Tuesday, March 12, 2013

Alliance Resources: astoundingly good - but why?

Alliance Resources (ARLP:NASDAQ) is a listed master limited partnership (MLP) in the coal mining space. The General Partner (AHGP) is also listed. The GP is also structured as an MLP.

Alliance mines roughly 35 million tonnes of coal annually which makes it a big mining operation but only about a seventh of the size of the American giants (Peabody, Arch Coal) and those are small compared to BHP which has over 13 billion dollars in coal revenue.

Alliance is unique among large coal companies in that the stock price and profitability is at an all time high.

Everyone else is suffering - or at least guiding to some sufferance.

This is the first of a series of notes to try and work out why. You can color me skeptical up front. The performance of Alliance is - relative to the competition - flat-out extraordinary. And that gets my spidey-sense on full alert.

Background to Alliance's operations and the current state of the coal industry

Alliance mines are mostly high sulfur and underground - some in the (very) high cost Appalachia but most in the lower cost Illinois Basin.

It is also no secret that the coal mining industry in America is stretched. Very stretched. There are a bunch of reasons - but for thermal coal the main one is that coal fired power stations are closing - driven by two main factors:
  • 1. Very low natural gas prices are making gas-generated electricity very cheap - cheaper than coal generated electricity in many cases and
  • 2. High environmental costs (especially mercury amelioration) causing plants to close.
These are related problems. It might be worth retrofitting old boilers with scrubbers for mercury if the electricity price were high. But because of cheap gas there is no prospect of that.

And there are plenty of signs of the stress. I am going to quote the last conference call of CSX - the railway company that hauls lots of coal - because it is Alliance's main carrier:

Finally domestic coal declined 21% although the rate of decline moderated somewhat from what we saw earlier in the year. Now let’s take a closer look at some of the individual markets in more detail and let’s start with coal. Coal revenue declined 18% to $747 million. Domestic volume declined 21% as natural gas prices remain low leading to the continued displacement of coal and high stockpiles at many utilities. In addition, electrical generation declined in the Eastern United States. Export coal volume declined 10% as demand for metallurgical coal softened particularly in the Asian markets. Total revenue per unit was flat as core pricing gains in domestic markets offset lower export rates. Looking ahead at this point export coal volume is expected to decline in the first quarter and our best estimate of full year volume is about 40 million tons. 
Furthermore we anticipate our rates to be pressured as we work with producers to keep U.S. coal competitive globally in an environment where underlying commodity process for thermal and metallurgical coal are low. At the same time domestic coal headwinds will persist but we expect them to continue to moderate throughout 2013. As a result we anticipate domestic volume will decline in the 5% to 10% range for the full year.

It is however fair that in this misery Illinois Basin coal has done relatively well. Whilst Powder River Basin (PRB) coal is still cheaper Central Appalachian Coal is flatly noncompetitive. Quoting from the question and answer session in the same conference call:
David Vernon - Sanford Bernstein 
Okay. And just as a quick follow-up with the length of haul increase on the domestic, is that a change in type of coal is it the Illinois Basin coming in perhaps going into a plant that used to be taking PRB or is it just the ebbs and flows across the network? 
Michael Ward - Chairman, President and Chief Executive Officer of CSX 
Some of it is Illinois Basin coal, but it’s not going into plants that took PRB, it was going into plants that took Central App. And the rest of it has just been the ordering patterns of the utilities fulfilling their coal contracts.
This appraisal of Illinois Basin coal displacing Appalachia coal is widely reported. The Energy Information Administration has reported the same thing - with rising volumes for Illinois basin coal but falling prices. They have reported falling prices and volumes for Appalachian coal.

Alliance has bucked these trends. It has produced rising volumes in both the Illinois Basin and the Northern Appalachia (with falling volumes in the Central Appalachia due to regulatory issues). And - contrary to all industry trends - they are reporting rising prices in the Illinois Basin. Specifically in the recently filed 10-K the price achieved in the Illinois Basin rose from $50.45 per ton in 2011 to $52.51 per ton in 2012. Not only are these prices not following industry trends but they are several dollars per ton higher than prices reported on Bloomberg for Illinois Basin coal of similar grades.

Coal mining is not a complicated business - and unless you have a substantially better resource than anyone else it is difficult to make these sort of numbers. Moreover whist one mine may be extraordinary  Alliance operates eleven mines. It is unlikely they are all extraordinary.

So it must be something done by the management. Something truly extraordinary done by the management. The main point of this series of blog posts is to work out precisely what.


PS. As readers know I am a short seller. Whenever I see something like this I am skeptical. In this case you can assume I am short.


Anonymous said...

Easy answers to your questions. (1) unlike most other coal companies, ARLP has been super conservative on contracting up volumes several years in advance. So the realized pricing you're seeing may not be market because they agreed to it in previous years. This strategy will see them lag any huge recovery in coal prices, but has made them by far the best performer in a declining market. Volume growth is coming from long-lead time mine projects where coal commitments have been locked up well in advance. ARLP has the best management team in the coal space (ask around) and is a preferred supplier to utilities, which also helps with contract pricing. So your "spidey sense" may be a little off here.

GW Peterson said...

In the past years, most of the utilities in the Central U.S. have retrofitted much of their existing base load generation to handle high sulphur coal related to new Clean Air regs and mercury. Ergo, the costs of underground mined Central App coal, even with higher BTU generation rate, is just not competitive with I-basin at many of these plants....I note that I-basin production is up at other companies too (RNO comes to mind) and also, ARLP has some of the most efficient mining ops in the biz and always has. Also, it's app coal is cross-over met.

Below, I've listed a comment out of the Feb Citi ARLP report...

ARLP Takes DD&A Hit but EBITDA Outlook Improves – We are lowering our 2013 EPU estimate to $5.30 from $6.75 due to higher depreciation but our EBITDA
forecast improves to $643 mln from $623. The company anticipated coal sales of 38.5 mln tons reflects a 9.4% YoY improvement and is fully committed and priced as they take market share.

Remember that these guys book in thirds (1/3 current year, 1/3 2 years and 1/3 three years out) like all big coal guys. Also, they are an MLP and pay huge, tax advantaged divy's on a quarterly basis. Good luck shorting that.

Think you are barking up wrong tree. ARLP best of breed in MLP coal land. Have no current position. JMHO


GW Peterson said...

Also, even though production declines, if demand goes up (and it looks like it will go up a bit in 2013 by about 20 million tons according to the feb. Citi report. Then even though production backs off, earnings can move higher, on margins and inventory reduction.

Again, don't think it's a great short....think others are better....western coal especially....

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. You should assume Mr. Hempton and his affiliates have positions in the securities discussed in this blog, and such beneficial ownership can create a conflict of interest regarding the objectivity of this blog. Statements in the blog are not guarantees of future performance and are subject to certain risks, uncertainties and other factors. Certain information in this blog concerning economic trends and performance is based on or derived from information provided by third-party sources. Mr. Hempton does not guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. Such information may change after it is posted and Mr. Hempton is not obligated to, and may not, update it. The commentary in this blog in no way constitutes a solicitation of business, an offer of a security or a solicitation to purchase a security, or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.