Wednesday, April 11, 2007

Cost/Ton is the Appropriate Measure to Value Coal Companies

A previous post in this blog asked the question: can an investor value coal companies based on gross value of reserves? The answer give there was "maybe." A clearer answer to value a coal company is: a much more appropriate valuation is cost/ton compared to the price/ton of coal.

Cost/ton is defined as the lifting costs per ton of coal -- an investor would compare this cost with the selling price of coal (both current and future). The difference would be the margin -- a large gross margin, of course, indicative of good profitability.

Rev/Ton - Cost/Ton Dependent on Geographic Region:

Certain producing geographic areas for coal have stronger margins than others. In Central Appalachia, International Coal Group (ticker: ICO) is producing coal at a cost/ton of $42 with an additional $4 in start up costs, while Central Appalachian coal prices are at estimated $45 to $48 until 2009 (coal contracts are of 1 to 3 years in duration). This does not leave a high margin. -- However note that ICO has operations in Illinois which are at higher gross margin, leading the overall company in profitability, but the company's main area of operations is Appalachia.

Note that both the Western US and Australia are approximately twice as profitable as the Eastern US on a margin per ton basis for Peabody Energy -- the United States #1 coal producer. Peabody Energy -- with its operations in the western and eastern US, and Australia, reports the following costs per ton in its geographic areas.

2006
Operations Rev/Ton Costs/Ton Margin %Margin
Eastern U.S. $37.96 32.24 5.72 15.1%
Western U.S. 10.66 7.47 3.19 29.9%
Australia 64.31 43.82 20.49 31.9%

In the US, it appears that those companies without exposure to the Eastern US and Appalachia have a stronger rev/ton - cost/ton margin:

Reserves (mm tons); Res Life (years); % Owned (vs leased); Reserve Value; EV/Reserve Value; Cost/Ton (total company); Rev/Coal (average co); Margin %

Peabody 9,479; 46; 42%; 214,946; 5.9%; 13.42; 22.68; 40.8%
Consol 4,546; 65; 56%; 170,721; 3.9%; 23.80; 37.55; 36.6%
Arch 3,076; 29; 13%; 52,525; 11.3%; 13.08; 17.08; 23.4%
Massey 2,260; 52; 16%; 106,501; 2.7%; 42.33; 47.12; 10.2%
Foundation 1,708; 26; 45%; 30,744; 6.9%; 14.30; 18.88; 24.3%
ICO 1,060; 72; 72%; 42,158; 2.1%; 38.00; 39.00; 2.5%
Alliance 549; 26; 5%; 20,749; 6.6%; n/a; 37.79; n/a
Alpha* 490; 19; 3%; 26,460; 6.1%; 45.96; 54.00; 14.9%
James River 225; 24; 7%; 10,393; 3.1%; $42; 46.19; 9.1%

Information on costs/ton from the respective company 2006 year end financial statements.

*Alpha Natural Resources holds approximately 35% of its resources as Metallurgical coal which is priced at $75/ton.

Potential Improvement in Rev/Ton - Cost/Ton:

The way to improve margin for a coal company is to 1) decrease operating costs, 2) open and/or find improved geological mines and/or 3) realize a higher price for coal (the price of coal is set in contracts and in the spot market).

On decreasing operating costs, (1 above) a reasonable assumption is that coal company costs will, all other things equal -- ie no drastic cost reduction programs announced -- increase in the future, due to general construction and worker price inflation as well as more and more difficult geology (in Appalachia, several sources have stated that the easy-to-mine coal has already been mined, making geological improvements in coal recovery less likely -- although note that several sources state that in Illinois and the West the easy to mine coal is still abundant).

An example of increasing cash costs per ton is Massey Energy -- which operating in the East and Midwestern US -- reported the following costs/ton for the past 3 years as of 2006:

2006 2005 2004
Produced tons sold (millions) 39.1 42.3 40.4
Produced coal revenue ($ millions) $1,902.3 $1,777.7 $1,456.7
Produced coal revenue per ton $48.71 $42.02 $36.02
Average operating cash cost per ton $42.33 $35.62 $30.50

Future Coal Prices
The question on 3) above to improve margin is: what is the future direction of coal prices? Coal appears to be on a slight uptrend, favored by continuing demand, more difficult to produce reserves on the east coast, but under pressure currently from environmental concerns. Note that the utility TXU announced that they are dropping their permit requests for 8 coal-fired electricity plants, -- moving to nuclear powered plants -- reducing the number of planned coal power plants from 11 to 3. This could potentially signal a move from other utilities away from less-clean coal.

Conclusion

Caution should be applied for the investor currently in Appalachian heavy coal companies. Overall, the steep upward price appreciation in the US appears to be mitigated, so dramatic improvements in profitability -- based on higher future coal prices -- does not appear to be realistic -- although this does not include other geographic regions such as Australia, China and Russia, which have their own unique pricing and operating dynamics.

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