Coal and Services
By now, everyone is aware that crude oil is closing in on $100 per barrel. Many assume that, with that backdrop, any company remotely related to energy must be doing well and reporting record profits.
But nothing could be further from the truth. Not all companies in the energy patch have reported stellar third quarter earnings. And just like every other year, not all energy names have participated equally in this year’s bull market for the group.
Consider the Philadelphia Oil Services Index, which includes just 15 companies involved in the oil services and contract drilling businesses. The best three performers in that index are up an average of nearly 98 percent in 2007.
The worst three have actually fallen this year an average of a little more than 4 percent. That’s a wide disparity in performance, especially for such a relatively small, homogenous group of stocks.
To help us sort through all these trends, every three months investors are treated to a flurry of activity as companies release their quarterly earnings numbers and offer detailed commentary on accompanying conference calls. The deluge of reports can be truly overwhelming; within the energy sector alone, there are hundreds of companies holding calls.
Some scrutinize every aspect of these releases, right down to management’s tone of voice during the question-and-answer (Q&A) session that follows every call. But amid the mass of corporate releases, I find there’s usually just a handful that truly stands out. These select few offer gems of information and a glimpse into important new trends that are emerging for the industry.
The mild winter of 2005-06 created increased coal supplies at many US utilities. However, a return to more normal temperatures this year has created an increase in demand. Those extra stockpiles may not last much longer. See Coal.
Domestic consumption isn’t the only source of income for US miners. Once self-sufficient Europe is now increasingly relying on imports, and tightening supplies in Indonesia and Australia may lead to increased import demand in Asia as well. See Coal Demand.
Older mines in the eastern US aren’t producing like they used to. And with increased regulations making it harder and more expensive to continue to operate some of these mines, the US may become increasingly more dependent on supplies from the western side of the country. See Changing the Means of Supply.
There are currently four coal plays in the TES Portfolios, one of which is a recent spinoff. Each one has a unique angle on this sector that makes them worth holding in your portfolio. See How to Play It.
A recent conference call from one of the major drillers has caused some concern on Wall Street. Although the North American market continues to remain somewhat weak, there could be some dips in the international market as well. However, it’s much more sustainable than the North American market, which is why I continue to focus on companies with more exposure abroad. See Oil Services and Drilling.
In this issue, I’m recommending or reiterating my recommendation on the following stocks:
Fast-forward to third quarter earnings season and the big coal-mining firms have once again posted results that missed expectations. Arch Coal, the first of the big names to report for the quarter, announced third quarter earnings of 19 cents per share, well under analysts’ consensus of around 27 cents.
But investors’ reaction to that news couldn’t have been more different than in July: This time, the coal mining stocks actually shot higher after releasing those negative numbers. Arch Coal is up around 15 percent since reporting.
Whenever you see stocks react positively to what looks like negative headlines, it’s time to sit up and take notice. That’s especially true given the fact that these stocks reacted so differently to equally weak numbers back in July. Something has obviously changed in the ensuing three months.
Conference calls from the miners offer some insight into this seemingly incongruous rally in the face of bad news. The Arch Coal call in mid-October was instructive. Management reported that, although coal prices remained far lower in third quarter 2007 relative to the same time last year, there are real signs of a strengthening in these markets and a tightening of the supply/demand balance.
If anything, that balance is set to get tighter still as we move into 2008. Coal prices could see a significant spike over the next few months.
I outlined some of the basic problems that have been facing the coal miners over the past year in the July 26 flash alert, Earnings Deluge. I issued that flash in response to the wave of second quarter earnings warnings and misses from the group.
(For those unfamiliar with the coal sector, check out the May 2 issue of TES, King Coal, for a review of the domestic mining industry and the Sept. 5 issue, Australia, Asia and Coal, for a closer look at the booming market for Australian coal.)
To summarize, the main problem facing the miners in the past year and a half has been weather. An unusually mild 2005-06 winter season meant that demand for coal-fired electricity was lower than normal; the result was a swelling in coal stockpiles in storage at the nation’s utilities.
With the utilities’ coal needs well supplied, these firms cut back on their coal purchases; the glut of coal spelled falling prices. The chart below shows US coal inventories at electric utilities in the past five years.
Source: Energy Information Administration
There are clearly seasonal swings in coal inventories. Utilities build their stocks ahead of periods of anticipated high demand to ensure adequate supply.
However, despite those small wiggles on the chart, the overall trend here is obvious: Coal stocks at utilities sank broadly from 2002 through 2005. In fact, at the end of 2005, inventories of coal were near multi-year record lows; there was a real danger of a shortage that winter.
But the 2005-06 winter was among the mildest ever recorded. You can see that, in late 2005 and early 2006, coal inventories shot higher rapidly. Since that time, there’s been a gradual build to new five-year highs.
