Could the Coking Coal Market Get Any Worse?
Could the coking coal market get any worse? Probably not. A lot has been written about the plunge in iron ore prices, down about 41% this year alone due to oversupply from the Big 4, Vale S.A., (NYSE: VALE) Rio Tinto plc, (NYSE: RIO) BHP Billiton Limited (NYSE: BHP) and Fortescue Metals Group (ASX: FMG). The outlook for 2015 is for even more iron ore supply, despite China’s growth rate slowing. A similar dynamic is taking place in coking coal, the coal used with iron ore to make steel.
Coking coal prices have plunged 64% since 2011
Like iron ore, coking coal prices have plunged. From mid-2011, the quarterly benchmark low-vol coking coal price collapsed from $330 per metric tonne to $119/tonne, a decline of 64%. BHP Billiton, through its BHP Billiton Mitsubishi Alliance, “BMA” Alliance and Teck Resources (NYSE: TCK) are the two largest players. Oversupply and elevated stockpiles throughout the supply chain are thought to be a dead weight on coking coal prices for at least the next several quarters. I agree. Inroads made by natural gas in recent years and ever increasing environmental scrutiny of the coal industry continue wreak havoc as well.
In the U.S. there are several coal producers that rely heavily on coking coal. One is pure play coking coal producer, Walter Energy (NYSE: WLT). Two others are Arch Coal (NYSE: ACI) and Alpha Natural Resources (NYSE: ANR). All 3 are in a world of pain with no end in sight. Their biggest problems are the same, too much debt. Given that some of the unsecured bonds of these companies are trading at 28 cents -58 cents on the dollar, bankruptcy is a real possibility, especially for Walter. How bad are the debt problems? Walter Energy has $2.9 billion of debt and a $145 million market cap. Alpha, $3.9 billion in debt and a $500 million market cap. Arch, $5.1 billion of debt and a $442 million market cap.
Do U.S. coking coal producers have a chance?
All 3 companies are burdened with debt due to acquisitions made at the top of the market in 2011. Alpha acquired troubled Massey Energy for its east coast coking coal assets. Massey had recently suffered a terrible mining accident involving 13 fatalities. Massey was a mess, but coking coal was hot so Alpha dove in. Arch Coal acquired east coast coal producer International Coal, a company with a moderate amount of coking coal production at the time, but a significant coking coal development project. Walter Energy looked far north from its core operations in Alabama. It acquired Canadian based Western Coal. Like Massey Energy, Western’s operations were high cost and plagued with operating problems. Yet, the equity and bond markets were happy to throw money at all of these deals.
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Fast forward 3 years and as I mentioned, the quarterly benchmark low-vol coking coal price is down 64%. Other coking coal categories like PCI, mid and high-vol coking coals are down even more. The 3 above mentioned company’s stock prices are down approximately 93%-97% from 2011 highs. The threat of bankruptcy is a dark cloud over the industry. The unsecured bonds of Arch, Alpha and Walter tell a tale of woe. Arch’s 7.25%’s of 2021 are trading at 49 cents on the dollar and rated Caa1/CCC+. Alpha’s 6.25%’s of 2021 are trading at 58 cents and rated B3/B-. Walter’s 8.5%’s of 2021 are trading at 28 cents and rated Caa2/CCC. Bond ratings below BBB-/Baa3 are junk bonds. Single B and CCC bonds trading between 28 cents and 58 cents on the dollar are distressed bonds.
With the stocks down so much, some investors see an opportunity to make multiples of their money when coking coal prices recover. I don’t see that happening, the bond prices noted above tell a different story. Fundamentals are not helping. A weak Australian dollar vs. the U.S. dollar is helping Australian producers a lot on the cost side. Most of the world’s coking coal comes from Australia. Coal stocks will continue to be quite volatile because these 3 companies have limited to no ability to pay down debt. The combined probabilities of severe equity dilution, coercive debt for equity swaps or bankruptcy outweigh the probability of the stocks soaring. Even if coal prices begin to rise again, there’s ample production capacity sitting on the sidelines that could be redeployed within months. Further, railroad operators have been helping to keep coal moving by cutting transport rates. Once coal prices rise, so will rail rates.
Coal stocks are not oversold, they could be worth zero in a bankruptcy
Could the coking coal market get any worse? Probably not. Arch, Alpha and Walter sealed their fates with ill-timed top of the market acquisitions. These companies are clearly not powerhouses like a BHP or Rio Tinto that can absorb such tremendous body blows. The sector is a value trap or worse. Some stocks that appear oversold are simply not. These companies are extremely risky. So much so, that retail investors buying them today should have a hurdle rate of a triple or more. Why so high? The stocks could lose another 50%-75% to trade purely on option value or be worth zero in bankruptcy. On September 29 we saw an example of what happens to a natural resource stock when a capital structure restructuring (outside of bankruptcy) is officially put on the table. Iron ore producer London Mining’s stock is down as much as 75% since Monday. Despite coal stocks being down tremendously from 2011, $2 stocks (Walter, Alpha and Arch are all trading with a $2 handle) can still become $1 stocks, and $1 stocks could still lose up to 100% of their value.
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