Shneur Gershuni: Coal Stocks Fired Up
Source: George Mack of
The Energy Report
The earthquake, tsunami and resulting problems at the
Fukushima nuclear power plant in Japan could impact some coal
plays as global demand shifts to fossil fuel. In this exclusive
The Energy Report,
UBS Securities Analyst Shneur Gershuni argues a bullish case
for coal demand and shares some select coal stocks poised to
The Energy Report:
How has the tragedy in Japan at the Fukushima nuclear power plant
impacted the outlook for coal globally?
There are actually two different types of coal. One we refer to
as "thermal," or steam coal, which is used in a boiler to
generate heat. It creates steam to hit the turbine space, and
that's how you create your power. The other type of coal is
called "metallurgical," or met coal. Some people incorrectly
refer to it as coking coal. This coal is mixed with iron ore, and
you put it into a blast furnace to create the pig iron for the
steel-making process. So, when you think about where and how you
want to be positioned, it's the steel fundamentals that will
drive metallurgical coal demand, and energy needs will drive
thermal coal demand.
Given the challenges with the Japanese nuclear facilities, we
expect fossil-fuel generation will be used to partially offset
the near-term generation losses related to the nuclear fleet to
the tune of 5-10 million tons (Mt.). We wouldn't be surprised to
see unscheduled shutdowns of nuclear facilities around the globe
as regulatory bodies seek to review nuclear safety procedures in
the wake of the Japanese crisis. The incremental demand will add
more pressure to the global supply/demand balance for thermal
coal, which has been tightening of late (as evidenced by the
recent move in API 2-delivered price into Europe, which has
surged in the last six months and will likely move higher on
increased Japanese demand.
Is that on top of the 10 billion short tons of global consumption
by 2030 forecast by U.S. Energy Information Administration (EIA)?
Even that would be a 48% increase over 2006's reported 6.7
billion short tons of coal.
Yes. Incremental demand will add pressure to the global
supply/demand balance that has been tightening of late anyway
based on the international delivered price into Europe API. API
surged in the last couple of months and will likely increase more
in the next few months due to events in Japan.
Tell me a bit about the growth drivers in both the thermal and
Sure. Thermal coal is used primarily for power generation. In the
United States right now, things are changing due to the way
commodity prices are moving with the fuel switch to natural gas
and so forth, but roughly 48% of power in the U.S. is generated
using coal currently. That number could increase at least in the
short term if there are cutbacks in nuclear power generation.
Internationally, as economies grow, the demand for power
increases and that tends to put pressure on power-generation
sources to deliver. Obviously, coal has been a big part of that,
especially in Asia, over the last couple of years and could be an
even bigger part going forward.
Does the use of thermal coal far exceed that of
Yes, on an absolute basis, it's a much larger market. But what's
interesting is that demand for steel, particularly with respect
to the infrastructure build going on in Asia, has really put
pressure on the metallurgical coal market. In fact, the price of
met coal touched $125/ton a couple of years ago. That was a
phenomenal price at the time; but then, in 2008, the settlement
reached roughly $300/ton. Even during the depth of the financial
crisis the annual settlement was $129/ton, which tells you demand
was effectively outstripping supply, which is kind of where we
sit now with a tenuous supply/demand balance.
So, while on an absolute basis, the thermal coal market is a
much larger market in scale, the fact is that we have seen some
tremendous pricing pressure and margin improvement on the
metallurgical coal side driven by steel demand. Go back to 2005,
for example, when we were consuming 1.1 billion tons (Bt.) of
steel on a global basis. In 2007, over 1.326 Bt. steel was used.
We forecast that will continue to increase in 2011, 2012 and 2013
and are looking at 1.4 Bt. steel in 2011. So, steel has been a
big driver, and the pricing environment on the metallurgical coal
side has actually been quite strong over the past couple of years
even in the face of the global financial crisis.
Is metallurgical coal still an opportunity for growth?
Yes. Margins in the thermal coal business could be $6, $7, $8 or
$9 a ton. But then, if you look at a met coal environment wherein
you're getting potentially +$300/ton, your margins could be north
of $100/ton. So, the margin expansion has become very different
between the two markets due to the tight demand/supply balance in
the met coal market.
Tell me how fast the met coal market is growing.