However, data on coal inventories are released by the Energy Information Administration (EIA) with a significant time lag. Moreover, data can be revised significantly months after they’re released; that’s why the chart above only includes data up until July of this year. We can see that inventories of coal did decline sharply in July.
A one-month blip lower in inventories doesn’t make a trend. But the Arch Coal management team made some interesting observations during its call.
Specifically, Arch estimates that coal inventories at utilities stood at 135 million tons as of the end of September. Although accurate EIA data isn’t available yet, Arch is one of the largest miners in the US and management has good insight into the supply of coal its customers (the utilities) have in their coal yards. It can certainly tell if early EIA estimates are accurate or totally infeasible.
Note that inventories of 135 million tons would imply a significant drop on the chart above; that’s actually below where inventories were at the beginning of 2007. The bottom line: There appears to be inventory normalization in progress.
Arch also went on to outline reasons it believes that’s happening. First, although 2006 was an aberrantly warm year, weather patterns in 2007 have been more normal.
According to the CEO, demand for coal from electric power plants was just shy of 100 million short tons in the month of August, a new record in terms of monthly coal demand. And although the weather was relatively warm in January across the Northeast, a cold snap in late winter and a hot summer pulled additional demand.
Overall, Arch pointed out that coal consumption surged 22 million tons in the first nine months of 2007 compared to the same period in 2006. This was primarily because of a surge in demand for electricity. The chart below shows data from the EIA on coal burned in US electric power plants.
Source: EIA
This chart measures the year-over-year change in coal demand by month over the past two years. So, when the line is above zero, that means that coal demand for electricity generation was up year-over-year; values under zero mean that coal demand was lower.
I’ve highlighted this year’s data in red. As in the prior chart, the most recent accurate monthly data from the EIA is though July.
The striking point here is that, in every month in 2007 except two, coal demand has been far higher than in 2006. And preliminary numbers, as Arch suggested in its conference call, suggest coal demand approaching 100 million tons for August, way ahead of last year’s levels. This just shows that weather in 2007 is more normal than in 2006, and that’s starting to help pull down inventories of coal.
Back to In This Issue
According to Arch, US coal imports are up about 1 million short tons year-to-date through the month of August as compared to 2006. EIA data updated through the end of June indicated that total US coal imports were roughly 17.2 million short tons. To put that into perspective, recall that US power plants consumed about 100 million tons of coal in August alone.
But over the same January-August period, Arch indicated that US coal exports were up more than 6 million tons from the same period in 2006. For reference, the EIA data shows that the US exported about 25.8 million short tons of coal in the first six months of 2007. The chart below depicts actual EIA data on imports and exports for 2006 and 2007 with preliminary estimates for the third quarter.
What’s clear from this chart and the data from the Arch call is that imports of coal into the US market are stagnant while exports are rising steadily. To calculate the actual impact on US coal supplies, consider the net export figures for the first nine months of 2006 and 2007.
The term net exports means total exports minus total imports. A higher net export figure means more coal is leaving the US and there’s lower domestic supply. This is bullish for coal prices.
Total net exports in the first nine months of 2006 were 9.4 million tons compared to a projected 15.6 million tons this year, based on preliminary data for the third quarter. That means that the actual swing in demand was 6.3 million tons.
This is how much more coal left the US this year compared to last year at this time. Although that 6-million-ton swing may not seem like a big number, it’s just another marginal source of coal demand that helps to reduce those hefty coal stockpiles referenced above.
But this short-term effect isn’t what I find most interesting. Check out the chart below for a closer look at the destination of US coal exports by region.
Source: EIA
The largest recipient of US coal exports is Europe, where trade surged more than 15 percent year-over-year in the first six months of 2007. If we divide Europe by country, the results are even more telling: Germany’s imports of US coal soared 46 percent in the first half. And exports to the Netherlands and Croatia were up 80 percent and 125 percent, respectively.
Also although Africa isn’t a huge importer of coal from the US, imports surged more than 200 percent this year. That growth was led by demand from Morocco in northern Africa.
These raw numbers indicate growth in the Atlantic coal trade from a low base. However, Arch made some anecdotal comments in its conference call that indicate this is the beginning or a more important trend and what we’re seeing in the raw numbers is only the first act. Arch indicated that it received a bid for coal in the quarter from a European buyer.
Unlike most domestic coal supply arrangements with the major utilities, this wasn’t a long-term contract. Rather, Arch had the chance to sell some coal opportunistically on a one-off basis at a far higher price than it could have in the US in the current environment.
This coal wasn’t metallurgical coal—coal used in steelmaking—but steam coal that’s burned in power plants. Management reiterated the solid returns it garnered from this deal on several occasions during the conference call and Q&A session.
Even more interesting, in answering an analyst’s question, management indicated that there’s significant growing interest in international steam coal term contracts. In other words, European buyers are interested in talking to Arch about long-term, multi-year steam coal supply deals.
