ARCH - Arch Resources: Metallurgical Coal Glut May Hamper Profits By 2024

2023-04-20 17:24:18 ET

Summary

• Thermal coal demand is crashing again after the 2020-2022 spike as natural gas prices crash abnormally low.
• Arch Resources is transitioning away from thermal coal but may face some exit difficulties considering the crash in thermal coal prices.
• The outlook for metallurgical coal (Arch's primary product) improved on the "China reopening" catalyst earlier this year; however, the country's construction issues could upend demand later this year.
• At current commodity prices, I believe Arch Resource's forward EPS is likely closer to $26, giving it a forward P/E of ~5X.
• If steel crashes lower, as I suspect, a metallurgical coal glut could push Arch's EPS much lower, potentially closer to $12 - closer to <2020 levels.

The energy sector has experienced tremendous volatility over recent years. Significant production cuts in 2020, followed by larger regional supply-chain issues, have caused considerable fossil fuel commodity prices to destabilize. The coal industry has faced the most significant cycle as it fell into a large shortage in 2020-2022 as natural gas availability declined. From 2020 to the 2022 peak, Newcastle coal futures rose by 10X in value due not only to the natural gas shortages (from 2020 output cuts, Russia-Ukraine, etc.) but also energy issues in China (that boosted coal demand and harmed supply from Mongolia).

Thermal coal-producing companies rose dramatically from 2020 to the 2022 peak. Arch Resources ( ARCH ) rose by around 600% over the same period, but has faced stagnation and moderate losses over the past two months. Since the fall 2022 peak, Newcastle coal prices have crumbled by over 50% to below $200/T. Despite the losses, thermal coal prices remain well above the 2010's averages, meaning producers are still making much more substantial profits than before the bull market. US coal prices have experienced more volatility, with most domestic markets falling to the $70-$90/T range . On an MMBTU basis, most US coal is around $3-$4/MMBTU, making coal considerably more expensive than domestic natural gas (currently ~2.2/MMBTU).

Although I expect natural gas prices to normalize , coal rarely performs well when significantly more expensive than gas, as gas is preferable due to its supply-chain efficiency and regulatory preference (as a cleaner power source). Accordingly, Arch Resources and its peers may face a prolonged profit decline over the coming year. Of course, Arch Resources is also trading at an extremely low P/E of 2.1X TTM and 3.5X on a forward basis, offsetting its weakening outlook with a discounted valuation. However, the stock still faces higher short interest of 8.4%, indicating many speculate against the company. Although ARCH has been relatively quiet for the past year, this scenario appears likely to trigger a significant directional move in the stock (and peers) over the coming months.

Expect Lower Coal Prices As Natural Gas Cools

Over the past two decades, most US and European energy grids have transitioned from coal to natural gas. Usually, coal is a "cheaper" power source, but "dirtier" and continued long-term efforts are set to phase out its use over the coming decades. To avoid long-term obsolescence, many coal producers, including Arch, have tried to transition away from thermal coal toward metallurgical coal (steel or coking coal); however, much of the company's output is still derived from thermal coal. Arch's "slower" transition has benefited the firm as thermal coal experienced a tremendous renewal over the past two years.

As you can see below, ARCH has closely tracked both the coal miner PPI (a rough measure of coal prices) and natural gas futures:

The coal miner PPI is a heavily lagged indicator of coal prices. Realistically, most US coal prices are currently around 66% below their 2022 peak prices due to the crash over recent months. The crash in coal prices is primarily led by the combination of factors that ended the natural gas bull market. These factors include a dramatic increase in US natural gas production, warm US and European winter weather (reducing power demand and improving gas storage levels), and trade deals in Europe that largely offset lost Russian power sources (at much higher costs). Last year, Europe (and China) were racing to buy US coal to offset natural gas shortages, but increased gas output largely upends the need for coal.

Today, natural gas production remains well-above pre-COVID levels, while domestic demand is not necessarily higher (although export demand is). Natural gas is well-below the breakeven profit level for most producers, implying drilling levels should decline soon - as indicated by the plateauing rig count. See below:

Over time, I expect the natural gas rig count will decline, eventually leading to lower gas production and normalization of prices back toward the $3-$5/MMBTU range. That said, coal trades at a $1/MMBTU premium to natural gas today and will likely only remain in demand if it trades for a significant discount to gas as it had last year. As such, I expect US coal demand to decline even if we see a moderate rebound in natural gas prices. Unless a new energy crisis emerges (which is entirely possible), I do not believe thermal coal demand will rise anytime soon and will most likely decline a bit more due to the recent decline in natural gas.

