Peabody Energy (NYSE: BTU), the nation’s largest coal producer, has trimmed its U.S. coal production forecast for 2012 by about 10 million tons per year and says it won’t be doing any mining just for “practice” as it looks to weather a current low-priced, low-demand market.
Peabody Chairman and CEO Greg Boyce, and Executive Vice President and CFO Mike Crews, answered analyst questions during an April 19 first quarter earnings call.
Crews said that U.S. sales volume in the first quarter were largely in line with the prior year. Peabody started the year with a fully priced book of business. Realized prices were up over the prior year in both the Western and Midwestern U.S., while overall U.S. cost increases were held at just 6%, leading to a 12% increase in gross margin per ton. “Our U.S. margin improvement was notable given the major industry pressures in the quarter,” Crews added.
In line with slumping power industry demand due to factors like coal-to-gas switching and a warm winter, Peabody has reduced its 2012 U.S. sales target by 10 million tons, down to 185 million to 195 million tons, which is a slump from 204 million tons of actual sales last year. These lowered expectations include expectations of lower volumes from certain requirements-based contracts with utilities, as well as select customers with whom Peabody may reach favorable commercial terms for restructuring sales contracts, Crews noted.
Boyce said that U.S. coal markets faced a weak first quarter with coal generation off sharply due to low natural gas prices, mild weather and a continued sluggish economy. “We believe that U.S. coal consumption could decline in excess of 100 million tons in 2012,” he added. “A portion of the lower coal use stems from lower U.S. electricity demand due to the mild winter, while most relates to coal-to-gas switching. You’ll recall we said in January that the coal-to-gas switching could be as high as 85 million tons should gas prices remain low.”
Boyce noted that overall U.S. coal production curtailments accelerated through the first quarter and reached an estimated 12 million tons in March, which annualizes out to more than 140 million tons of lower shipments.
Fully priced 2012 book has insulated Peabody so far
Peabody’s commercial strategy allowed it to begin the year with a fully priced book of business for 2012, Boyce noted. “In the first quarter, our U.S. output benefited from high customer deliveries even as industry shipments fell 7% from the prior year. But we’re also being very patient in contracting 2013 volumes. We priced just 9 million tons in the past quarter, with half relating to scheduled reopener contracts and most occurring in the early part of the quarter. Peabody continues to leverage our unique position within the leading presence in the regions that are expected to experience the largest demand growth over the next years.”
Peabody sees Powder River Basin-served new power plants being completed, with low-sulfur PRB coal also benefiting from anticipated regional shifts due to new environmental rules. PRB coal will also substitute for declining Appalachian and lignite coal and move to the seaborne market through the West and Gulf Coast. Illinois Basin coal is also expected to increase based on greater SO2 scrubber installation, backfilling for Appalachia coals and increased Gulf Coast export demand. Peabody continues to advance high-value U.S. projects, including the extension at the Gateway deep mine in Illinois and Twentymile longwall mine in Colorado, progression of the relatively new Bear Run strip job in Indiana to full production, and commercial and permitting development of West Coast port access.
Because Peabody entered the year fully contracted, its customers were taking their coal on a ratable basis, while others that had uncommitted positions, you’d have to assume were falling off on deliveries, Boyce noted. “So we were able to actually have a very strong shipping quarter. Now as we go into the next three quarters of the year, as we said last call, we’ve had a number of customers who had looked at their volume needs for the year. We’ve got some requirements contracts, which will have lower burns this year, as well as other customers who have fairly healthy stockpiles that we’ve had some commercial discussions around rescheduling those shipments. Some of those will be in ’13 and some of those will be in ’14 in terms of the replacement volumes. And that isn’t always necessarily ton for ton. When we negotiate these changes to these contractual positions, we look at the [net present value] of the contract. We try and maintain that value. And so it’s a combination of timing, volume and future price that we set as we make those contractual changes. To the extent what does the rest of the year look like, as we indicated, I think there’s the potential that we’ll see some continued decrease in coal demand for the rest of the year, which will require potentially some additional reductions across the industry.”
