Tag: HCC

Costs matter – a brief look at coal

There is a paradoxical rule in investing that when you anticipate the underlying price of whatever a company sells to rise, you want to be invested in a higher cost producer. The reason for this is embedded leverage. In a flat to declining price environment, you want to be invested in the low cost producer.

An example will suffice.

Say the market rate for widgets is $100. Company A (high cost producer) can make widgets for $90 a piece, leaving $10 of profit per widget. At a 10x multiple, the company would be worth $100 a widget. If the price of widgets goes up to $200, the company would be worth $1,100 a widget, 11x your money at the same multiple.

Company B (low cost producer) makes widgets for $50 a piece, leaving $50 of profit per widget. At the same multiple, it would be worth $500. If the price of widgets goes up to $200, Company B would be worth $1,500 or a mere 3x. Not bad, but nowhere close to the high cost producer.

The reverse is true – especially if the price of widgets goes below the costs of some producers. If the price of widgets goes to $70, Company A will suffer (they will have to dig into their balance sheet), while Company B will still make a living.

Markets can anticipate these leverage effects and compensate valuations accordingly – in particular price to earnings multiples decrease as prices increase. But over market cycles, costs matter.

I’m looking at earnings of coal companies, and the contrast between ARCH and BTU is quite striking.

In Q1-2023, ARCH produces its metallurgical coal at a cash cost of US$82.66 per short ton, while BTU is $151.13. In Q4-2022, HCC was $123.40, while AMR was $112.97. Teck reported US$103 per metric ton, which is about US$94 per short ton. (In the case of Teck, there is a bit of an accounting fudge factor as some of this cost is the amortization of “capitalized stripping”, which creates unevenness in cash flows, a technical matter well beyond the point of this discussion).

As met coal prices come back down to earth (they were as high as US$450 per short ton last year and are roughly US$260 or so presently), low cost producers should start to feel the pinch on their cash flows.

It leaves the question why one would want to invest in a company producing a commodity in a lowering cost environment, and that is where some market skill comes into place – there is an anticipation of cyclicality in these companies. You can also play expectations against each company by engaging in pair trading – long one, short another (and pray that your short doesn’t get bought out).

However, there is one raw number that really counts – cash dividends. If you’re going to get paid a reasonable return on equity, it still might be good enough.

In this respect, ARCH’s 50/50 plan (which is giving 50% of free cash flow directly off as special dividends and the remaining 50% for debt/capital/remediation/buybacks) has a certain elegance to it. As more shares get repurchased, the amount of the dividend that gets distributed will rise over time. It is like a very strange version of dollar cost averaging except the company is deciding to do it for you.

In 2022, ARCH gave out about $25/share in dividends. I do not anticipate this level of distribution will continue. For one, they will start paying significant cash income taxes which will reduce the dividend stream. However, there is a reasonable chance that the cash payouts will continue being in the double digit percentages, coupled with share appreciation through buybacks. Another paradox about having high amounts of cash flows is that you want to see the stock price lower, not higher – the reason is because reinvestment (in the stock) can compound at higher rates when done at lower prices.

It would not shock me in the least to see some more consolidation in the sector. We’re already seeing Teck trying to avoid one.

Also, for reference, read my December 2019 post on Arch. Even after Covid-19, this write-up is aging pretty well.

Briefing note on Arch Resources

For historical context, read my December 2019 post on Arch Coal where I give a primer on coal mining and discuss Arch Coal.

This is a short briefing update on the renamed company, Arch Resources (NYSE: ARCH).

My timing from the December 2019 post was a bit botched up – indeed, at one point I exited the entire position (during the Covid crisis) but later took a very healthy position at lower prices than they are trading at today. It is a large but not gigantic position currently. I am expecting it to get larger by virtue of appreciation.

Between then and now, other than Covid-19, the other major setback they hit was the regulatory blocking of the merging of their Powder River Basin thermal coal operation with Peabody Energy. This probably cost the company tens of millions of dollars a year in synergies.

It also turned out that they engaged in poor capital allocation. They bought back way too many shares in the 2017/2018 coal boom and were forced to tuck their tails behind their backs when doing some subsequent debt and convertible debt financings to fund the $390 million Leer South Project, but it appears that path is now clear and the need for future capital is gone.

The reason for this is that the Leer South project is due to be operating in Q3-2021 and this project, at current met coal pricing, is going to make a ton of money. The project is anticipated to generate 4 million tons of High-Vol-A coking coal a year for the next couple decades.

Right this very second (partially instigated by the trade war with Australia), prices to China are around US$300/ton. Indirectly, demand from China will continue to suck supply from other suppliers of the world.

Because shipping tens of thousands of tons of material is not an easy feat, transportation logistics became a ‘weighty’ issue. There is a limited capacity to transport from an eastern inland mining area (West Virginia) to the west coast (typically Long Beach, CA), and then onto a freighter across the Pacific Ocean. The opportunities for westward export are limited (indeed, Teck is making a fortune doing this from Elk River mines in southern British Columbia). As a result, the prices that ARCH will be receiving will be well less than US$300/ton, but it will be significantly higher than the averages received in 2019-2020.

High Vol-A, from what I can tell, is around US$190 spot currently. At that price, Leer South, once completed, will contribute an incremental US$500 million or so at existing pricing to the entity, in addition to the existing metallurgical operation. This is crazy amounts of money. Also, by virtue of the entire coal industry being decimated, competitors will have to take their time to open up more met operations (looking at Warrior Met Coal (NYSE: HCC) here), so Arch will eat up the lion’s share of marginal met coal dollars.

There is a lag effect between when coal is mined and when it is sold – contracts and deliveries have to be signed quarters and years in advance, so the pricing seen on GAAP statements will not be see until well after the economic substance of such transactions is actually performed. You can sort of see this being factored in the existing share price (which is the highest it has been since the Covid crisis) but my question will be what sort of valuation the market will ascribe to the company when they generate around $15-20/share next year (current analyst estimates are $7.63). Ultimately it depends on how much this boom for steel production (the primary driver of metallurgical coal consumption) continues world-wide.