Coal: Strike While It's Hot

This week we visit a topic that has been persistent in recent headlines: coal. In doing this we will look at two large-caps that have delivered a seemingly extraordinary return in this bear market.

​As always we begin with context. 

Context

The story of coal is, as with all things this year, one of supply. The Russia-Ukraine war stands front and centre of recent price action, Newcastle coal futures climbing from circa. 151 USD/T to  385 USD/T now. So, what gives?

There are a litany of factors currently affecting the spot price of coal. As Russia is one of the world’s leading coal producers, the sanctions stemming from their invasion of Ukraine are definitely making their mark. But many may be unaware of the fact that, since the beginning of the crisis, Russian oil and coal revenues have both actually increased this year. Big net buyers, including India and China, have left no stone unturned in trying to obtain discounted crude and coal direct from the source (this discount still being a premia to the price at the beginning of the year). Given the assumption that Russian coal remains online, can we then conclude that the price action is overdone? 

This is a little more complex. As usual, future expectations are also priced in. Longer-term, the global market is dealing with both the disentanglement of supply (i.e. as Germany is doing to avoid reliance on unstable players like Russia) and a broader shift in the energy mix resulting from the ongoing Green transition. In the medium term, price action may also be exacerbated as China comes out of lockdown, creating buying pressure. Short term, Europe is simply going into winter. These are just a few examples of the types of expectations affecting prices right now.

While the price action may very well be overdone right now there is every reason to believe that, after years of underinvestment and rising energy demand, we could have higher spot prices for longer. Where does that leave pricing? Our call is an average of 280-320 USD/T over the next two to three years before gradual declines over the following three. In doing so we make the following assumptions however:
​

1. Indonesian and Columbian production takes over the slack in Russian production. This could make up for around 70% of the Russian losses (i.e. substantially lower grade and energy content in both of these jurisdictions to recoup loss in absolute terms).
2. Russian losses are somewhat minimised as sanctions mature.
3. There is a ramp up of domestic Chinese production.

Take away any of these assumptions and the situation changes though. So, now that we’ve made a call on the spot price, let’s look to two securities that could be significant beneficiaries.
​

Whitehaven Coal (WHC.ASX)

​This year, Whitehaven has actually been a pleasant investment for its long-suffering shareholders. The business has bought back around $70m of stock and paid out a further $80m in dividends. Even after this the business still sits on close to $161m in net cash. If those numbers aren’t enough, this implies $2.4bn in FCF for the year. What’s interesting about the latest set of results is that the realised price for the June Quarter was 229 USD/T, a substantial 18% discount to the average spot price over the same period. With FY22 guidance around production largely unchanged at 19-20.5 Mt (having now increased by 60%) on a ROM (Run-of-Mine) basis, we continue to see this business as substantially undervalued. This is even assuming shorter term gyrations in the spot price (though the price of the security may continue to closely track it in the short run). 

On the flipside, costs driven by labour shortages and rising diesel costs continue to pose a threat. Current unit guidance ranges from $79-84 AUD/T. However, using our average price target for thermal over the medium term, we feel that FCF should more than offset any rises. At the current price of $4.91, this implies that the business trades at approximately a 40% FCF yield while the dividend yield of around 12% p.a. (again, assuming our base case for spot prices). Going to the actual valuation, it stands at an attractive 11% discount to NAV (which we estimate to be around $5.50 AUD). 

To sum up, this is a capital return story and we expect a continuation of the strong share buyback and dividend program. 

Note on the Queensland royalties: Many maybe aware of the new slate of royalties levied by the Queensland Government on coal. These were previously frozen for ten years. The new tiers (effective from 1 July) include an incremental rate of 20% for the value realized above A$175/t, 30% above A$225/t and 40% above A$300/t. This was previously capped out at 15% of realised value above A$150/t. Whitehaven’s primary exposure comes via the slated Winchester South Development which will not be online till 2026. While this does pose a potential longer term risk in terms of the actual profitability of the project, it is something to be monitored but a lot can change in four years. 

Opinion on the Queensland royalties? Smart to take advantage of elevated prices but significantly hampers the overall sector in preference for less costly jurisdictions unless other states follow suit (mainly referring to NSW here).

New Hope Corporation (NHC.ASX)

​New Hope is another security that has seemingly benefitted from the rise in spot prices. With production continuing to ramp up, especially with New Acland Mine (QLD) beating even the most optimistic estimates while NHC’s Bengalla (NSW) interest remained in line with expectations despite suffering substantially from wet weather. 

Nevertheless, we feel that the business has continued to face significant headwinds from the external policy environment though the New Acland Stage 3 win at the Land Court offered some reprieve. Looking to the numbers, underlying EBITDA came in A$553m for 1H. Contract lags with South Korea, Taiwan and lower priced domestic contracts (which account for 3-5% of Bengalla sales) have proven to be hurdles. Add to this the royalty hikes, which put the company in the line of fire, and it appears to be less attractive than Whitehaven. Not to mention, from a valuation perspective, it trades at 1.1x NAV (i.e. compared to WHC trading at a discount).

Using our base case for spot prices and even accounting for the increase in royalty, we can still assume a forward dividend yield of approximately 10%. Thus, the company remains a reasonably attractive proposition. That said, this may be significantly dented by management's stated M&A driven outlook. This is not perhaps as great a capital return story for the yield hungry investor.

---

Disclaimer: Both Whitehaven (WHC.ASX) and New Hope (NHC.ASX) are currently owned in TAMIM portfolios.