Investors in coal-producing master limited partnership Alliance Resource Partners (NASDAQ:ARLP) and its general partner, Alliance Holdings GP, L.P. (NASDAQ:AHGP), are no strangers to a distribution reduction. That is because both companies took an ax to their payouts in the middle of last year. However, despite the cut, each still offers investors a high yield of 7.8% at current prices. That said, investors should not bank on these companies maintaining those lucrative payouts given Alliance Resource's contract situation and the uncertain outlook for the coal market.
The end of an era
Alliance Resource Partners and Alliance Holdings GP entered 2016 with the expectation of maintaining their very lucrative quarterly distributions, which had steadily increased for more than a decade. In fact, Alliance Resource Partners estimated that it would generate enough distributable cash flow to cover its distribution by 1.1 to 1.2 times. Driving that forecast was the company's decision to shift production to its lowest-cost mines and match output with firm contracts so it could maximize cash flow generation.
However, Alliance Resource Partners changed course a few months into the year, making the difficult decision to reduce its distribution by 35.2%, which forced Alliance Holdings GP to slash its distribution 42.7%. Doing so would improve Alliance Resource's coverage ratio to 1.6 times at the midpoint of its 2016 guidance, enabling the company to generate excess cash flow to reduce debt and strengthen its balance sheet. It has actually outperformed that guidance and now expects coverage to be 1.84 times at the midpoint thanks in part to its decision to monetize roughly half of its coal inventories.
That coverage ratio seems to imply that the Alliance distribution is on solid ground. While it is true that the company is in a stable financial position, several issues could still force another distribution reduction.
The first problem is that Alliance only had firm coal contracts encompassing 29.1 million tons for 2017 as of the end of last quarter. That is noteworthy because those contracts cover fewer volumes than the company's 2016 production guidance range of 34.5 million to 35.5 million tons and last year's expected coal sales volumes of 36.5 billion to 37 million tons, which is higher due to sales from inventory. In other words, unless the company signs additional coal contracts for 2017, its revenue and cash flow would decline, putting downward pressure on the distribution coverage ratio. Furthermore, the coal producer only had firm volume contracts covering 17.4 million tons next year and 8.9 million tons for 2019. While it has plenty of time to find customers for these volumes, there's always the risk that demand does not materialize, which could force Alliance to trim production capacity even more to match demand.
Another issue is the fact that coal prices remain weak. As such, even if Alliance signed all of its current capacity to firm contracts, it would likely have to accept lower prices for these volumes. That was certainly the case in 2016, when the company expected its average coal sales price per ton to be 5% to 6% below 2015's average price realizations. Those realized prices could continue falling given where coal prices are these days. For example, last quarter, Alliance's realized coal sales price per ton was $47.48 in the Illinois Basin and $53.22 in Appalachia, down 6% and 13%, respectively, year over year. However, in the month of December, spot prices in those basins averaged $34.50 per ton in the Illinois Basin and between $45.75 to $48.05 per ton in Appalachia according to data from the U.S. Energy Information Administration. These eroding prices suggest that Alliance's cash flow could fall even if it sells out its current capacity.
The longer-term outlook for coal is not much brighter. While the coal market started to improve in the middle of 2016 due to stronger demand and weaker supplies, there is a major factor that could disrupt market fundamentals in 2017: the reemergence of formerly bankrupt producers. As these producers get out from under a mountain of debt, they will have the financial flexibility to increase output and capitalize on any improvement in market conditions. On top of that, coal has to compete with cheap, abundant, and cleaner natural gas, which has been stealing market share in the power sector for several years and could continue doing so in the future.
Also, despite the election of pro-coal Donald Trump as president, there isn't much he can do to spur demand for coal in the U.S. in the short term given that utilities continue to retire coal power plants and replace them with cleaner-burning gas facilities or renewable sources. In other words, at best the coal market might stabilize, but increasing demand and pricing does not seem to be on the horizon.
All of these factors suggest that Alliance Resource's cash flow could continue to decline, which might eventually put its distribution at risk of another reduction. Such an event would cause an even deeper payout cut at Alliance Holdings GP. That said, another distribution cut is not a foregone conclusion because Alliance could work through its issues by signing new contracts at higher prices. Furthermore, it could always use its balance sheet strength to acquire cash flow-producing coal mines, which could help it mute the impact of a stagnant coal market. Investors, however, should know that these payouts are not safe bets right now.