Digging for Coal Values in the Powder River Basin

The Powder River Basin in northeast Wyoming and southeast Montana is home to the most abundant, low-cost, low-sulfur-content coal in the United States. PRB coal prices plunged in late 2011 and early 2012 as a result of unseasonably warm winter weather in 2011-12 and weak natural gas prices that dipped below $2 per thousand cubic feet equivalent in early 2012, which caused domestic utilities to drastically reduce coal burn. Now that natural gas prices have climbed above $3 per Mcfe, we think PRB coal should be trading well above its current spot levels around $10 per ton. We think this price dislocation is being caused by bulging coal stockpiles among the domestic utilities, and we believe PRB coal prices could spike higher once this inventory overhang is removed. We believe narrow-moat  Cloud Peak Energy  is the miner best positioned to capitalize on a rebound in PRB coal prices, thanks to its 100% exposure to the PRB, cost leadership in the basin, and sturdy balance sheet. Our $28 fair value estimate implies that Cloud Peak's shares are significantly undervalued.

Powder River Basin: Best Coalfield in the U.S.?
The Powder River Basin is the most prolific coal-producing region in the U.S., generating 462.6 million tons of coal in 2011--roughly 50% of total U.S. power generation coal demand that year. The PRB is not only the most abundant domestic coal source but also the cheapest, with dollar/ton extraction costs in the midsingle digits on average, compared with costs that can exceed $50-$60 in the central Appalachian (CAPP) coal basin. The PRB's cost advantage lies in geology, as the basin contains thick coalbeds lying close to the surface that are amenable to surface mining on a massive scale. Even accounting for government royalties and rail transportation costs, PRB coal is very competitive versus natural gas and especially versus other coal basins on a dollar/energy content basis in vast swaths of the country. We believe this inherent cost advantage will help PRB coal to maintain or even regain share of the power-generation market from natural gas (depending on where gas prices move) while also stealing some market share away from other higher-cost coal, most notably Appalachian coal.

PRB coal's other main virtue is that it is one of the cleanest-burning coals in the U.S., boasting the lowest pollutant levels of sulfur dioxide as well as heavy metals such as mercury (on a weight/energy content basis) among the domestic coal basins. As a result, we believe PRB coal could become a more attractive option for domestic power plants that will need to comply with more stringent air pollution legislation, although we would note that potential future carbon legislation that limits carbon dioxide emissions would be a negative for all coal basins, including the PRB.

Who Are the Main Characters in the PRB?
The PRB is dominated by four major players.  Peabody Energy  and  Arch Coal (ACI) are the two largest miners in the basin, while Cloud Peak is a strong third player;  Alpha Natural Resources  has a much smaller production base in the PRB. A few smaller private companies also operate there, but the aforementioned big four public miners generate 85%-90% of PRB's total coal output in a typical year.

Within the PRB, the mining cost curve is relatively flat, since the same mining techniques and geology prevail across most of the basin. Usually, Cloud Peak is the lowest-cost producer, Arch is the highest-cost producer, and Alpha is somewhere in the middle. It is hard to know what the exact cost structure for Peabody looks like because the company does not separately disclose operating metrics for its PRB segment.

While mining costs are extremely low, a big disadvantage for the basin is that it is far removed from the majority of U.S. coal plants, the end consumers of PRB coal. Freight trains transport all PRB coal headed to these coal plants and can use their advantaged middleman positions to extract significant economic rents. However, even after accounting for the hefty rail freight charges, which we estimate to have averaged roughly $0.19 per mile per ton of coal transported in 2012, PRB coal is still very competitive against other coal types as well as natural gas in large swaths of the U.S.

PRB Coal is Winning Versus Other Coal Basins and Holding the Line Versus Gas Depressed natural gas prices, particularly in early 2012 when Henry Hub gas prices briefly breached $2/Mcfe, have pressured thermal coal demand in the U.S. Domestic utilities have seen low natural gas prices as an opportunity to use more gas and less coal to generate electricity. However, it would be a mistake to paint all domestic coal with a broad brush, as low-cost PRB coal can compete with natural gas much more effectively than high-cost CAPP coal. In fact, as natural gas prices climbed above $3 per Mcfe in late 2012, we saw some reversal in the coal-to-gas switching. As a result, coal's shares of the domestic power market rebounded to 42% in November 2012 after dipping as low as 32% in April 2012, which was identical to natural gas' market share percentage in April.

Share of the Domestic Power Market Between Coal and Gas

Source: Morningstar, EIA.

While PRB coal is able to hold its ground versus natural gas at current levels, it has been able to do more than just play defense against other higher-cost coal basins. In fact, PRB coal has been able to slowly steal power generation market share from higher-cost CAPP coal during the past few decades. It is now extending its reach into traditional CAPP coal strongholds in the deep Southeast, the Ohio River Valley, and even the Appalachian regions of the U.S., where PRB coal now represents a cheaper source of energy--even after incorporating rail freight costs--on a dollar/Btu basis.

Why Are Current PRB Coal Prices So Low?
Given the cost advantage that PRB coal currently enjoys over other coal basins and even natural gas at $3.50 per Mcfe, why have PRB coal spot prices remained moribund at $10 per ton? This phenomenon is even more puzzling given that marginal costs in the PRB exceed $11 per ton on a cash basis, meaning that PRB coal miners would be losing money hand over fist if they sold their coal into the current depressed spot market. We believe PRB coal prices are in a state of extreme dislocation because of elevated coal stockpiles at the utility level. We think PRB coal prices will be able to return to more reasonable levels relative to natural gas once this inventory overhang is removed and utilities are more willing to increase PRB coal purchases on both a contract and spot basis.