This is a highly unusual situation. Management said it hasn’t seen any real sustained interest in term contracts from European buyers since the early 1990s. The company, in fact, now has discussions ongoing for term contract deals and is focusing considerable attention on this market.
And Arch doesn’t produce just steam coal but also metallurgical (met) and pulverized coal injection (PCI) coal. (I described and explained these different coal types in the Sept. 5 issue of TES. I won’t repeat that entire explanation here; suffice it to say that both met and PCI coal is used in steelmaking.) Demand for these coals abroad is also high, and Arch has commenced discussions for term deals for met coal as well.
And it’s not just Europe. Right now, the US exports almost no coal to Asia—less than 1 million tons in the first half of 2007. But that may be changing. Arch alluded to the fact that there’s some significant interest in the industry in exporting coal from West Coast ports to coal-hungry markets like China.
This growing interest in US coal shouldn’t come as a surprise to anyone. Although most investors seem to believe that all coal plants in Europe have been shut down, nothing could be further more the truth. Check out the chart below.
Source: BP
The truth is that Europe burns a great deal of coal and doesn’t produce enough domestically to meet demand. Traditionally, the region has been dependent on seaborne call trade to help fill that gap.
But here’s where the situation gets interesting. As I highlighted at length in the Sept. 5 issue of TES, the global seaborne coal markets are ultra-tight right now both for thermal and met coal. The main drivers of this trend are growing demand from key Asian countries coupled with supply issues at traditional coal export nations.
Specifically, for the first time in history, China is now a net importer of coal. Not only is the country no longer able to supply some of its Asian neighbors with the commodity, it has to import coal in ever larger quantities. A similar situation is ongoing in India.
Meanwhile, the traditional coal suppliers in Asia-Pacific—Indonesia and Australia—both have challenges right now. In Indonesia, domestic coal demand is ramping up quickly, limiting the country’s ability to export to meet all the demand.
And in Australia, demand is booming so much that the nation’s infrastructure just can’t keep pace; congestion in Australian coal export ports is shocking. At last count, the average waiting time for a ship loading cargo at the Port of Newcastle stood at 19.65 days, up from 17.18 a week earlier. Forty-three ships on average are waiting in the harbor for cargo.
With these big traditional exporters challenged, Europe is having problems importing the coal it needs. It’s, in effect, competing with Asia for the world’s scarce, hard-to-obtain coal supplies. That’s why coal prices for delivery in Europe have been spiking in recent months. See the chart below.
Source: Bloomberg
As you can see, steam coal for delivery into Rotterdam cost $68 a metric ton (1.102 short tons) in January and has recently soared to more than $130. Although US prices have also risen in 2007, the gains have been far more subdued.
Spot prices for high-quality, low sulphur steam coal in the eastern US are currently around $49 per short ton. With that sort of a price discount, it’s no wonder European buyers are looking more closely at locking in supply of US coal. I also don’t see much scope for seaborne coal prices to fall anytime soon.
One of the best indicators of coal demand is the Baltic Dry Index. This represents dry bulk shipping rates, the cost of leasing a dry bulk ship to carry commodities like coal. The chart XX shows that dry bulk rates have been on fire recently.
Source: Bloomberg
Dry bulk shipping rates have been soaring in no small part because of import demand for coal from Asia is strong. At the same time, port congestion in Australia and a shortage of dry bulk ships means that it’s difficult to move enough coal to meet that demand. The fact that this trend continues suggests that the supply/demand balance for coal in Asia remains tight.
Back to In This Issue
Source: EIA
This chart shows US coal production broken down by region. As I’ve highlighted before in TES, production from Appalachia, particularly Central Appalachia (CAPP), remains troubled and has been steadily falling over the past year and a half. Production from Appalachia was 103.5 million short tons in the first quarter of 2006, falling to less than 93 million tons in the third quarter of this year.
The reason is mines in this region have been operating for well more than a century. Seams of coal are getting thinner and more difficult to produce. Over time, Appalachia will remain a major coal-producing region but will become increasingly overshadowed in production by western coal from places such as the Powder River Basin (PRB).
Shorter term, a series of regulatory changes and issues are the prime driver of falling production. I detailed many of these changes in the July 26 flash alert.
Basically, surface mining operations in Appalachia can involve stripping large quantities of dirt and rock from the top of a mountain to expose coal seams. Coal mining firms have often applied for permits to dispose of this material in nearby valleys.
The problem with this is that it can cause damage to streams. Environmental groups have been fighting the practice for years. But recently the environmentalists have been winning some notable victories, and the courts have been blocking valley fill permits.
According to Arch, no new valley fill permits have been issued in the past nine months. Recent judicial decisions have effectively shut down this mining practice, a major source of eastern coal.
