Why Coal? Why now?
We’re all fans of green energy and we’re big proponents for the industry. But coal is still the preeminent natural resource on the planet, which means investors cannot afford to ignore the sector. Coal remains the most affordable and reliable source of energy we have. It’s also the foundation of prosperity in the modern world. Thermal coal currently fuels about 37% of global electricity, and metallurgical coal contributes to 74% of worldwide steel production, amounting to 1.3 billion tons in 2017. Coal is also responsible for 85% of the fuel used to manufacture cement, resulting in 3.91 billion tons in 2016 and that’s just the tip of the iceberg. Coal is used in the production of dozens of other household products such as water and air filtration, paper manufacturing, carbon fiber, cell phones, and silicon metals.
Clean energy companies have become so popular on Wall Street, it seems as if investors have forgotten that the world economy is still wholly reliant on coal companies to produce coal. That’s why we’re always going to be interested in a fast-growing coal company because they’re hard to find.
But some unusual circumstances in the coal industry have left a void in the middle market.
Price volatility over the last several years has created a very fragmented marketplace, because bankruptcies have taken out many of the mid-market coal companies. Now, all that remains are a few large companies, and some very small companies. Additionally, the wave of bankruptcies has forced coal buyers to diversify their supplier base in order to reduce their risk profile. Consequently, buyers are looking for access to more stable, second generation coal producers.
American Resources Corp (AREC) (American) is a new-age middle market coal company that we believe is perfectly positioned to fill the industry’s void. American’s business model is extremely opportunistic. They acquire distressed or bankrupt operations or companies at bargain prices, then right-side the business by streamlining employee headcount, acquiring or shedding permits, and upgrading machinery. At the end of the process, the acquired company is producing coal more efficiently and contributing to the overall growth of the company.
Currently, global demand for coal remains very healthy. The domestic market has typically been the US producers’ “bread and butter”. However, the new reality is that the international markets pay a premium and seaborne demand has been very durable. The EIA has forecasted that US coal production will decline by about 1.1% this year, while US coal exports should increase by about 5.7% year-over-year. The coal industry is not seeing much, if any, supply growth and the market has become inelastic.
There’s an old finance axiom, “don’t fight the Fed”. Right now, the Fed is raising interest rates and that trend is likely going to continue going forward. In an environment where interest rates are rising, and inflation begins to take hold, commodities like coal usually go up in price. This bodes well for the coal industry as a whole, because increased coal prices tend to translate to higher margins over time.
Additionally, the current administration is very coal friendly and they support a cheap and reliable base-load of electricity. President Trump has unveiled the Affordable Clean Energy Rule (ACER), which is intended to replace the Obama-era Clean Power Plan. The ACER would give states broad authority to determine how to restrict greenhouse gas emissions, and simultaneously roll back regulations for coal producers.
This is a stark contrast to the policies set forth by the Obama Administration, which resulted in a 10% reduction in the number of coal-fired energy plants in the U.S. between 2015-2017. The rapid plant decline caused a decrease in demand for coal, to the point that current levels of inventory at coal-fired utilities are 20% below their historic levels. There are a number of reasons to believe this trend will likely reverse itself, if for no other reason than maintaining such a restricted level of reserves could jeopardize the stability of power grids and possibly even national security.
Overall, we believe the macroeconomic environment will create a significant tailwind for American which should further propel their growth in the coming years.
The Growth Story
American’s growth strategy is two-fold. First the company will rely heavily on its ability to organically grow its business within the company’s current footprint. Within the last 12 months, the company has doubled the number of its producing mines, and that number could easily double again within the next 12 months. American currently operates on six permits, with 33 idled permits throughout three of its operating subsidiaries. These subsidiaries have access to high-quality bituminous metallurgical coal, which are ideal for production of steel and energy, and are in high demand. This means that the company already owns a substantial number of mines with the potential to produce high-quality, highly-profitable coal.
American also has enough processing and logistics infrastructure to support rapid organic growth. Currently, the company’s four wash plants can process approximately 19 million tons of coal per year. The company is currently working on bringing several of its previously acquired mines back online, and their current infrastructure is robust enough to handle the additional output. What this means for investors is that American’s startup costs for relaunching a mine are significantly lower than industry standard.
A specific case study would be the company’s McCoy Elkhorn Coal complex. Mine 15 is currently undergoing a conversion from two single-sections to two super-sections. This upgrade in its mine plan and machinery should result in a 50% increase in production and a decrease in cost-per-ton by 12-15%. The same mine also has the potential to add a third super-section which would further drive output. McCoy Elkhorn has another mine, Carnegie 1, that is being enhanced to support similar efficiency upgrades. These upgrades could increase mine production at Carnegie 1 by approximately 300% once fully implemented.
In addition to McCoy Elkhorn, the company is implementing similar upgrades at its other operating subsidiaries, Deane Mining, Knott County Coal, and various mines that feed each complex. When all is said and done, we expect American’s coal output to be significantly larger than it is today. In fact, we think the company might be able to double its production base over the next several months, and then double it again by executing its current organic growth plan. We also expect to see margin expansion as operating efficiencies are implemented and the company begins to benefit from economies of scale and macroeconomic momentum.
With all of the growth potential, it’s hard not to get excited about American.
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