Crews said that when working with customers, there’s a couple of different ways that Peabody can go. “You can look at cash payments that impact realization on a near term,” he noted. “You can look at pushing out volume. You can talk about the pricing and how that would impact later periods. We didn’t have good, strong year-over-year growth there. We were fully committed here. And we’re encouraged by the revenue growth that we’ve had. As we work through the negotiations on some of these volumes, that would ultimately have an impact on the ultimate revenue realization. What I will say as it relates to the U.S. platform, even with the guidance that we’ve given around taking out 10 million tons, and we’ve said this before and I’m happy to say that we still believe that we’re going to have stable margins in the U.S. And when we look at the cost position that we have and relative to what we think the inflation may be, which goes to the question of; with lower volume, could you have a little bit of an uptick in cost? But we’re looking at mid- to high-single-digit cost increases between the Midwestern platform and the Western platform, and that helps preserve the margin. And that, coupled with contracts a little bit later on and prior periods and strong markets leads us to a favorable position in the U.S.”
Coal inventories not in the ‘rafters’ – yet
Boyce was asked if power generator coal inventories are rising and whether those generators are re-selling coal into the domestic and/or export markets. When you look at overall inventories in the U.S., they’re estimated at over 190 million tons, which is a high level, he noted. “It’s different by region” Boyce added. “The [Central Appalachia] region is the highest in terms of volumes and number of days supply. We don’t have a significant number of those pure CAPP power plant customers.” Notable is that Peabody a few years ago spun off its Central Appalachia mines through Patriot Coal (NYSE: PCX), but does market some coal from that region.
“The Illinois Basin is up there, and then the Powder River Basin has started to come up,” added Boyce about inventories. “So we’re not with anybody right now that’s saying, ‘Look, we’re up to the rafters, and we can’t take another delivery.’ But they’re all looking at their inventory levels, looking at the fact that we’re now in the summer season, trying to anticipate what a summer burn may be, and then looking at how do they make sure nobody gets into a crisis situation. And so those are the customers that we’re talking to. And we’ve talked to some of our Illinois Basin customers and we’ve talked to some of our Powder River Basin customers. We’ve got a few other requirements contracts, particularly one in the Southwest, where the burn is anticipated to be lower than it has been historically. And so we’ve adjusted those production levels as well.”
Boyce, in answer to another question, elaborated on the projection of at least 100 million tons of coal demand loss in the U.S. this year and whether announced production cuts are keeping pace with that demand slump. “The best we can assume right now is normal weather patterns and gas staying in the range it is now. That’s where we come up with a demand lost of in excess of 100 million tons. We kind of flagged that 85 million ton number for gas-only in our last call. Now how will that reduction in demand translate into production for the year vis-à-vis where the inventory levels are? I mean, that really remains to be seen in terms of what the entire industry does. You can look at announced production cuts, but they don’t come close to the number that we actually saw in March where volumes were down 13%, which annualized to 140 million tons, which would give you the sense that if we maintain that pace through the end of the year, we’ll actually see some reductions by the end of the year in the inventories. Now our view is it’s probably a bit too early to actually make that as an affirmative statement, but we also think that we’re going to see more production cuts announced going forward.”
Boyce said Peabody won’t produce coal for a market that’s not there. “We’re not going to mine for practice in terms of the Powder River Basin,” he noted about a region where Peabody has the largest coal mine in the country. “We’re going to make a margin on everything that we sell. Or we’ll wait until we can make a margin on what we sell. But it probably is significantly early right now to really determine what the outcome for ’13 is going to be. A normal or a normal-to-warmer-than-normal summer goes a long way. It’s the highest burn season of the year in terms of coal.”
Peabody is a market leader in the Illinois Basin, with mines in Illinois and Indiana, but not currently in western Kentucky. Illinois Basin coal is moving in the export markets lately at unusual levels and Boyce was asked about prospects for that coal. “Well, I think the demand will continue to strengthen for Illinois Basin coal as we get more global customers trying that product,” he said. “It’s a product that typically needs to be blended because of its quality constraints. And to a certain degree, its global reach currently is limited by the size of vessels that can be loaded out of the Gulf Coast. And so we see growth there. It’s been growing. And our total level of exports this year is up a couple million tons over what they were last year. But those are the two issues that the Illinois Basin continues to need to work on relative to seamlessly flowing into the international marketplace.”