One of the best performing asset classes this year has been coal. As the rest of the stock market has struggled with economic uncertainty, political volatility and central bank quantitative tightening, coal prices and the stocks of associated companies have been reporting record gains thanks to surging demand for the commodity.
Newcastle coal futures, the benchmark for the world's top consuming region Asia, are currently trading at around $385 per tonne, which is down slightly from the 52-week high of $450 per tonne, but it is still more than double the $150 recorded at the beginning of November last year.
What is really fascinating about this market is the fact that only a year ago, many analysts and commentators were speculating that the coal industry as we know it is dead. Demand for coal, analysts argued, would continue to decline as the world moved away from dirty hydrocarbon energy sources towards a future powered by green, clean renewable energy. Yet, all it took was one conflict between major energy suppliers to have the West rushing back to coal. Following Russia's invasion of Ukraine and the subsequent deluge of sanctions, the Western world has rushed to find new energy sources to replace Russia's role in its energy economy. Coal, which is relatively easy and cheap to mine and burn, has become countries' go-to backup fuel source in this energy security rush.
The changing market is a boon to Arch Resources
One company that has seen a significant turnaround in its fortunes thanks to the changing backdrop for the coal industry is Arch Resources (ARCH, Financial). This company is a producer of coal and metallurgical products for the steel industry, primarily supplying premium metallurgical coal globally, which tends to be used to produce high-quality steel, although it also supplies thermal coal for the power generation industry. It operates seven mines in the United States, primarily to supply this market.
However, the coal market is a global market. Just because Arch is focused on supplying the U.S. does not mean that the company is not benefiting from the international rush to secure coal supplies. Its profits are set to surge this year with analysts forecasting a net profit of around $1.3 billion, up from a net loss of $345 million in 2020.
Before I dive too deeply into the company's financials and prospects, I think it is worth taking a step back to analyze the outlook for the coal sector in general. In 2019 and 2020, before the current energy crisis began, it was widely believed that most coal companies would struggle to survive in a world that was moving away from burning hydrocarbons for fuel. This has changed, but I think it is difficult to argue that the long-term fundamentals of the industry have improved dramatically.
Coal is a horrible fuel source. When it burns it creates suffocating smoke, and thousands of minors are killed every year around the world in coal mines. I think it is difficult to believe that this fuel source has a future in a world that is trying to improve the welfare of its employees and reduce pollution.
That being said, I think it is unlikely the world will suddenly move away from coal in the way that some people believe it will. Paramount to this is that coal is still a key component in steel production, and many emerging economies rely on coal power stations to balance the electricity grid (even developed nations also have a need for coal in this respect). Coal may be terrible as a fuel source, but its ease of use is unparalleled.
Based on these factors, I think there will be a demand for coal in the long term, but I think it would be misleading to proclaim that the current demand will last. Coal is also quite expensive as a fuel source. In the U.K., one of the most developed markets in the world for renewable energy, energy from coal can cost 10 times as much as renewable energy at today's prices. So you have a fuel source that is much more expensive, is incredibly dangerous to produce and destroys the environment.
Windfall profits will not last
I think it is important to understand the fundamentals of the coal market before acquiring a company like Arch just because it's done well in the short-term. Today the stock looks attractive on the surface level. It is trading at a forward price-earnings ratio of 2.91 based on Wall Street estimates for the 2022 financial year. Earnings are expected to fall back from the record next year, declining 43%. Based on this projection, the stock is trading at a 2023 forward price-earnings ratio of 4.3.
The company's windfall profits have allowed it to eliminate its borrowings and it is now returning huge amounts of cash to investors. A dividend of 19% is penciled in for 2023. This might look attractive, but it does not seem sustainable. I'd consider it as more of a last bonus for loyal existing shareholders.
Over the past decade, coal prices have averaged around $75 per tonne. Newport coal prices are not directly comparable to the prices Arch receives for its output, but they do give us a benchmark for its profitability. On that basis, one could argue Arch's profits may fall as much as 70% if coal prices return to historical norms. Such a decline could have a significant impact on the stock price and certainly force the company to reduce its dividends.
