3 Reasons to Sell This Coal Giant

• Report this Comment On March 17, 2013, at 10:53 AM, Paulson545 wrote:

  Billionaires George Soros and T Boone Pickens both opened positions in several coal stocks. Arch Coal and Peabody Energy. Boone in Arch and Soros in Peabody.

• Report this Comment On March 17, 2013, at 2:02 PM, gumby0130 wrote:

  Dear Taylor,

  I don't usually comment on investment pieces I read via Yahoo! Finance (i.e., Motley Fool and Seeking Alpha) but your analysis of Peabody Energy is so egregiously wrong I felt compelled to sign up and comment in order to set the record straight and have your readers better understand the risks of BTU.

  I can't help but begin by saying you're a fool (and not a Motley one).

  1. Continued suppression of natural gas prices.

  This is by far your best point (of an otherwise horrible piece) and could potentially drive a thesis on why one should sell BTU; however, your lack of understanding of coal-to-gas switching and conflation of met coal (mixed with iron ore in blast furnaces to create steel) and thermal coal (used by Duke and others to provide electricity) demonstrates how unqualified you are to discuss Peabody Energy or, using the same gross extrapolation techniques you use throughout your piece, any natural resource company.

  First, coal-to-gas switching has largely already taken place within the current installed base of power plants. The utilization rate of coal plants has plummeted over the last 24 months in response to the shale gas boom. Gas, once the marginal-cost producer of electricity, has come down the cost curve, reducing both dark and spark spreads. Coal historically priced off of natural gas (try to remember micro econ here, Taylor: Marginal Cost = Price), therefore, as natural gas prices came down and coal became the marginal cost provider many old coal plants became uneconomic since they were no longer pricing off of natural gas peaker plants (i.e., the former marginal cost producer).

  Second, "creep in the steel industry." There are two ways to make steel, Taylor: (1) Blast furnaces and (2) electric arc furnaces. I recommend you do a little research into how these processes work before spewing a patently false conjecture to your fellow "Fools." Since it's clear you have no authority to speak about the aforementioned topic, let me drop some knowledge on you. Blast furnaces use coke (a derivative of met coal) and iron ore to produce steel. There is no substitution for met coal in this process. However, since Peabody doesn't have a met coal footprint in the United States this is largely a moot point (but extremely important for BTU overall because of its Australian met operations -- see point 4 below). Electric arc furnaces use electricity and steel scrap to produce new steel. Note that there is no coal in this process, only electricity which I've already covered in the above paragraph.

  Third, you make no mention of the inevitable demand response to America's shale revolution. Given the extremely low natural gas prices in the US relative to the rest of the world, many industries that use natural gas as a cost input are flourishing (e.g., fertilizers, chemicals, manufacturing, etc.). Companies are spending billions of dollars of capex in order to take advantage of this dislocation. This should in theory help set a floor on natural gas prices over the long-term, which I presume is your investment horizon.

  2. Possible exportation of LNG on a meaningful scale.

  I don't even know where to start on this point. If anything, the build-out of LNG trains in the US and eventual exportation of natural gas to Europe and Japan is a net positive for US coal companies, including Peabody. Most of Peabody's thermal coal operations are in the US (the Co's Australia operations are predominately met coal). Since you clearly don't understand the commodities markets, allow me to put this into simple physics terms for you. You have a cube full of high-pressure gas. You cut a hole in the top of said cube. The gas is released into the surrounding lower-pressure environment. Pressure inside and outside the cube stabilize and reach equilibrium. In case you can't follow, America is the cube; the gas I speak of is natural gas; and the outside environment is the international LNG market. The new equilibrium price is dependent upon how big the cube is to the surrounding environment and the cost structure of other LNG providers in the larger surrounding environment. Just some tiny nuances you failed to mention.