Well, here's where it gets kind of interesting. Growth of late is
driven largely by China where steel production has been
tremendous. If you look back to the earlier part of the last
decade, China was using 300 million tons of steel. We don't yet
have final numbers for 2010, but we're looking at potentially 590
Mt. of steel for China. What's interesting is that China's been
somewhat self sufficient in producing its own metallurgical coal
and really hasn't been a major participant in the seaborne market
until recently. In fact, in 2009, due to safety issues and also
to increase capacity utilization of some of the mines, the
country actually shut down some mines, but its infrastructure
Suddenly, China, which had not been much of a market
participant, became a major importer of met coal. In 2009, for
example, the country took roughly 34 Mt. met coal, and we
estimate that it likely took 45 Mt. in 2010. That's a significant
percentage of the total marketplace given that the
seaborne-traded market for met coal was 268 Mt. in 2010. That
would be about 16% of the seaborne-traded market. Because the
U.S., Europe and Western nations haven't necessarily recovered on
the demand side for steel, China has come in and taken the demand
the West would've put on this marketplace.
So, we're struggling now and looking to grow supply from a lot
of nontraditional sources. Mongolia has become a source of
supply, and Australia is looking to expand as much as it can. The
U.S. is also looking to bring new met coal supply online and put
it into this marketplace. And some of the lower qualities of coal
are crossing over from the steam market into the met market to
satisfy all this demand.
Consequently, as Western-civilization demand starts to come
back online over the next couple of years, we're hoping this new
supply kind of offsets that. Because China is in the marketplace
now and taking that kind of tonnage when previously it wasn't
even a major participant, it adds a lot of pressure. That's kind
of why we're in an environment now in which we have an elevated
pricing environment above what we believe should be a
traditionalized, more long-term, normalized price because of this
pressure on supply/demand right now.
Is it becoming more difficult to get coal out of the ground
because we've taken so much already?
The answer is definitely yes-and this goes for both met and
thermal. What it comes down to is you always want to mine the
easiest coal that you can deliver first. About 100 years ago,
they were mining easier seams than those we are mining today. In
fact, in Appalachia, the seams continue to get thinner and
thinner and that continues to hinder productivity. If you think
about it from a fixed-cost-absorption perspective, it increases
your costs over time. Because met coal is relatively scarce right
now, people are going to areas they might not have chosen to mine
20 years ago. But at current prices, it suddenly makes sense to
mine those reserves.
It sounds like the price increase far offsets any margin pressure
caused by greater difficulty.
Right. To put a couple of things in perspective, when we set our
long-term, normalized pricing assumption, we think that
everything tends to normalize over the longer term. Obviously, if
you've got great prices it's going to incentivize people to bring
on more supply, which will then force your margin back down to
something more normalized, right? So, you do have this elevated
margin opportunity over time; but over the next three years, we
are expecting it to move down gradually.
Shneur, I've created an unweighted portfolio of a group of coal
stocks and I'm looking at 51% price appreciation over the last
six months. Was that seasonal? Was it due to the floods in
Queensland, Australia? What has caused this?
A lot of it has to do with the economic recovery, frankly.
Certainly, the most recent move had much more to do with
Queensland and, clearly, that affected some of the more
metallurgical coal-sensitive names like
Walter Energy, Inc. (
. There also has been some M&A in the sector, but it's
largely met coal pricing that has improved margins. Companies
that were able to move production out of the thermal coal market
into the met coal market and achieve that margin expansion have
really enjoyed the benefit.
At the same time, in the U.S. thermal coal market, we hit peak
inventories of 203.4 Mt. in November 2009-that was a record
inventory build. Going back as early as April 2009, companies
attempted to cut production in an effort to get it in line with
demand. We don't have the final 2010 data yet, but what happened
is that in one year the U.S. went from 203 Mt. down into the 170s
in what we like to refer to as an "inventory cleanse" between
2009 and 2010. It also had these production cuts, which limited
the supply side a little and did have a good hot summer, which
also helps power generation burn. So, all of these together have
resulted in an improving inventory outlook.
How might Japan's nuclear problems impact the price of thermal
coal going forward?
Thermal coal will be a beneficiary of the nuclear challenges.
CONSOL Energy Inc. (
Peabody Energy Corp. (
International Coal Group, Inc. (
are fairly well positioned to be thermal coal exporters. Peabody
exports both met and thermal coal out of its Australian
operations, so it's right in the heart of Asian demand.
Are there any other companies that you'd like to mention?
I think it's worth mentioning that Peabody is not as volatile,
but earnings growth has been a bit more stable. It's very well
respected and, on a longer-term basis, is well positioned
globally. On the value side, we prefer CONSOL and believe its
natural gas assets aren't fairly valued due, in part, to the weak
gas environment. When we put the coal and gas businesses
together, we see the stock at a deep discount. But the catalyst
for CONSOL will be continuing strength in both the global thermal
and gas markets.
