This Lump of Coal Is Great!

06/25/2013 7:00 am EST

Focus: STOCKS

Elliott Gue

Editor and Publisher, Energy and Income Advisor and Capitalist Times

The spike in natural gas prices has created an opportunity for this fossil fuel miner, says Elliott Gue of Energy & Income Advisor.

Shares of coal producers have languished this year, and remain out of favor with investors. But our favorite coal miner's stock trades at a deep discount and stands to benefit from several upside catalysts in the back half of 2013.

In the US, prices for thermal coal have benefited from the rising price of natural gas. The no-show winter of 2011-2012, coupled with robust production, sent natural gas prices spiraling to $2 per million British thermal units, prompting a wave of coal-to-gas switching among utilities.

On an energy-equivalent basis, thermal coal from all the major producing areas in the US is less expensive than natural gas.

Peabody Energy (BTU), which boasts core operations in both the Central Appalachia and Powder River Basins, will benefit from utilities switching back to coal from natural gas. Gregory Boyce, CEO of Peabody Energy, acknowledged as much during a conference call to discuss the company's first-quarter results:

"We've seen a dramatic improvement in coal fundamentals from this time last year. We now project 60 million to 80 million tons of increased coal demand in 2013, as the industry reclaims the majority of demand lost in 2012 to natural gas.

"Within the US markets, winter was 17% colder than last year. And natural gas prices have more than doubled from last April, driving a 15 million ton increase in the first-quarter coal burn at the same time that gas generation dropped 11%.

"Coal now accounts for approximately 40% of total generation, while gas has fallen to 24%. The supply side of the equation was also favorable in the first quarter, as US coal shipments fell 10%.

"The end result is that PRB and Illinois Basin stockpiles have improved 20% over the last year. And over the next five years, we expect the low-cost PRB and Illinois Basin demand to grow more than 125 million tons through greater capacity utilization and regional switching. And this is after taking into account an estimated 60 gigawatts of retirements during that time.

"You see, US generation only ran at 55% of full capacity in 2012. These plants can run much harder, and utilities have invested more than $30 billion in new equipment over recent years to allow them to do just that."

Peabody's exposure to pulverized coal injection (PCI) is another advantage. With steel producers looking to reduce costs, they've experimented with using more PCI and less metallurgical coal in their furnaces.

In 2012 the price of a metric ton of PCI averaged about 69% of the cost of a metric ton of hard coking coal. Today, this ratio has increased to 80%, thanks to robust demand for PCI.

Moreover, Peabody Energy's operational performance continues to improve. Management has delivered on its promise to reduce first-quarter Australian mining costs by 10% from year-ago levels. Peabody also lowered its full-year guidance for production costs Down Under to $80 per metric ton from the low $80s.

Peabody paid down $100 million of debt in 1Q 2013 and another $100 million at the end of May, closing in on its goal of repaying $600 million in debt this year. The stock has suffered in recent years because of concerns about the leverage taken on to finance its late 2011 MacArthur Coal acquisition.

With a dividend yield of 2% and a stock price roughly on par with book value, Peabody represents a deep-value play on an eventual recovery in coal markets. Although potential downside appears limited at these levels, investors should note that this trade entails higher risk and could take time to play out.

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