  LNG contracts in Europe are negotiated off of the National Balancing Point ("NBP") which is based off of oil prices. LNG contracts in Japan are negotiated off of the Japan Crude Cocktail ("JCC") which, per its name, is based off of oil prices. Do you see a pattern here? International LNG contracts are dependent upon international oil prices. This is enticing to US producers as our country's shale boom has created a completely different and lower cost structure than other international LNG projects, and there is the potential to make serious money if Cheniere and other LNG hopefuls can negotiate JCC- and/or NBP-based prices.

  Your logic that the exportation of American LNG will bring international prices down into equilibrium with US prices is so wrong it's almost criminal. American LNG will push the marginal producer out of the stack (i.e. cost curve), which indeed will lower the price. However, the new equilibrium price is dependent upon how steep the cost curve is and how much new supply is brought into the international market via US LNG trains (how big is the cube, Taylor?).

  3. Increased environmental regulation.

  This is a major issue in the coal space. But yet again one which you fail to understand. You make no mention of the two impending federal regulatory regimes: CSAPR and MACT. CSAPR and particularly MACT will force US power producers to install scrubbers and/or other sequestration technology in the coming years. No one knows exactly how this is going to play out. I researched this for months and couldn't get a clear answer from anyone. Right now every utility is reviewing their portfolio of power plants and trying to decide which coal plants have compelling enough economics to justify spending the capex to install a scrubber (which is essentially a small power plant within a power plant). These things are not cheap and billions of dollars are on the line (not to mention senior executives' careers). In order to understand the economics of a particular FERC region (e.g., PJM, MISO, NYSO, etc.) in 2016 one has to have a good idea of which coal plants are going to be retired. The more plants that get retired, the better the economics are for the remaining scrubbed plants. However, everyone knows this so any would-be marginal plants are staying open as long as possible in order to maintain their option value -- it's essentially one big game of chicken. Anyone who tells you how many scrubbed coal plants are going to be retiring in a post-MACT environment doesn't know what they're talking about.

  4. Some other fun facts about BTU you failed to mention.

  Peabody has material exposure to China's infrastructure build-out via its Australian met coal operations (formerly Macarthur Coal). Although a small production footprint, the Australian operation has an outsized EBIT contribution because of the much higher margins BTU makes selling met coal into China and other Pacific-basin nations. Therefore, any assessment of BTU requires a view on met coal prices, steel prices, and China's continued economic growth and urbanization, something you failed to do.

  In sum, you clearly don't understand the commodities industry and the companies that operate within it. If you were investing your own money that would be fine; but because you are an analyst at a purportedly reputable firm, you have a fiduciary obligation to your clients / "Fools" to understand that facts before making pronouncements like the ones above.`

  Very Truly Yours,

  Gumby0130

  Disclosure: I do not own BTU nor am I endorsing the Company with a "Buy" rating.

• Report this Comment On March 17, 2013, at 11:23 PM, WillRodgersHomes wrote:

  Taylor I am confused why you are arguing why one should sell Peabody when not three days ago you did a video on why it should be bought.

  http://www.fool.com/investing/general/2013/03/13/3-reasons-t...

  Gives us all the facts in one article then give us your professional opinion on its rating, considering the challenges it faces its strengths. These two contradictory really hurt your credibility.

• Report this Comment On March 18, 2013, at 10:54 AM, TMFrunAMuck wrote:

  @gumby1030 - thanks for your response to my brief overview video meant to alert investors to a few overarching topics which they can research further themselves. My response to your message can be found below:

  1a. Coal-to-gas switching largely taken place - not even close: Duke will be closing 6,800MW by 2015; MidAmerican Energy (Warren Buffet) will be closing 6 Iowa-based cola plants by 2016; American Electric Power will be closing 3 Ohio-based coal plants; Southern Company is retiring 2,000MW of fossil fuel plants (reducing coal exposure from 70% to 47%). The EIA states that NG is likely to equate to 40-50% of all power generation in the U.S by 2020. That is up from the current 35-38%. So, it appears that coal-to-gas switching still has a pretty decent runway.

  1b. Creep in steel industry - companies can begin switching to "Direct Reduced Iron" - Nucor (largest steel manufacturer in US) is moving in this direction with its plant in Louisiana and will be substituting low-cost natural gas (from a 20-yr contract) in lieu of coal. Others are likely to follow suit.

