No one in the world can predict when commodity prices will make their next move, nor does anyone know whether or not that move will be higher or lower.
It's a statement made abundantly clear by watching the management teams of commodity producing companies completely misjudge their market time and again. For example, from 2009 to 2014, oil and gas companies borrowed $786 billion to fund drilling and acquisitions based on the premise that oil prices would remain over triple digits for the long term.
And then this happened:
The 50% haircut from the peak caught energy companies off guard. It's why the industry is now bracing for a massive bond default wave to hit the sector in the coming years.
Commodity producers use debt to deliver leveraged growth when commodity prices rise. However, that leverage works both ways, as it cuts deeply into returns when prices fall. That's what makes this such a bad business model for commodity producers, because when prices head lower, it can obliterate returns earned during the up-cycle.
Instead, the best business model in the commodity space is one built upon not only a much lighter debt load, but with limited direct exposure to the potential for volatility in commodity prices.
It's a business model that's on full display in the coal sector, of all places. Coal MLP Alliance Resources Partners, L.P. (NASDAQ: ARLP) uses a business model built on limited debt and coal price stability via long-term contracts to vastly outperform its peers. It's why the company has been largely immune to the devastation that's impacting peer Peabody Energy Corporation (NYSE: BTU), which has seen its stock price decimated, as can be seen on the following chart:
The coal industry in America appears to be on its deathbed. Nearly all the top producers are on the precipice of bankruptcy. The reason for the industry's demise is twofold: Coal prices have fallen due to weak global demand, and the industry itself is being weighed down by high legacy costs and debt.
In a sense, it's a disaster of the industry's own making, as producers levered up when coal prices were high to boost capacity, and they're paying the price now that prices have fallen due to over capacity. As the slide below makes clear, 2011 was really a tipping point for the sector.
As those two charts note, coal producers added $10 billion in debt right as coal prices were peaking in 2011. These producers are struggling under the weight of that debt now that coal prices have been cut in half. It's that leveraged exposure to the downside of coal prices that's threatening to push these companies over the edge.
Alliance Resources Partners, L.P., however, has largely avoided debt, as evidenced by the fact that its current debt-to-EBITDA ratio is just 1.1 times. That's well below its peer group, where Peabody Energy, for example, has a debt-to-EBITDA ratio now approaching 9.0 times in 2015.
Locking in future earnings
One of the reasons Alliance Resources Partners' debt ratio isn't in the danger zone is because the company isn't seeing as deep an impact from weak coal prices as its peers, which is keeping its EBITDA from falling. This is because the company's coal volumes are sold under long-term contracts. While that reduces its upside should coal prices spike, it also limits its downside when times get tough.
In fact, for 2015, Alliance has 96% of its coal volumes under contract, while also having solid coverage for its coal volumes going out until 2018. Those contracts largely mitigate the company's exposure to coal price volatility.
It's volatility that just recently took another unexpected $20 million chunk out of Peabody Energy's second-quarter results, which are already expected to be weak. That $20 million is coming from lower than expected pricing on Australian metallurgical coal and will result in the company reporting an even deeper per share loss than its previous forecast of $0.49 to $0.59 per share.
Given the current market outlook, Peabody is expected to generate negative cash flow for the next two years, while Alliance Resource Partners produces more than enough cash flow so that it can pay a growing distribution to its investors.
Over the past five years, Peabody Energy's stock is down 95%, while Alliance Resource Partners is up almost 50%. The difference lies in the business models these two companies employ. Peabody Energy uses a hefty dose of debt and is directly exposed to coal prices, while Alliance Resource Partners limits the amount of debt it uses while mitigating its exposure to coal prices by contracting its production under long-term contracts.
Clearly, Alliance Resource Partners has the best business model for commodities.
Matt DiLallo has no position in any stocks mentioned. 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.