Declining Trend In International Met Coal Prices Poses Threat To Alpha Natural Resources’ Margins

One of the leading U.S. coal companies Alpha Natural Resources ‘(NYSE:ANR) metallurgical coal business continued to struggle as a result of seabourne glut in the first quarter of fiscal 2014. The met coal business remained lackluster, with volumes falling by around 13% year-over-year to about 7.58 million tons, while price realizations dropped 13% to around $90 per ton. The global seaborne met coal markets continue to see oversupply due to a seasonal slowdown in Chinese iron production, higher coking coal production in Australia as well as weaker exchange rates in many producing countries, which have helped miners lower their dollar costs of sales. ^[1]

Alpha expects the met coal markets to remain oversupplied through 2014, but expects to see better supply-demand balance in 2015, as many of the suppliers in the seaborne coal market are believed to be operating with negative cash flows, which would be unsustainable. The company indicated that large miners in markets such as Australia, Canada and the U.S. have been scaling back on supplies. The company has cut its guidance for met coal volumes for 2014 to 15 to 18 million tons, down from its previous guidance of around 16 to 20 million tons. ^[2]

Despite the troubles of the global steel industry, the outlook for the metallurgical coal remains steady, according to a report by Mike Elliott, of Ernst & Young Mining and Metals. As the price realization of metallurgical coal is strongly tied to the global demand for steel, any indications of an increase in the latter imply an increase for the former. The report points out that the current oversupply in the met coal market should be corrected in the near term, as global steel demand increases. Below we summarize the results of the report and consider its implications for the valuation of Alpha Natural Resources. ^[3]

Our current price estimate for ANR is around $5, which represents an 8% premium over the current market price.

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Steady Outlook For Met Coal

Oversupply from markets such as Australia and Indonesia has led to a reduction in the price of metallurgical coal. The reduction in the price of met coal has meant that high-cost producers have scaled back production in order to preserve their margins. The market, however, should correct itself over the next seven years, owing to an anticipated increase in demand for import of metallurgical coal from India and China. The report forecasts Chinese metallurgical coal imports to increase to reach 80 million tonnes by 2018, implying a CAGR of 12%. Chinese metallurgical coal imports are expected to grow not only due to an increase in steel production and demand, but also because of current lower metallurgical coal prices. The consumption of metallurgical coal in India is projected to increase by 30% to 59 million tonnes between 2013 and 2017, with almost 70% comprised of imports. Additionally, the possibility of a brighter global economic outlook can further boost the demand for metallurgical coal. Despite the growing demand for metallurgical coal, supply constraints due to project delays and the high costs associated with bringing steel projects online are likely to keep the price from reaching its equilibrium value. ^[3]

Impact on ANR’s Valuation

U.S. coal manufacturers like Alpha Natural Resources(ANR) have seen their profits decline due to weak domestic demand. As a result, the percentage share of total coal sales volume exported has increased from 15% to 22% between 2011 and 2013. But a declining trend in the price of met coal on the international market has meant that the revenues realized from these sales have also been impacted. Moreover, in the international market, ANR has been losing competitiveness due to the lower price of coal from Australia and Indonesia. This has meant that despite a 7% increase in the share of coal volumes exported, the revenue share from exports has declined by 1% to 43% in the same period. ^[4]

In the future, the likely appreciation of the US dollar due to the tapering of quantitative easing is likely to hamper its cost competitiveness. Moreover, as the report points out, an increasing trend towards the adoption of innovative methods of steel production, such as the use of newer, cleaner technologies, can also have an impact on the units of met coal shipped by ANR in the medium-long term. Another worrying sign for ANR is the declining trend in the contribution of coal sales volume to long-term clients. In 2011, 81% of metallurgical coal sales volume was delivered pursuant to long-term contracts, but by 2013, the figure has declined to 69%. ^[4] Even though long-term agreements come with provisions of the re-negotiation of sales prices, they keep the volumes of shipments fixed. A decline in the share of sales volumes to long-term clients, will mean that an unwillingness to supply coal at competitive prices can lead to a decline in the volumes of coal shipments as well. In either scenario, ANR’s EBITDA margin realized from the metallurgical coal business is likely to be impacted.

Our forecast for the EBITDA margin of metallurgical coal is expected to grow from 3.97% in 2013 to 19% by the end of our forecast period. Instead, an increase in the margin to 13% will represent a downside of nearly 50%. Less aggressively, if the margin increases to 16%, there will be a 30% downside on our current valuation.

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1. Alpha Natural Resources 10-Q [↩]
2. Alpha Natural Resources’ CEO Discuess Q1 2014, Seeking Alpha, May 2014 [↩]
3. Outlook For Metallurgical Coal Is Steady, World Coal, January 2014 [↩] [↩]
4. Alpha Natural Resources 10-K [↩] [↩]