In addition, new regulations from the Mine Safety and Health Administration (MSHA) have gone into effect in the past year. One key change has been regulations related to sealing off unused sections of older mines. When gases accumulate in unused sections of older mines, a lightning strike can trigger a major explosion.
MSHA has changed its seal regulations mandating that these seals be made far stronger and be checked more regularly. Some older Appalachian mines can have hundreds of seals, making that an expensive endeavor. With coal prices depressed, many miners simply couldn’t afford to make the changes and their mines simply shut down.
MSHA has also changed other safety regulations as part of the Mine Improvement and New Emergency Response (MINER) Act of 2006. These regulations mandate the creation of detailed emergency response plans and provide for more careful federal scrutiny of mines. These regulations also greatly increase mining costs.
Arch thinks these issues are likely to get worse in 2008. Some miners in Appalachia still have valid valley fill permits for their mines but will need to seek new permits once those expire.
As those permits come up for renewal, these mining firms won’t be able to renew, which will lead to still more mine closures. Other miners may be working off longer-term contracts signed at higher coal prices; as those contracts roll off, they’ll no longer be profitable.
Increased mine production from the surface mines of the western US will likely be able to fill in the gap left by falling production from eastern mines. But prices would need to rise enough to make investments in new capacity practical.
All told, the coal supply situation continues to tighten in the US while seaborne coal supply is already tight. When you factor in falling coal production in the East, rising international demand and more normal US consumption, it all adds up to higher prices.
Back to In This Issue
Peabody, like Arch, has long had exposure to all major coal-producing basins in the US; in that respect, the two companies have performed similarly. (I wrote about Peabody at some length in the May 2 issue of TES, for those unfamiliar with this story.)
I continue to prefer Peabody over Arch coal for two primary reasons: its direct exposure to the seaborne coal trade through its Australia-based operations and its decision to spin off its eastern mining operations into a separate company, Patriot Coal (NYSE: PCX).
To the first point, Peabody bought Australia-based Excel Coal last year. Excel has traditionally exported the vast majority of the coal it produces in Australia.
Short term, Peabody is suffering, just like all Australian producers, from ongoing port bottlenecks that have slowed exports. This could continue to be an issue over the next few quarters, but I’m not overly worried about that longer term.
These bottlenecks are also serving to tighten up coal supplies and drive prices higher for thermal, met and PCI coal alike. Eventually, port expansions will help ease the problems. But in order to encourage Australian producers to undertake the necessary investments, Asian customers will need to be willing to pay higher prices on a term-contract basis.
For anyone who ever doubted the wisdom of Peabody’s purchase of Excel, note the comments Arch made in its own call. Management indicated that it’s interested in an overseas purchase and in furthering its seaborne coal business. Peabody was clearly the first mover on that, buying into the international coal story early on.
At this time, valuations for purchasing a similar mining franchise would be much higher and a firm would likely encounter something of a bidding war. In this case, imitation really does appear to be the sincerest form of flattery.
As I highlighted in last week’s flash alert, Peabody’s spinoff of its eastern coal assets is now complete; Patriot Coal started trading on the New York Stock Exchange on Nov. 1. For every 10 shares of Peabody you owned, you should have received one share of Patriot on that date.
I’ve long recommended avoiding the eastern-focused miners. These companies face rapidly rising labor and regulatory costs, as well as difficult geology, a euphemism often used to describe older mines with thinning coal seams. I prefer to recommend companies such as Peabody and Arch with exposure to the PRB, a vast reserve of coal in the West that can be mined with a smaller skilled workforce using simpler surface mining techniques.
But my opinion is shifting somewhat. What the eastern mining firms do own is relatively sizeable reserves of high-quality steam and met coal located near Atlantic ports. That means that it’s relatively easy to load this coal onto a dry bulk carrier and ship it to Europe.
Arch’s management sounded extraordinarily excited about its new Mountain Laurel mine in CAPP. This mine produces both steam coal and met coal. The company also noted the potential for this mine to serve foreign markets.
This suggests that CAPP producers with a relatively low cost base, as well as the size and financial power to meet new regulatory requirements, should see ongoing benefits from European coal demand.
Patriot fits well in that mold. The company has some of the highest-quality mines in the East and sports a low cost of production. Patriot also produces a sizeable quantity of met coal that’s in particularly high demand abroad; roughly 20 to 25 percent of production this year is met coal.
As a result of that export potential, I recommend that subscribers hold on to the shares in Patriot Coal received as a result of the Peabody spinoff. I’ll track the stock in my Wildcatters Portfolio.
Logically, one might ask why Peabody would want to sell off such a valuable asset into a separate firm. The fact is, however, that underground mines in the East need to be managed differently from mainly surface mines in the PRB. During the past few quarters, the CAPP operations have been a notable distraction for management.
