Contrarian Profits in Coal MLPs

Submitted by Investing Daily as part of our contributors program.

US coal producers, including many royalty-focused partnerships, took a beating Wednesday, Nov. 7, 2012, in the aftermath of President Barak Obama’s reelection, as investors threw a speculative hissy fit over regulations-to-be from the re-minted administration.

Rationality left the building, as the largest coal stocks, including Peabody Energy Corp (NYSE: BTU), Alpha Natural Resources Inc (NYSE: ANR), Arch Coal Inc (NYSE: ACI),Consol Energy Inc (NYSE: CNX), James River Coal Co (NSDQ: JRCC) and Walter Energy Inc (NYSE: WLT) posted an average decline of 13.1 percent for the day.

James River was down 30 percent, while Consol held up best among the largest coal-focused traditional equities with a 6.1 percent slide.

The performance of coal-related master limited partnerships was relatively glowing, with an average decline of 5.3 percent.

Alliance Resource Partners LP (NSDQ: ARLP) shed 6.4 percent, Natural Resource Partners LP (NYSE: NRP) 6.1 percent, Rino Resource Partners LP (NYSE: RNO) 7.9 percent. PVR Partners LP (NYSE: PVR) was the valedictorian of this class, off just 0.7 percent, likely due to its more diversified revenue streams.

Coal has been under the Environmental Protection Agency microscope during the first Obama administration. Operators have been subjected to stricter permitting requirements in Appalachia, and the agency has promulgated new regulations for emission reductions at utilities.

The perception is that another Obama term will bring more and even stiffer attempts to regulate the mineral. It’s important to note, however, that on Aug. 21, 2012, the US Court of Appeals for the District of Columbia struck down new EPA rules on cross-state air pollution.

This decision reinstated Bush administration rules allowing considerably more time for power producers to reduce emissions of sulfur dioxide and nitrogen oxide gases that cause acid rain.

It was a major victory for electric utilities that have historically been heavily reliant on coal. The added time and flexibility for compliance potentially means billions of dollars in savings.

The victory in the DC Court of Appeals is unlikely to affect the long-term shift to natural gas by electricity producers. Gas will generate 23 percent more electricity in the US this year, while coal’s share will fall by 12 percent.

Here’s the thing: Rising natural gas prices–not Obama administration regulation–will be the most important driver for coal demand. US coal producers shut mines and fired thousands of workers this year after cutting tens of millions of tons of output in the face of weaker demand and prices. Coal has suffered as power stations switched to gas, which had been cheaper than coal in the aftermath of the US shale revolution.

But the economics of coal as feedstock for power generation are once again improving as natural gas prices recover from a long depression. And coal is still the dominant fuel when it comes to US power generation. It remains abundant and cheap. Americans still use about 20 pounds of coal every day in the form of electricity, and producing electricity from coal costs about half that of using other fuels.

The kingdom is certainly under assault. But according to the Energy Information Administration (EIA) coal will be the major source of electricity generation in the US until 2035. Even under worst-case assumptions it will account for 36 percent of the US electricity generation from 2010 to 2035, a higher share than any other fuel used to generate power.

Electricity generation, however, is just one use of coal in the US. Coal is used to make chemicals, cement, paper, ceramics and metal products. And due to its heat-producing feature, metallurgical/coking coal is a key ingredient in the production of steel; nearly 70 percent of global steel production depends on coal.

There is trouble in coal country. Natural gas is replacing coal in power generation and will continue to long as prices stay this low, which will be until we see some meaningful export capacity. Environmental regulations are going to tighten going forward and will further discourage coal use.

But utilities are still going to use coal to generate electricity for a long time to come, and the mineral will continue to be put to other uses as well.

At these levels, the troubles have been well priced into coal-focused MLPs.

One high-yield name aggressive contrarian investors should look at is Natural Resource Partners (NYSE: NRP), which has metallurgical coal and other mineral assets besides the thermal coal used in power production.
Natural Resource Partners doesn’t actively mine any of its reserves. It leases its properties to various operators in exchange for royalty payments. Production from mines it owns accounts for about 25 percent of all the metallurgical coal produced in the US on an annual basis. And about 5 percent of all US coal (metallurgical and thermal) is produced from its properties.

In August 2012, the company completed the acquisition of the Deer Run mine near Hillsboro, Illinois, from Colt LLC, an affiliate of the Cline Group. The acquisition was funded through the partnership’s credit facility.

Deer Run is capable of producing approximately 7 million to 9 million tons annually and this deal, coupled with others made recently, adds 200 million tons of reserves at a cost of $255 million. Its addition is a clear sign that Natural Resource Partners is not only bullish on its future but that it has the financial power to follow through on its ambitions. And it’s buying these assets at a time when rivals are distressed, so it’s getting them cheaply.

I’m a big fan of distribution growth. A dividend boost is the best possible sign that a dividend is safe and that the underlying company is growing. Being able to complete a major acquisition in a troubled industry while rivals are floundering is a similar vote of confidence.

Companies are still going to use coal to generate electricity for a long time to come. And this MLP has metallurgical coal and other mineral assets besides the thermal coal used in power production. It’s also one of the most conservatively run companies you’ll find, demonstrated by the fact that it covered distributions handily even in the most recent quarter.

Distributable cash covered distributions by 1.1 times in the third quarter, a payout ratio of 89.6 percent. Now yielding 11.1 percent, Natural Resources is an aggressive play on coal’s long-term place in the domestic and global economies. For another high-yield coal MLP pick, see this free report.