  1c. I have been well documented in discussing the usage of natural gas in all manner of materials industries, such as the ones you mentioned. Some $95B in capital expenditures coming from the petrochemical industry has been announced and will undoubtedly increase demand. The one fact you neglect to mention is that producers of natural gas are flaring or moving towards oil until prices begin to rise. There is more than enough supply to keep prices competitive with coal for the next 5-10 years.

  2. Pricing of natural gas to oil on an international scale has come under fire recently and has a the potential to be de-linked. Companies like Statoil are already providing customers w/ de-linked contracts to gain a competitive edge against peers like Gazprom. BP also signed a 15-yr contract with a Japanese-based company to sell natural gas at prices based on HHub pricing. Once the U.S. begins to export LNG, it will place added pressure on int'l producers to de-link since it will be opening up a cheaper market to the world (think economics here).

  3. I believe that it's Auzzie operations are reasons to BUY Peabody Coal, not to sell. Therefore, its business there was not mentioned in this article.

• Report this Comment On March 19, 2013, at 10:22 PM, gumby0130 wrote:

  Taylor,

  First and foremost, and sarcasm aside, thank you for responding to my post. Many analysts would have ignored my fierce rebuttal -- some may even venture so far as to describe it as an intellectual tirade; but to those individuals I would say, in the words of former Governor Arnold Schwarzenegger, "stop being economic girlie men" (http://www.youtube.com/watch?v=SUzUbtIptqQ). You, however, did not; and for that, many thanks. Though I cannot promise to refrain from sarcasm in this post, going forward I will be sure to show you the same respect you showed me in your response.

  Before I get to coal, I would like to just bring up one administrative item I take issue with. After reading the post submitted by the curt and grammatically error-prone @WillRodgerHomes, I came to learn that you posted a piece titled "3 Reasons to Buy Peabody Energy" on March 13, where you made note of (1) the rapidly growing export market for coal, (2) BTU's high margin Aussie met business, and (3) the Company's market-leading position in the "best" U.S. basins. We can argue these points anytime (though I tend to agree with most of them), and I'm happy to do so in the format of your choosing; however, the key takeaway from your two posts was my newly found (and possibly misguided) understanding of how Motley Fool operates. It appears that analysts give individual and discrete positive or negative commentary in any given post rather than posting a comprehensive review of the equity in question. If this is your style rather than an institutional policy, I would kindly ask that you change the format of your posts. If on the other hand, this is how Motley Fool operates, then (1) you unfortunately work in a highly repressive system, and (2) such compartmentalized posts do a severe disservice to the average, and most likely financially uneducated, reader. However, this fight is not with you. That said, however, I'm happy to write to the individual at Motley Fool who is responsible for such a draconian and asinine policy.

  And now on to our new favorite subject: coal.

  1. "Coal-to-gas switching has already taken place -- not even close." I think we've had a slight miscommunication on this point. It appears that I was speaking English and you were speaking French. Coal-to-gas switching has largely already taken place (and arguably peaked when gas hit a low of $2.50/mmbtu back in 2012). Coal-to-gas switching is the optimization of economic dispatch within the current installed base. For example, if I'm a utility with a portfolio of two power plants -- one coal-fired plant and one combined cycle gas turbine ("CCGT") -- I will optimize the utilization of the whole portfolio by only dispatching into the stack when my variable cost of my respective individual plant is at or below the current power price. So, back in 2010 I was probably running my coal plants at an 80% capacity factor and my gas plants at a 30% capacity factor. However, as gas prices dropped dramatically in 2012, I switched the utilization of my portfolio to run my gas plant at 80% and my coal plant at 30%, selling energy via my coal plant during peak hours when the price exceeded my variable operating costs. This is a terribly simplified example, but should suffice in communicating my point.