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Domestic coal plant inventories peaked at more than 200 million tons in May 2012 as a result of of warm winter weather and depressed natural gas prices. Coal inventories declined since then to our estimate of 180 million-185 million tons at the end of 2012 (the most recently released inventory figure from the U.S. Energy Information Administration was 186.6 million tons at the end of November 2012). While domestic coal inventories are not as swollen as they were in early 2012, they are nevertheless much higher than normalized levels, which we estimate to be in the neighborhood of 140 million tons (based on assuming 60 days of average coal burn by domestic utilities, as well as 850 million tons of coal burn in a normal year).

Until coal plants reduce their inventories to more normal levels, we think PRB coal prices will remain depressed, as utilities would want to draw down their stockpiles before contracting for significant amounts of new coal or purchasing coal from the spot market. However, once stockpiles are whittled to more reasonable levels, we believe PRB coal prices could spike higher. In our netback cost analysis, $10/ton PRB coal is a much more cost-effective option for generating electricity than $3.50/Mcfe gas in many regions of the country, and we believe the swollen coal inventory figures are the main reason this huge cost differential hasn't been arbitraged away by domestic utilities. We believe that if natural gas prices remain around $3.50/Mcfe, PRB coal prices could easily climb over $15 per ton and still remain competitive on a cost basis. If gas prices move even higher than that, the upside for PRB coal prices would correspondingly increase.

Domestic Utilities' Coal Stockpiles (Millions of Tons)

Source: Morningstar, EIA.

We believe a drawdown in domestic coal stockpiles could happen sooner rather than later depending on certain key variables. The EIA estimates that domestic coal burn for power generation could increase roughly 40 million tons in 2013 from the depressed 2012 levels of 827 million tons. This EIA forecast assumes normalized weather patterns in the U.S., as well as 2013 gas prices adhering to the current Nymex futures curve. In addition, domestic coal production declined by roughly 75 million tons in 2012 and we project it to decline even further in 2013, given that many of the high-cost CAPP coal mines shuttered in 2012 may remain closed. In our view, this combination of higher coal burn and lower coal production in 2013 should help whittle down coal inventories close to normalized levels approaching 140 million tons by the end of the year, although the timing of this inventory drawdown will undoubtedly depend on weather patterns as well as natural gas prices.

Cloud Peak Is the Best Way to Play Higher PRB Coal Prices
Among the four big PRB miners, we think Cloud Peak represents the best way to gain exposure to PRB coal prices. The company represents a pure play on the basin, as the other three PRB miners have exposure to other coal basins, for which we may not have as rosy an outlook. Arch and Alpha generate significant coal output from the Appalachian coal basins, which we believe will suffer steep market share loss to lower-cost PRB coal as well as to natural gas over the next few years. We believe Cloud Peak's extensive PRB operations also grant it a narrow economic moat. We think existing large PRB miners are relatively protected from new entrants, given the sizable infrastructure investments they have already made in the basin, allowing them to mine adjacent coal deposits using much lower incremental capital than a new miner without any existing operations in the basin could.

Also, Cloud Peak consistently registers the lowest unit cash costs among the major PRB miners. In 2012, for example, its average cash cost was $9.57/ton, the lowest in the PRB, compared with Arch Coal's $11.19/ton during the same year. Cloud Peak's cost leadership means that the firm can still eke out operating income even if PRB coal prices remain depressed for longer than we expect, and profit margins once PRB coal prices recover to more normalized levels will be that much wider than its competitors'.

A PRB coal price recovery may take longer than we expect if natural gas prices remain low for an extended time or if warmer winter weather and cooler summer weather prevail across the U.S. However, Cloud Peak's sturdy balance sheet should tide the firm over even if PRB coal prices remain moribund for a few more years. The same cannot be said of Arch and Alpha, which ravaged their balance sheets with expensive acquisitions in 2011. We think Cloud Peak's strategy of increasing its coal reserves through small, bolt-on purchases will be more likely to generate shareholder value and will also help maintain sound financial health.

While we believe Cloud Peak represents a compelling buying opportunity, investors might need to be patient. Even if PRB coal prices start moving higher in 2013, this year will still be tough one for Cloud Peak, as the firm has benefited from favorably priced coal contracts that will start to roll off. As a result, we believe the company will see a modest earnings decline in 2013. In addition, a recovery in PRB coal prices may take longer than we expect, depending on weather conditions and natural gas prices. In our stress-test scenario, which assumes that a recovery in PRB coal prices never arrives and PRB coal prices remain stuck around $10/ton in real terms over the long term, Cloud Peak's shares would be worth roughly $8, in our opinion. In our less harsh but more likely bear-case scenario, where PRB coal sells for a nominal price of $12.50/ton by 2016, we think Cloud Peak shares would be worth roughly $16, which is only slightly below where the stock is trading currently. In our base-case scenario, where we assume spot PRB coal prices break above $15/ton in nominal terms by 2016, we think Cloud Peak would be worth $28 per share.

We believe a sound balance sheet and cost leadership in the PRB will help Cloud Peak to weather low coal prices better than most other miners. We do think the current low PRB coal prices are unsustainable, given improved natural gas prices, and we believe a rebound in PRB coal prices is inevitable. When the recovery in PRB coal prices arrives, we believe Cloud Peak is in an excellent position to ride this wave and generate attractive returns for shareholders.