The Dutch Explorer

Original sin, the phoenix, and black gold

Curtis van Son

Original sin, the phoenix, and black gold

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The idea of reincarnation presents itself in nearly every culture around the world. It underlies the basis of many religious stories as well: From Greek, and Hindu, to Egyptian and Christian.  So it should be a surprise that a similar story also exists in financial markets, but it’s called something different: mean reversion. Just like the Phoenix rises from the ashes so too can an organization, commodity, currency, or credit.  In many cases these mean reverting features are a forgone conclusion as they are based on human behavior, the more free the society the more likely they are to be reborn.

I find mean revision in commodities to be of particular interest and currently ripe with opportunity. This is due to phenomenon known as price elasticity. Specifically, the fewer the alternatives to a particular use of a commodity, the lower the elasticity of the demand curve is to prices. In other words, you are not going to walk the 5 miles to work each day just because oil prices have risen 10%. The alternative (time) is simply too expensive relative to the additional fuel charge. It’s no surprise that the R-square of GDP per MJ of fossil fuel consumed was greater than 0.9 between 1950 – 2013.

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But this is not an article about oil. It’s about a different, more pernicious black gold. One that goes back to the very beginning of the industrial revolution.

Let’s talk coal.

If you haven’t noticed, coal is likely the most hated investment in financial markets today. So much so that I’m surprised there still exists publicly listed companies to be traded.  Demonized not just by those that see what they produce as an existential threat to the survival of the world as we know it, it’s also been avoided by investors who have watched these companies get crushed as coal prices have stagnated for more than a decade.

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This brings us to the, why?  Why have coal prices declined so precipitously this past decade?  If I had to simplify it down to just two reasons it would be (1) competition from cheap, abundant associated gas produced from Shale oil wells, and (2) Gas specific drilling in previously untapped shale Appalachia and Pennsylvania.  These two sources of natural gas have provided stiff competition for coal fired power plants around the world, even resulting in an liquified natural gas export boom where historically LNG had been imported into the United States.

Surmised a different way, a combination of low interest rates, new drilling processes/techniques, and antiquated management incentives caused a title wave of low-cost natural-gas.  Let’s just say that for thermo-coal producers, the neo-puritans have not been their sole concern these long years.

Henry Hub natural gas prices

Henry Hub natural gas prices

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For the most part, the majority if not all westerners have been okay with this shift from coal to natural gas, as many of those coal mining jobs lost have been subsequently offset in gas. If it wasn’t for Trumps coal proclamation in 2016 most people would have just assumed that the US coal industry might have well just vanished like a fart in the wind.  

The shift was further placated by natural gas having a lower carbon component (at combustion) than coal, resulting in a larger perceived environmental benefit.  Although that narrative is being challenged by those who include the emissions of methane leakage throughout the natural gas production and transportation process which may offset this benefit.  Let’s just say, it’s a little complicated and not just in regard to emissions. But it also strikes at the very core of American religious fervor.

In case you missed it, the narrative surrounding coal isn’t so good. In fact, in the wrong crowd burning coal has become an unimaginable, inhuman cost to spaceship mother. With externalities that fully personify the parasites to which some environmentalists view us humans.   It’s a narrative that sadly many Westerners crave, as it provides a religious dogma in an otherwise secular world. The devil himself is less easy target.

““Let those who are without Carbon Sin cast the first Coal.”
- Terrence H. King”

Regardless, this sentiment has had just as much of an impact (if not more) on the share prices of coal miners as their declining EBITDA.  It’s been a decade long double whammy that has scared away all but the most skeptical of deep value investors.

Which brings us to today; where COVID-19 has accelerated many pre-existing trends to their point of breaking. Those coal producers that have survived this economic winter have been tested to their limit. If they’ve survived this, they are likely to see another commodity super-cycle.  Even if you are skeptical that we are in fact at the beginning of a new commodity super-cycle (which I still am), you must at least agree that a reflation trade exists so far to fill the massive economic gap left by COVID and will be with us for at least the next year or so.   