Ok, so any other companies you'd like to mention?
You know, another company that we think is interesting is
Arch Coal Inc. (
. It has a lot of exposure to the Powder River Basin on a
production basis, so the company is well positioned. But its
eastern coal business has metallurgical coal exposure, and that's
a material part of its earnings play. So, you can almost say that
a stealthy piece of its earnings does come from the met coal
side. The company completed the Jacobs Ranch acquisition
successfully and things seem to be going well. Cash flow is all
right, and we believe its earning-guidance range will likely
continue to move up through 2011. We think there's an opportunity
for positive earnings revisions.
Can met stocks appreciate from these levels dramatically?
Yes, we think they can appreciate further from current
What are the plays? What should growth investors be looking
On the metallurgical coal side, the Asian market is definitely
important. Two names are Walter Energy, which I mentioned
Patriot Coal Corporation (PCX)
. Walter is just about the closest thing to a pure met play.
Patriot has exposure to both.
You've mentioned Walter a few times and I know you like it, but
it's up 73% over the past six months. Should an investor be long
on Walter now?
It's actually seen an even bigger move than that over the last
two years. The stock is at $116 right now but, based on our
discounted cash-flow analysis, we believe it should trade closer
to $150-clearly, that's material upside from where we are right
now. The company is in the process of closing a transaction-a
USD$3.3 billion merger with Canadian met coal producer
Western Coal Corp. (TSX:WTN)
, and that will help to diversify its operations. Walter produces
the highest-quality coal in the U.S.
Is Walter your favorite play?
For met coal, it depends on your risk tolerance. Patriot has
lower-grade metallurgical coal but ends up with wider earnings
expansion as a result; however, it tends to be a lot more
volatile than does Walter. So, if our thesis plays itself out and
things do well or even better than what we're anticipating, then
Patriot is likely to outperform Walter. Walter is a little lower
down on the risk profile, so it's really about your risk
tolerance. The beta for Patriot is just higher, but part of that
has to do with the fact that the earnings expansion, in theory,
Patriot's market cap is almost exactly one-third that of
Walter's. That has to contribute to its volatility, does it
I think that might be a fair conclusion. Obviously, larger versus
smaller cap is part of it. Walter hopes to close the Western
transaction. If it does, the company's market cap and enterprise
value also will increase, so it will widen that, too. Patriot is
definitely a smaller market-cap company relative to Walter.
It's been so nice talking with you, and I hope to speak with you
again sometime in the future. Best wishes.
Ok, that sounds great. Thank you.
Shneur Gershuni is an executive director in the Energy
. An analyst since 2004, Shneur covers the coal sector and,
until recently, also was second lead for the natural gas sector
with Ronald Barone. Before UBS, Shneur was a U.S. equity
analyst for Bissett Funds at Franklin Templeton Investments in
Toronto. Prior to that, he was a credit analyst in the Canadian
Private Placement Group and a portfolio management assistant in
the U.S. Bond Portfolio Group at Canada Life Assurance Company.
He began his career at Primerica Financial Services, a member
of Citigroup, as a mutual fund and high-liability specialist.
Shneur holds an MBA in finance from Degroote School of
Business, McMaster University and a BA in economics from York
University in Ontario. He is also a CFA charter holder.
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1) George Mack of
The Energy Report
conducted this interview. He personally and/or his family own
shares of the following companies mentioned in this interview:
2) The following companies mentioned in the interview are
The Energy Report:
3) Shneur Gershuni: UBS AG, its affiliates or subsidiaries
beneficially owned 1% or more of a class of the following
company's common equity securities as of last month's end (or the
prior month's end if this report is dated less than 10 days after
the most recent month's end): Peabody Energy.
These companies/entities are, or within the past 12 months have
been, clients of UBS Securities LLC and investment banking
services are being, or have been, provided: Arch Coal, Consol
Energy, International Coal Group, Natural Resource Partners,
Patriot Coal and Penn Virginia Resource Partners.
This company/entity is, or within the past 12 months has been, a
client of UBS Securities LLC and non-investment banking
securities-related services are being, or have been, provided:
International Coal Group.
Within the past 12 months, UBS Securities LLC has received
compensation from these companies/entities: Arch Coal, Consol
Energy, International Coal Group, Natural Resource Partners,
Patriot Coal and Penn Virginia Resource Partners.
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