Met Coal Hampered By Construction Slowdown

The outlook for metallurgical coal is also relatively weak. Most of Arch's tonnage output is thermal coal; however, its metallurgical coal prices are much higher, making it a mildly more important operating segment. Last year, metallurgical coal made up around three-quarters of its total adjusted EBITDA ( 10-K pg. 82 ). US Metallurgical coal rose to over $300/T the previous year but is now closer to $245/T . Arch's Met coal sale prices are likely around or below $200/T since most producers sell the bulk of their output at lower prices than the US export price index.

Steel prices fell by over 50% last year as the construction slowdown in China negatively impacted demand despite reduced global steel production. Steel rebounded early this year as China's economy reopened with renewed construction demand outlook, boosting the metallurgical coal demand outlook. Metallurgical coal prices have held up stronger than thermal in recent months due to this shift; however, as discussed regarding copper, I firmly believe the Chinese demand factor is overstated and that source of steel demand will likely decline by year-end. Combined with potential recessions in the US and Europe, I suspect steel and metallurgical coal prices will return to pre-COVID levels as demand falls back below supply. This would translate to an expected metallurgical coal selling price for Arch to fall below $150/T.

Arch Resources Profit Outlook

Last year, Arch sold ~7.8M tons of metallurgical coal at an average price of $233 compared to a cash cost per ton of $93. The company also sold 70.5M tons of thermal coal at an average price of $19.50 and a cash cost average of $14.60. This data can be found in 2022 10-K, pg. 82 . Note Arch Resources sells via the Powder River Basin coal market, the lower grade at just ~$14.85/T, or $0.85/MMBTU . Although its 2022 profits from thermal coal were significant, it is continuing to look to exit the market and expand its metallurgical coal production. While that seemed to be a poor business decision last year, it may prove wise as the company is likely starting to lose money per ton on its thermal segment as prices slide below its cash costs.

I anticipate Arch's metallurgical coal selling prices will eventually decline to around $150/T (with a considerable range) as steel demand declines later this year. My outlook is well below the consensus estimate, mainly due to my negative outlook on the Chinese construction market and economy (which is critical for global coking coal prices, even for companies that do not sell to China). Further, as virtually all US coal mining companies transition toward metallurgical coal operations, supply may grow too fast as demand stagnates (and more likely declines). Accordingly, I would not be surprised to see metallurgical coal prices fall closer to the $100 level; however, that may not occur for several years, depending on many factors.

At $150/T with a ~$95/T cash cost (from the 2022 average), I expect Arch will earn a cash margin per ton of metallurgical coal of around $55 over the next twelve months. At 7.8M tons of anticipated production, the company's expected segment EBITDA of about $430M, well below its ~$1B segment EBITDA level last year. At current Powder River Basin coal prices, Arch will likely earn a flat EBITDA on thermal. However, slight segment losses could occur if thermal demand falls as expected. Thus, I expect Arch's EBITDA to be around $400M-$450M over the coming twelve months.

Arch Resources has had annual depreciation and amortization of around $133M over recent years and $13M in net interest expense (or ~$280M in est. EBT). After 22% in estimated taxes, that figure translates to an expected income of $215M (~$12.3 per share). Potential P&L from its ongoing thermal coal exit could cause its realized profits to deviate from that figure. My projection largely depends on a more significant decline in metallurgical coal prices. At today's metallurgical coal price, the firm should sell closer to $190/T or ~$95/T margin, equating to around $740M in est. EBITDA or ~$460M in estimated forward earnings (~$26.3 per share).

At current prices, I believe ARCH's forward EPS is closer to $26, giving it a forward P/E of around 5X. That is a low valuation, although the current analyst EPS outlook is a bit higher than mine at $38 , which may not account for the recent declines in metallurgical coal prices. Further, based on my view that metallurgical coal will continue to slide, I believe ARCH's EPS in 2024 may be closer to $12.30, equating to a forward P/E of 10.5X. Although that is not necessarily a "high" valuation, it is above the typical range for coal companies with more significant risks, particularly in the current environment.

The Bottom Line

Overall, I believe Arch Resources is slightly overvalued today and is relatively likely to decline from its current levels. The company's thermal coal segment is most likely losing money, which could create exit issues and balance sheet issues. Further, falling metallurgical coal prices will cause its 2023 profits to be well below its 2022 level, possibly bringing its EPS back below $20. However, that outlook depends on negative changes to China's steel demand.

If we assume metallurgical coal prices will remain where they are, then Arch is not necessarily overvalued today, though it also does not appear to be undervalued at a 5X forward P/E. However, if metallurgical coal demand falls while supply grows over the next year, ARCH could decline back toward its pre-COVID levels as its EPS outlook falls below $20. At this point, I do not believe there is any short opportunity in Arch Resources. A decent short opportunity may form if steel prices crash again and ARCH remains near its current price. Until then, I have a slightly bearish outlook on the stock, but not enough to warrant a short position.

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