  What you are describing is not coal-to-gas switching but rather coal plant retirements due to the CSAPR and MACT regulations that will come online in or around 2014-2016. Notice that all the examples you gave me had plant retirements occurring in 2015-2016, conveniently just before the planned implementation of MACT. Now, don't get me wrong, coal plant retirements is a huge issue for coal producers, but it's arguably one that is mostly priced in to coal equities at this point. The other issue you implicitly hit on is the build-out of CCGTs in response to planned coal plant retirements. Thus you are correct that the installed base of power plants may shift further to nat gas plants, but this phenomenon does not fall under the purview of "coal-to-gas switching." Thus, my conclusion that we were speaking different languages -- I English, you French. Unfortunately, our audience only speaks English (watch some French guy respond to this).

  1.(b). Creep in the steel industry. I concede that I had never heard of DRI technology, and going forward I will be sure to include DRI as a way to make pig iron and, ultimately, steel. Though, I also have to admit that I don't understand how such technology proliferating in America is a net negative for BTU. Peabody's met coal exposure is in the Pacific Basin, so any increase in gas usage due to the proliferation of DRI technology is probably a net positive for BTU's thermal coal operations. Now, ANR, ACI, PCX (rest in peace our Chapter 11 friend) and JRCC would certainly be impacted if DRI proliferated widely, as all three names have material exposure to US met coal. Nucor does a good job of breaking out the economics of DRI and Blast Furnace cost structures on page 26 of their latest investor presentation. Though, at first glance, one has to wonder why the US has never utilized such technology in the past 20 years if it takes a nat gas price of $7.45/mmbtu for blast furnaces to break even with DRI technology. And I also don't foresee throngs of independent gas producers signing up for $4/mmbtu for the next 20 years when they could hedge out their production by selling forwards or purchasing puts against the henry hub forward curve which is in steep contango (price is $6.50-$7.00/mmbtu in 2023, 10 years from now). But hey, people do dumb stuff. Note: liquidity would probably be a limiting factor for the large nat gas producers to enter into such contracts, but I imagine if you dangle enough dollars in front of an investment bank they could quickly find a counterparty for such a risk.

  1.(c). Demand response to low nat gas. I'll keep this short and sweet. (1) I haven't read your previous posts so apologies for not coming into this debate with a comprehensive understanding of your former points (it appears that I too have fallen victim to Motley Fool's compartmentalized system). (2) I agree that we're probably range bound in nat gas over the medium term as there is a ton of capacity in dry basins such as the Haynesville waiting to come online as gas increases. However, I will say that the significantly reduced rig count in dry basins creates the potential for short term corrections to the upside (though associated gas, as you mention, could mute any impact).

  2. LNG de-linking. I've been watching this de-linking phenomenon as well, but I think it's difficult to list this as a reason to sell Peabody or any US thermal coal producer. My (limited) understanding of the de-linking phenomenon is that with European demand decreasing due to the economic troubles across the pond coupled with increased competition from LNG exporters, certain long-term contracts are being negotiated off of non-oil based pricing formulas. In Asia, Japan and Korea recently created a spot LNG market index, allowing for more flexibility in pricing long-term contracts. This could definitely be the wave of the future but currently it's a fringe element in the global LNG market, and not one that I would include in any thesis to short BTU and other US thermal players for the following reason: (1) US coal is largely a captive domestic market (yes exports are increasing, but thermal has to compete with met for limited port capacity) so any gas leaving the country, regardless of price, is a net positive. (2) Producers are likely using de-linked long-term LNG contracts in order to finance greenfield projects rather than for selling gas from currently producing projects which can sell into the higher spot market -- this is economically rational given that project finance banks require long term contracts in place to provide debt financing for new projects. And (3) if we do move to a de-linked environment for spot prices many current LNG projects would be rendered uneconomic (I'm not very familiar with what the global cost curve looks like, but one could envision a world where only unconventional and middle eastern gas price into such an LNG market), bringing supply offline and increasing the price (just trying to remember my economics here!).

  3. Motley Fool's institutional policy of compartmentalized information rears its ugly head again.

  Very Truly Yours,

  Adam (I figure we are on a first name basis at this point)

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