The skill sets for managers in these regions are very different, as are production growth prospects. Even the customer base is potentially different. PRB coal would be mainly steam coal, whereas Patriot’s mines hold significant met coal. It makes more sense for Peabody to focus its attention and capital spending resources on the two true coal growth markets: the western US and Australia.
Meanwhile, Patriot can focus its attention on managing reserves to maximize profitability rather than generate substantial growth. Peabody Energy remains a buy under 55.
Consol Energy is a slightly different story. Specifically, Consol’s mines are located mainly in Northern Appalachia and CAPP. The company produces a mixture of high-sulphur coal, met coal and low-sulphur steam coal. Northern Appalachian coal production hasn’t experienced the same level of geological difficulty as CAPP.
The growth for high-sulphur steam coal has been subdued in the US because of regulations governing emissions of sulphur dioxide. There are really two ways to reduce these emissions: Burn low-sulphur coal, or install advanced scrubbers.
Because of a lack of scrubber capacity, there have historically been a limited number of potential customers for high-sulphur coal supplies. But that’s changing. Scrubbers are finally being built in the east; as a result, there’s growing interest in high-sulphur coals. As more utes install scrubbers, this market is only going to get bigger.
Consol is also well positioned to benefit from the international story I outlined above. In fact, for the entirety of 2007, Consol expects to export 2.5 million tons of met coal and some 4 million tons of steam coal to Europe. Next year, steam coal exports should be up around 25 percent, and the company will have as much as 3 million short tons of met coal export available.
Like Arch, Consol pointed out the potential for more long-term coal supply contracts with Europe; management echoed Arch’s statements that the strength in these markets represents a major change from the steam coal export markets for the past five years. This is particularly true on the met coal side, where Consol sees export prices at an even bigger premium to domestic coal.
On factor hitting results in the company’s most recent quarter was a cave-in at a disused section of its Buchanan mine in Virginia. But there’s been progress on eliminating potentially explosive gases from the caved-in section of the mine.
Consol already wasn’t factoring in production from this mine in the fourth quarter; this wasn’t new news. Buy Consol Energy.
Finally, Macarthur Coal is our pure play on the boom in Asian demand for coal; the company supplies a fifth of the world’s PCI coal. (I highlighted this company at length in the Sept. 5 issue.) In late October, Macarthur announced a shortfall in revenues and lowered production guidance for the rest of the year.
That sounds like terrible news, but it wasn’t unexpected. The shortfall was entirely because of ongoing port congestion in Australia. Although this may mean that Macarthur doesn’t sell as much coal near term, it’s also a sure sign that demand isn’t slackening one whit.
The stock actually opened lower on that news and then rallied all day—a sign that investors weren’t surprised. Macarthur Coal remains a buy.
Note: Peabody Energy released its third quarter numbers and held its conference call just as this issue was to be posted. My early read is that Peabody has made many of the same comments that Arch did in its call last month. The stock also performed similarly, opening lower and rallying soon thereafter and straight through the company’s conference call. Investors are recognizing the strengthening environment for coal prices.
Back to In This Issue
I held Schlumberger in the Wildcatters Portfolio for many months, finally selling out of the stock in July and August as Schlumberger started rising in a near vertical fashion. As I wrote when recommending subscribers get out of the stock, I see no deterioration in fundamentals; rather, the stock just got ahead of itself and Wall Street expectations were just too high.
In listening to the call and watching the subsequent reaction in the stock, I believe my caution was warranted near term. Although Schlumberger beat earnings expectations and generated growth and profit margins well above expectations, the stock saw a near 11 percent drop the day it released its report (Oct. 19) on heavy volume.
The prime reason for the selling was that some of management’s comments seemed cautious. Given sky-high expectations for the quarter, a modicum of caution was enough to send the stock lower. Specifically, most analysts and investors already know that North American services markets are weak; what really caused alarm were Schlumberger’s comments that suggested slower-than-expected growth outside the US.
Services in North America
The problem with North American markets remains that most drilling activity onshore targets natural gas, not oil. While oil prices have recently pushed to new all-time high, natural gas has remained relatively flat and well off the levels seen in late 2005 and early 2006.
I won’t rehash all of the reasons for that here; suffice it to say that the same warm weather conditions in 2005-06 that pushed up coal inventories also inflated gas inventories. The resulting excess supply that persists to this day has been an ongoing headwind for natural gas prices.
Gas drilling activity has responded to that falloff in prices. In Canada, drilling activity this year is way off 2006 levels; higher cost reserve bases such as Canadian shallow gas have been particularly hard hit.
Also impacting Canadian activity was, of course, the change in the Canadian trust tax law. This tax change reduced incentives to produce gas from mature fields and hit the industry hard.
US drilling activity has held up far better than in Canada, at least on land. The worst affected market within the US has been drilling on the Gulf of Mexico shelf—basically, the shallow waters of the Gulf of Mexico.
