Peabody Energy Isn't out of the Woods Yet

Peabody Energy is set to report second quarter earnings tomorrow; the numbers are likely to be bad, but it's the news about the future that will be most important.

Jul 21, 2014 at 3:38PM

Peabody Energy (NYSE:BTU) disappointed on the earnings front in the first quarter. That's set the tone for the second quarter, which is likely to see continued weakness. However, the big question to ask isn't, "Is the coal market in a trough?" We know it is. The question to ask is: "Is the coal market ready to turn yet?"

The bad is the good
It wasn't too long ago that the U.S. coal market was the big negative in the coal industry. And it wasn't any different at coal mining giant Peabody Energy. While the prevailing anti-coal sentiment hasn't changed all that much, the other big boogeyman, natural gas prices have. So much so, in fact, that coal from the Powder River Basin and the Illinois Basin are price competitive again.

That's important, because these two regions are the main focus on the thermal side of the business at Peabody Energy. And with natural gas prices roughly double their 2011 lows, coal is again the main source of electric generation in the United States. For example, in April Peabody noted that coal powered 43% of the country versus 31% at this time two years ago. Natural gas went from a 31% share to a 23% share.

Henry Hub Natural Gas Spot Price Chart

Henry Hub Natural Gas Spot Price data by YCharts

So far, a lot of that coal use has come from utility stockpiles, but that can only last so long before utilities have to rebuild their inventory or risk running out of this still vital fuel. That's the good news and one thing you should be paying attention to during Peabody Energy's first quarter conference call. But, sadly, it isn't the only news to watch for.

Good news is bad news
The exact opposite trend, however, has taken place in the metallurgical coal market. Prices in this sector have collapsed over the past few years taking results at Peabody Energy down with them, not to mention met focused miners like Walter Energy (NASDAQOTH:WLTGQ). Peabody Energy's operations are split between thermal and met coal, so it has an offset. Walter Energy gets around 95% of its coal revenues from the met market—it has virtually nothing to soften the blow.

How bad is it? Last quarter, Peabody Energy watched the gross margin per ton in its Australian segment collapse from $12.15 in 2013 to a meager $0.22. The company's met operations are in this segment. Walter Energy, meanwhile, saw the sales price of its met coal drop nearly 17% year over year in the first quarter. Those numbers are even worse when you go back to 2012 or 2011.

And, sadly, this dynamic isn't likely to change because the met coal market is still oversupplied. That's the issue that's going to keep earnings weak at both Peabody Energy and Walter Energy for, most likely, the rest of this year.

BTU Chart

BTU data by YCharts

It's all relative
The reason for this at Walter Energy is pretty obvious, as met coal goes so goes Walter Energy's business. However, for Peabody Energy an improving domestic thermal coal market would seem like a big bright spot. It is, but margins in the thermal coal market are relatively thin compared to margins in the met market—or at least that's the normal way things operated before the recent met coal price collapse.

Since met margins are weak right now, Peabody Energy and Walter Energy will be mired in weak financial results until pricing gets back to normal on the met front. And that's the update you really want to hear about during Peabody Energy's second quarter conference call.

Pay attention to supply and demand statistics, since that's going to be more important for the future than current met prices. Of course you'll want to hear continued good news on the domestic thermal front, but that won't be enough to turn things around at Peabody Energy or any of the miners with notable met coal operations.

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Reuben Brewer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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