A Coal Perspective on Commodities

April 19, 2016

A Coal Perspective on Commodities

  • Coal has seen lots of bankruptcies but companies continue to produce and the price remains low.
  • Iron ore provides better investing opportunities and a better demand scenario.
  • Low cost and low debt producers with increasing demand should be the best risk/reward investments.

Introduction

Yesterday’s newsletter mentioned that there might be opportunities in the commodities markets. Today’s letter is going to elaborate on why the coal mining industry is seeing many bankruptcies and extract important insights in order to enable finding opportunities in other commodities that minimize risks and maximize returns.

Coal Mining Industry

If commodities prices go down, as it is the case for coal, slowly but surely, some of the companies engaged in the production of the specific commodity are bound to fail. As the below figure shows, the decline in coal prices is not an extreme case seeing that the price decline from the 2010 high is about 50%.

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Figure 1: Thermal coal price from 2001. Source: InfoMine.

Oil (65%), copper (53%), iron (72%) and natural gas (62%) prices have all declined more than coal prices from their highs but coal miners are the ones having the most difficult times. In January Arch Coal Inc (NYSE:ACI) filed for bankruptcy and last week Peabody Energy Corporation (NYSE:BTU) did the same increasing the already long list with Walter Energy, Alpha Natural and Patriot Coal that filed for bankruptcy last year. If we would add Cloud Peak Energy (NYSE: CLD) to the above list, we would have more than 50% of US coal production bankrupted. The high number of bankruptcies in coal implies that commodities do not always rebound from a downturn cycle as most investors and managers expect and that down cycles can last longer than liquidity available to companies. Other things that are not helping coal miners are environmental pressures and low gas prices that are lowering domestic and international demand. Apart for slowing demand, another factor that influenced the above mentioned bankruptcies was chronic indebtedness. BTU had 69% of assets financed by debt, CLD 67% and ACI 65% back in 2011 when things still looked good for coal miners. With the bad sentiment, debt became more difficult to refinance, impairment charges become imminent and declining margins brought to the above mentioned bankruptcies.

Another crucial factor for miners and other commodities producers is the cash cost in relation to the average selling price.

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Figure 2: Coal production costs. Source: Martson.

As US production is the most expensive, combined with the declining demand, high debt the large number of companies bankrupt or close to bankruptcy should not be a big surprise. But all the data above should give a clear indication of what and where to look for in order to find over performing opportunities in the beaten commodities world.

What to look for?

Now that the things to be careful about are known let us see if there are better commodities markets that allow grasping the opportunities that a downturn commodity cycle brings. The coal case brings to the conclusion that before investing in miners or other commodities producers, investors should look at:

  • The supply/demand structure of the commodity. Declining demand with unrestrained supply leads to ugly scenarios.
  • High debt levels combined with cycle downturns make refinancing very difficult and lead to bankruptcies.
  • The lower the cash cost of producing the commodity the more time the company has to weather a cycle downturn.

Oil

Oil might experience a coal like scenario if electric cars become able to weaken the increasing demand for liquid fuels. For now, the general expectation is that oil production will grow at a slower pace than demand seeing the lower oil prices.

Figure 3: World Liquid Fuels Production and Consumption Balance. Source: EIA.

A look at the production cost curve shows where to look for survivors if the slump in oil prices continues.
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Figure 4: Oil production cost curve.

The above figure shows that the lowest cost producers are mostly state owned companies and western world corporations have lower margins. This limits the investing potential and increases the risks as the lowest cost producers are not investable. On the other hand, with the ease of adding production in relation to increases in oil prices it can be estimated that the price of oil and thus also oil stocks will be volatile. Investors should always keep in mind the possible coal scenario due to the potential decline in demand influenced by electric vehicles.

Iron Ore

Iron ore is a commodity that is strongly related to steel production and steel production is strongly related to World GDP growth. As World GDP growth is strongly correlated to demographics most long term analyses show that the global economy will grow at about 3% in the long term as global population is expected to reach 9.5 billion in 2050. This growth should be reflected in demand for steel and consequently demand for iron. The cost production curve is more favorable for investors as the lowest cost producers are corporations and not state owned companies like for oil.

Figure 5: Iron ore cost production curve. Source: Mining.com.

The biggest producers like Rio Tinto (NYSE:RIO), BHP Billiton (NYSE:BHP), Fortescue (ASX:FMG) and Vale (NYSE:VALE) have the lowest production costs and are trying to eradicate the higher cost producers by keeping supply higher than demand.

Figure 6: Supply and demand for iron ore. Source: LKAB.

The supply is just marginally higher than the demand but by looking at the above cost curve (figure 5) any production shut downs from the more expensive producers could quickly erase the current supply glut.

A look at the debt ratios from the above mentioned iron ore producers shows that RIO has 59% of assets financed with debt, FMG 65%, VALE 62% and BHP is the best with only 48%. A deeper investigation before investing is necessary here as most of the above companies are involved in more commodities and not just iron ore.

Conclusion

The combination of low cost production, low debt, demand growth for the product and a compelling price is surely one that is hard to find. But seeing that commodities prices have fallen more than anyone expected there might be opportunities created by market panic. Goldman Sachs, notorious for its bullish oil price forecasts of $200 per barrel for 2009 and $100 for 2015 that ended with oil prices down to $40 in 2009 and $30 in 2015 is a perfect example how experts can be dead wrong. Wrong bearish forecasts by experts should be the ones that create the biggest opportunities for investing in commodities.

One final warning, the interesting thing with coal is that even if the biggest players declared bankruptcy, they did not stop producing. This trashes most managers’ and Saudi Arabia’s thesis that the downturn will end when companies start failing, because even if companies go bankrupt they will continue to produce as long as production costs are lower than the market price.  All a bankruptcy does is shift ownership of the company to the debt holders and continues to depress the commodity price, since these bankrupt companies do not immediately stop producing.  This clearly explains why oil fell from above $100 to $30 per barrel and has had a difficult time recovering.  As long as a company can produce at a cost lower than the market price, it will continue doing so. Therefore certain commodity prices could remain low for an extended period of time, which strengthens the thesis that the low cost and low debt producers are the best risk/reward investments, when acquired at a reasonable price.

By Sven Carlin Commodities Investiv Daily Share:
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