Here, production costs are relatively high so producers aren’t willing to undertake major drilling activities unless gas prices are trading at higher levels. But overall, the US rig count remains near multi-decade highs despite all the talk of a falloff in activity. The rig count simply isn’t rising steadily as it was for most of 2005 and early 2006. See chart below.
Source: Baker Hughes, Bloomberg
Schlumberger stated on its call that it expects the US rig count to remain basically flat in the coming year while Canada will remain weak. Although Schlumberger reported an uptick in Canadian demand for the quarter that was mainly because of seasonality, drilling activity picks up in the warmer months.
Some may ask how the rig count can stay relatively stable, even with gas prices where they are. But the reality is that gas prices aren’t exactly depressed by any historical measure and certainly not when compared to the sub-$2 per million British thermal units (MMBtu) price that gas witnessed back in 2001. There are still plenty of drilling projects that make sense at current gas prices.
A perfect example is Wildcatters recommendation EOG Resources, an exploration and production (E&P) firm with a strong position in Texas’ Barnett Shale play. In that company’s recent conference call, management laid out a plan for growth whether gas remains around $7 or rallies back to more than $9.
Specifically, the company stated that in a depressed gas situation, it would simply focus its activities on its lowest cost reserves in the Barnett Shale. If gas prices rise, it’ll look to more aggressively develop some of its other reserves.
Overall, EOG, if anything, would like to have more rigs working in Barnett Shale; its costs in that region are around $3 per MMBtu.
The real problem with the services and drilling markets in North America isn’t the total rig count but capacity, particularly in the area of pressure pumping. And example of pressure pumping is fracturing, a procedure that’s absolutely necessary for producing many North American gas reserves economically.
As long-time readers know, gas doesn’t exist in giant underground caverns but in pores, cracks and crevices of reservoir rocks. If those pores aren’t connected, the reservoir lacks permeability, making it difficult for gas to flow into a well.
In fracturing, a liquid is pumped under high pressure into a reservoir, actually cracking the reservoir rock. This helps to open up channels between pores, improving reservoir permeability.
The problem is that, although gas drilling activity remains relatively healthy, services firms added a great deal of pressure pumping capacity in the past few years. That was fine when the rig count was soaring as in 2005; but as the North American rig count has stagnated, that growth incapacity is overwhelming demand.
This means that pressure pumping operators have to get more aggressive on cutting their prices to compete. Profitability of this service function has been decimated.
Note that this is a very different situation to the last cycle. Back in 2001 when gas prices fell, the rig count fell sharply. The pressure pumping business weakened because of a combination of falling rig count and some increase in capacity. This time around, it’s all a matter of capacity growth.
Schlumberger has only minimal exposure to pressure pumping services in North America. And to the extent that it does have exposure, it’s involved in more complex fracturing operations rather than simple so-called commodity fracturing jobs.
However, management stated that pricing deteriorated in the third quarter and it expects pricing to deteriorate at an even faster pace in the fourth quarter of this year. CEO Andrew Gould said he doesn’t know where the bottom will be for this business. Note that these comments apply only to North America, not to overseas work.
The services companies most exposed to US pressure pumping would be pure play BJ Services and Halliburton. Both BJ Services and Halliburton should be avoided and are rated sells in the How They Rate Table.
In light of Schlumberger’s comments, I’ve also decided to sell Gushers Portfolio holding Carbo-Ceramics for a loss of about 3 percent. My rationale for buying this stock last winter was twofold.
First, a firming up of gas prices would prompt a deceleration in deterioration for pressure pumping margins toward the end of 2007. And second, Carbo doesn’t perform pressure pumping services but sells a specialized product known as ceramic proppant. Proppant is used in fracturing operations to actually prop open the cracks and crevices created during pressure pumping work.
Ceramic proppant is more effective than conventional proppant made of sand particles. And Carbo has also been expanding overseas, with a manufacturing plant in Russia where demand for pressure pumping services is growing quickly. (For a detailed overview of my rationale for recommending the stock, check out the Feb. 21 issue of TES, All Eyes on Gas.)
However, Carbo still has significant reliance on North American revenues, and without growth there, it’s unlikely to see growth overall. Moreover, the fourth quarter is seasonally a weak one for Russia because of the onset of winter, so there’s risk that international growth will seasonally slow down in the next few months. And significant exposure to the ultra-weak Canadian market is also dragging on results.
Carbo reported during its third quarter conference call that, so far, it hasn’t seen much pressure on the prices it can charge for proppant. However, management hinted that may change. After all, the main buyers of proppant are the services companies that perform fracturing work.
If Schlumberger is correct and margins continue to deteriorate in that business, these firms will start putting more pressure on Carbo to cut its own prices.
I firmly believe that Carbo will be a good play on the rebound in pressure pumping demand in North America at some point. But until we get real signs of an upturn, the stock will be, at best, dead money.