Well, my friends, if you happened to have overindulged in your Christmas eggnog you may have missed it: but like the phoenix rises from the ashes so to does thermo-coal prices!

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Enter CONSOL Energy Inc.

Operating is western Pennsylvania; CONSOL Energy is a coal producer and exporter. The company is a combination of its western Pennsylvania thermo coal operations called the Pennsylvania mining complex (PAMC) and a Marine coal export terminal (CMT) located in Baltimore, Maryland.

Another interesting fact is that hedge fund manager David Einhorn currently owns 29% of the company either personally, or through the Green Brick Partners entities that he controls.  David is a value investor who has had a long and storied career and his presence should not be taken lightly.

The assets:

The 25 million tons of thermo coal that PMAC produces each year is in the 1st quartile of the production cost curve, at a cash cost of under $30/tonne.  Not bad considering current pricing.  The PAMC complex is a unique North American asset, as the company has invested over $2.1Billion in its development since 2009.

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Furthermore, the company has rail access to its wholly owned facility (CONSOL Marine Terminal) giving it access to world markets. The terminal also accepts tonnage from third parties who pay on a contracted take or pay basis. This outlet is vital to diversifying its market abroad where consumption is still growing. 

Finally, the company has a metallurgical coal project called Itmann which is expected to reach full production in 2022, at an investment cost of $80million.  Even if operating costs are conservatively estimated at $75/tonne, there is still adequate margin to be had.

My Bull economic thesis is rather simple

1)     Economic recovery

Both thermo and met coal prices have seen dramatic improvement in recent months.  As the world continues to get back on its post-Covid track, I expect both thermo and met coal prices to steadily rise.

2)     Commodity super cycle

The last 10 years have been seriously difficult for commodity producers, as over production of commodities to bring China into the world economic mix caused serious excess capacity. That excess capacity has finally been absorbed and any growth will require higher prices.

3)     Shale oil production

As shale oil production in the united states flatlines, so does natural gas (a by-product of shale wells).  The greatest cause of decline in coal prices can be attributed to its number one alternative – Natural Gas.  I expect natural gas prices to stay strong in 2021, as exports will remain robust and associated gas production continues to lag.

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Bear risks to my thesis:

1)     Debt, debt, debt

Coal producers are perpetual bankruptcy filers and while CONSOL has fantastic assets it also has significant debt. Though the company has no maturities until 2024, they do need to use future cash flow to deleverage. If the economic recovery stalls, it could become a problem when trying to roll the debt.

2)     Oil Price recovery

Oddly enough, a dramatic rise in oil prices could cause significant downward pressure on both natural-gas and coal as associated gas from shale oil wells would add additional gas supply to the market.

3)     Green new deal

I generally see the new Biden administration as a positive for the reflation trade. However, there is a risk that Biden introduces draconian measures on domestic thermo coal consumption that would put it at a disadvantage to natural gas.  I’m not worried about Nuclear, as that transition is likely at least a decade away.  Well beyond my investment horizon.

Valuation:

Based on a 10-year DCF model assuming current conditions I get to an implied fair value of $32.86/share. This of course is a very conservative estimate given that conditions are likely to improve dramatically over the next few years.

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Finally, In my opinion, the company has a strategic advantage over its competitors based on its 100% ownership of the CMT Terminal and its super-low cost, low-sulfur tonnage assets.  Moreover, the anticipated 2022 startup of Itman met-coal project in West Virginia adds further upside value not included in the above DCF.  

Conclusion: 

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I’m long CEIX for a reflation trade.  The share price has been rising fast but in my opinion there is still significant upside in the name. There is upside resistance at the June high of $13.35 and then again, the again the December 2019 high of $19.80.  This is not financial advice and please due your own due diligence.

Until later, the Dutch Explorer