Financial Distress May Visit Central Appalachian Miners
We're increasingly concerned about their vulnerable balance sheets.
As natural gas prices continue to fall and the outlook for coal--especially from Central Appalachia--worsens, we are becoming more nervous that leveraged coal firms may fall into distress in the next two or three years. Our concern centers on Central Appalachian miners that participated in blockbuster acquisitions in the past two years--namely Arch Coal (ACI) and Alpha Natural Resources (ANR). We lowered our fair value estimates materially in large part because of this. In general, we foresee coverage and leverage ratios deteriorating over the medium term.
We expect Central Appalachian miners will face tremendous headwinds for at least the next two years. Spot CAPP thermal coal has plunged to $60 per ton. Contango brings pricing up to $70 by mid-2013. These prices do not make for economic production. We estimate that average cash production costs for CAPP thermal coal are about $60-$65 per ton today. Therefore, based on the current curve, producing thermal coal is money-losing today and will be barely profitable a few years hence. Given the very high capital intensity of the industry, these cash margins do not allow producers to reinvest in efficiency or to replace depleting mines. As the old saw goes, the best cure for low commodity prices is low commodity prices. However, in this case, natural gas acts as a cap on CAPP thermal coal. With gas at $2 per thousand cubic feet, CAPP coal is deeply out of the money in its core markets. Given current production costs, we estimate that gas needs to rise to at least $4.50 per thousand cubic feet before miners can produce coal and earn an adequate cash margin, which we set at $10 per ton. Given current prices, the coal-to-gas switch will continue, albeit at a slowing pace, for the next several years.
Michael Tian does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.