multiple), somebody would still need to cough up $15 billion to buy the operation. This puts pretty much every coal operator out there except for the super-majors (like Glencore) out of the picture.

However, if Teck were to dispose of the coal unit, it would likely be in conjunction with a significant distribution to shareholders – a $15 billion sale would result in roughly a $22/share distribution, assuming a 25% tax rate (the actual tax paid will likely be less since Teck’s cost basis will be considerably higher from the Fording Coal acquisition). At a zero-tax rate, that would be roughly $29/share.

However, a giveaway is the non-answer during the conference call:

Orest Wowkodaw
Analyst, Scotia Capital, Inc.
Hi. Thank you. Jonathan, your number two priority seems to be rebalancing the portfolio to low carbon metals. I’m wondering if that if your strategy there is solely around growing the copper business and i.e. diluting the coal business, or do you see the potential for accelerating that transformation perhaps by either divesting some of the coal business?

Jonathan Price
Chief Executive Officer & Director, Teck Resources Limited
Yeah. Hi, Orest, and thanks for the question. There’s a number of approaches that we’ve been taking to that. The first as you’ve seen overnight is the announced divestments of Fort Hills. Clearly oil sands carbon, an opportunity there to reduce weight in the portfolio through that divestment, something we’re very pleased to have agreed and have gotten away.

Secondly, as you highlight really the key approach for us is the growth around copper with the doubling of copper production as we bring QB2 online next year. And then with the projects I mentioned being new range being San Nicolás being the QB mill expansion all bring more copper units into the portfolio which further swing us towards green metals and away from carbon. As we’ve said before, we’ll always remain very active and thoughtful in reviewing the shape of the portfolio and the composition of our portfolio. But right now those factors I’ve mentioned are the key execution priorities and that’s what the team is focused on. And that’s what we’re gearing up to deliver.

I’m pretty sure reading between the lines that they are, at the minimum, thinking of doing this. But who in their right mind would buy such an operation in a very hostile jurisdiction?

Diversification

There are events that you just can’t predict, such as having to deal with malware on your web server.

This week has been full of them, and it is only Wednesday.

Teck (TSX: TECK.B) announced on the evening of September 20 that their Elkview coal plant (their major metallurgical coal operation) had a failure of their plant conveyor belt and it would be out of commission for one to two months. If out for two months, this would result in a loss of 1.5 million tonnes of coal. Considering that they can get around US$400/tonne for their product, and very generously they can mine it for US$100, this is a huge hit. Not helping is that one export terminal (Westshore (TSX: WTE)) is going on strike, but fortunately Teck managed to diversify from this operation last year with their own coal loading terminal!

Cenovus (TSX: CVE) owns 50% of a refinery in Toledo, Ohio. BP owns the other half, and they are the operating partner. There was a story how a fire at the plant resulted in the deaths of two workers, and the refinery has been shut down to investigate. Making this more complicated is that on August 8, 2022, Cenovus announced they will be acquiring the other 50% of the refinery for US$300 million in cash. Ironically in the release, it is stated “The Toledo Refinery recently completed a major, once in five years turnaround. Funded through the joint venture, the turnaround will improve operational reliability.”

Given the elevated level of crack spreads and the 150,000 barrel/day throughput of the refinery, the cost of this fire will not be trivial, and quite possibly will involve an adjustment to the closing price.

The point of these two stories is that there can be some one shot, company-specific event that can potentially affect your holdings – if there are other options in the sector you’re interested in investing in, definitely explore them and take appropriate action. Teck and Cenovus are very well diversified firms, but if you own an operation that has heavy reliance on a single asset (a good example would be when MEG Energy’s Christina Lake upgrade did not go as expected a few months ago), be really careful as to your concentration risk of such assets.

On a side note, have any of you noticed that many, many elevators are out of commission in publicly-accessible buildings? It’s like expertise in anything specialized is simply disappearing – it makes you wonder whether the maintenance operations of the above companies (and many others not listed in this post) are being run by inexperienced staff.

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.

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.