Carbo is also among the only losers in the Gushers Portfolio. It’s time to sell it, take a small loss and make room for some new, more promising recommendations in the coming months. Sell Carbo-Ceramics; I will track the stock in the How They Rate Table.
Outside pressure pumping, drilling activity in the Gulf of Mexico was another weak spot for Schlumberger. However, management stated that most of that weakness was due to operators slowing down their activity into the heart of the Atlantic hurricane season, particularly in the deepwater. This activity should rebound strongly in the fourth quarter.
In addition, shallow-water drilling activity—where Schlumberger has almost no exposure—continues to suffer because of low gas prices.
Wildcatter Pride International and Gusher Rowan both have exposure to the Gulf and shallow-water shelf drilling. Both firms are contract drillers that lease their rigs to operators for a fee known as a day-rate.
But Rowan owns mainly high-specification rigs that have the opportunity to seek much higher rates for work outside the Gulf. And within the Gulf, day-rates for high-spec rigs have held up far better than for simple commodity rigs.
I see Rowan as insulated from the worst of the weakness in the Gulf. Rowan remains a buy. The company is up about 12 percent from my original recommendation.
Pride owns a combination of land drilling rigs, deepwater rigs and shallow-water jackups. Rates for deepwater rigs are holding up well even as day-rates for jackup and other shallow-water rigs in the Gulf deteriorate.
I don’t see weakness in Gulf rates as a major problem for Pride. Pride International is up 8 percent from my original recommendation last spring and continues to rate a buy.
Finally, land driller and Gusher Nabors Industries has exposure to day-rate deterioration in North American land markets. I’ve highlighted this stock on a few occasions over the past few month, most recently in an Oct. 5 flash alert, Buying the Dip.
My thesis here remains unchanged: Nabors has seen and will continue to see weakness in its North American operations. However, that weakness is well-known and largely priced into the stock.
Moreover, it’s the highest-quality play in that market because of its high power rigs; these rigs are capable of performing work on more complex gas fields. Therefore, Nabors is insulated from the worst of the weakness that has been concentrated on low-power rigs capable of performing only the simplest jobs.
Nabors also has a rapidly growing international business that’s starting to reduce its historical reliance on revenues from North America. I continue to rate Nabors Industries a buy.
International Services Work
The real crux of concerns surrounding Schlumberger’s conference call was comments relating to international growth prospects. Management didn’t say that international demand was slowing down; Schlumberger stated that growth in these markets is a great deal more sustainable than the market realizes.
However, management did say that Wall Street doesn’t always recognize the potential for lumpiness in these growth rates. For example, because of strong demand abroad, there’s a global shortage of equipment and labor; delays in equipment deliveries or the unavailability of workers to perform work can prompt temporary involuntary delays in international projects.
Management was careful to point out that the growth and demand is still there. It’s simply a matter of slippage in schedules because of shortages and logistical issues related to moving rigs, people and equipment.
He also expressed concern about the market’s perception of offshore drilling activity. Specifically, there are a number of new rigs scheduled for delivery between 2008 and 2012; there are already drilling projects planned that are scheduled to use these new rigs as soon as they’re delivered.
But just because a rig is delivered and goes out on a project doesn’t mean that it’s performing at peak efficiency. It takes time to work out equipment issues and to get a new crew up to speed on operating the rig. Because many new deepwater and jackup rigs are new designs, it would take time for even experienced crews to start operating at peak efficiency.
Schlumberger indicated that Wall Street seems to have assumed that a total of 146 offshore rigs will be delivered in 2008 and 2009 and will immediately begin operating at peak efficiency on new projects. Management believes that view is naïve and there could be offshore project delays because of inefficiencies in new rig operations.
The important point to note is that all the problems that Schlumberger outlined are because of high demand for oil- and gas-related services; shortages are caused by demand outstripping supply. This is hardly a sign of weakness in the international markets but could certainly cause some one-off timing issues for services firms operating in these markets.
Ultimately, it’s healthy that Schlumberger brought up these issues because it’s served to temper investors’ limitless enthusiasm for internationally levered services names. However, these comments have led some analysts to temper their growth expectations for 2008 slightly, which have killed momentum in the group temporarily.
I’m looking for an opportunity to re-enter Schlumberger for the model portfolios because I believe downside in the stock should be limited to the upper 80s. I also believe that Wall Street overreacted to what were really bullish comments.
My strategy for playing this group remains unchanged: Avoid companies overleveraged to North America, and focus on firms with exposure to big international oil and gas projects.
Projects such as the liquefied natural gas (LNG) developments discussed in the most recent issue of TES won’t be canceled regardless of what happens to US natural gas prices. And Schlumberger’s high-tech services will be absolutely necessary for producing oil and gas from more complex reserves such as those in deepwater.
