What Would Make Me Buy This Coal Powerhouse?

Peabody Energy used to be the class act of the coal sector. Now, it's suffering greatly along with most coal peers with weak coal pricing. Peabody could be a good investment again, but only if both coking and thermal coal prices stage a rebound.

Jul 1, 2014 at 11:13AM

There are plenty of headwinds facing the coal industry in the U.S. and globally. It's easy to find negative articles and reports on coal. However, I've also seen some positive sentiment forming on select coal stocks such as Peabody Energy (NYSE:BTU) and CONSOL Energy (NYSE:CNX). I recently wrote an article on CONSOL in which I said that I think that the company is strong, but its stock is fully valued. CONSOL's management team nailed it by diversifying from coal into natural gas, most notably through acquisitions in the Marcellus Shale. CONSOL also has a strong, but shrinking coal business relative to its gas segment.  

Peabody, on the other hand, doubled down on coal in 2011 with its acquisition of Australia's MacArthur Coal. Peabody already had a presence in Australia where it owns coking coal assets. Prior to Peabody's foray into Australia, it was the class act of the coal industry in the U.S. Peabody had a dominant thermal coal position in the Powder River Basin, "PRB" of Wyoming and Montana. The PRB is a low-cost coal basin that produces about 400 million tons of coal per year. Other key players in that basin are Cloud Peak (NYSE:CLD) and Arch Coal (NYSE:ACI).  

Cloud Peak is a pure-play thermal coal company with all of its assets in the PRB. Cloud has done a great job by avoiding the debt-fueled acquisition spree that peers Peabody and Arch fell prey to. Instead of expanding internationally or diving into coking coal, Cloud redoubled its focus on building reserves and cutting costs in the PRB. As a result, its stock has significantly outperformed most coal peers. Arch has the second largest position in the PRB after Peabody, but it made a large East Coast acquisition in 2011, leaving it with a scary, debt-heavy balance sheet to this day. Arch's coking coal capacity in the U.S. is ample, but the quality of the coking coal it produces is not top-notch, making it hard to move in a depressed coking coal market. 

Peabody used to be the top dog, but the PRB market is hurting 
Five years ago, Peabody was the darling of the coal industry. In my opinion, that title has now moved to Alliance Resources Partners LP (NASDAQ:ARLP). Alliance has far and away the highest margins and strongest balance sheet. The company is in the two best coal basins in the country, the Illinois Basin and Northern Appalachia. Alliance has contracted a large proportion of its volume in 2015 and 2016 at attractive levels. Visibility toward earnings and production growth is solid. 

Peabody's main area of focus, the PRB in the U.S., has been under pressure for the past few years. PRB coal is low-cost, but it has a low heat value and has to travel great distances to end markets. Over the years, there have been waves of excitement that PRB coal would get exported in large quantities to Asia from the West Coast. However, environmental challenges of proposed new coal export facilities in Oregon and Washington, among other places, have continually delayed these initiatives. 

What it would take to make Peabody a buy?
Peabody requires a rebound in the global coking coal price and stronger pricing in the PRB. While there are signs of improvement in the U.S. thermal market, coking coal prices remain a disaster. From a high of $330 per metric tonne in mid 2011, the benchmark coking coal price is now $120 per tonne. I believe that Peabody needs $170-$180 per tonne coking coal to thrive. In the PRB, thermal coal prices are stuck near $13 per short ton, a level at which no one in the basin is making much headway. However, utility stockpiles of PRB coal have shrunk lately, and that could point to higher coal prices next year. PRB coal prices of $14 per ton or higher, combined with evidence of a rebound in coking coal prices would make Peabody an attractive investment again. 

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Peter Epstein owns shares of Alliance Resource Partners and CONSOL Energy. The Motley Fool recommends Alliance Resource Partners. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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