For now, however, my only pure oil services recommendation is Weatherford. Weatherford has been rapidly expanding its presence outside the US, selling services such as underbalanced drilling. (I explained my rationale for owning the stock at great length in the April 18 issue of TES, More Bullish Signs.)
Weatherford remains the fastest-growing internationally exposed oil services company in my coverage universe. And the company’s third quarter release and conference call, released a few days after Schlumberger’s showed no sign of a slowdown on the horizon.
I also believe that there’s upside to integrated project management (IPM) business for Schlumberger and Weatherford alike. Basically, IPM services are when a national oil company (NOC) contracts with a service firm to manage an entire project. That means ordering equipment, providing or obtaining services from third-party contractors and managing the day-to-day operations of the projects.
Historically, many of these management functions have been handled by international integrated oil firms such as BP, Chevron Corp or ExxonMobil. These NOCs would partner with the integrated companies to manage a project and would grant the integrated oil firms a share of the revenues from the project as payment. Because most NOCs don’t have the technical expertise to produce complex fields like the big integrateds, this was a way to improve project development and import know-how.
However, there’s been a wave of resource nationalism in recent years; NOCs, usually controlled by the local governments, don’t want to give up control over resources by partnering with other NOCs. IPM services offer another route: The NOCs can simply pay the services firms to manage their projects for them. They don’t have to cede control of the projects in the same way they do with the integrateds.
This is also great for the services firms. These companies can effectively push their own services on projects they manage, and it gives them preferential access to promising new developments.
Both Weatherford and Schlumberger indicated strong growth in IPM services. And Schlumberger indicated that interest in IPM has spread beyond Latin America, traditionally a big market for IPM, to NOCs in other regions of the world. Weatherford rates buy in my Wildcatters Portfolio.
But nothing could be further from the truth. Not all companies in the energy patch have reported stellar third quarter earnings. And just like every other year, not all energy names have participated equally in this year’s bull market for the group.
Consider the Philadelphia Oil Services Index, which includes just 15 companies involved in the oil services and contract drilling businesses. The best three performers in that index are up an average of nearly 98 percent in 2007.
The worst three have actually fallen this year an average of a little more than 4 percent. That’s a wide disparity in performance, especially for such a relatively small, homogenous group of stocks.
To help us sort through all these trends, every three months investors are treated to a flurry of activity as companies release their quarterly earnings numbers and offer detailed commentary on accompanying conference calls. The deluge of reports can be truly overwhelming; within the energy sector alone, there are hundreds of companies holding calls.
Some scrutinize every aspect of these releases, right down to management’s tone of voice during the question-and-answer (Q&A) session that follows every call. But amid the mass of corporate releases, I find there’s usually just a handful that truly stands out. These select few offer gems of information and a glimpse into important new trends that are emerging for the industry.
In This Issue
This year’s conference calls have been no exception. In this week’s issue, we’ll take a closer look at recent releases for a handful of companies in The Energy Strategist coverage universe and outline ways to position ourselves for the coming trends.The mild winter of 2005-06 created increased coal supplies at many US utilities. However, a return to more normal temperatures this year has created an increase in demand. Those extra stockpiles may not last much longer. See Coal.
Domestic consumption isn’t the only source of income for US miners. Once self-sufficient Europe is now increasingly relying on imports, and tightening supplies in Indonesia and Australia may lead to increased import demand in Asia as well. See Coal Demand.
Older mines in the eastern US aren’t producing like they used to. And with increased regulations making it harder and more expensive to continue to operate some of these mines, the US may become increasingly more dependent on supplies from the western side of the country. See Changing the Means of Supply.
There are currently four coal plays in the TES Portfolios, one of which is a recent spinoff. Each one has a unique angle on this sector that makes them worth holding in your portfolio. See How to Play It.
A recent conference call from one of the major drillers has caused some concern on Wall Street. Although the North American market continues to remain somewhat weak, there could be some dips in the international market as well. However, it’s much more sustainable than the North American market, which is why I continue to focus on companies with more exposure abroad. See Oil Services and Drilling.
In this issue, I’m recommending or reiterating my recommendation on the following stocks:
- Consol Energy (NYSE: CNX)
- MacArthur Coal (Australia: MCC; OTC: MACDF)
- Nabors Industries (NYSE: NBR)
- Patriot Coal (NYSE: PCX)
- Peabody Energy (NYSE: BTU)
- Pride International (NYSE: PDE)
- Rowan (NYSE: RDC)
- Weatherford (NYSE: WFT)
- BJ Services (NYSE: BJS)
- Carbo-Ceramics (NYSE: CRR)
- Halliburton (NYSE: HAL)
Coal
Back in July, during second quarter earnings season, most of the big coal mining firms reported results that missed analysts’ consensus estimates. The stocks got slammed in the wake of these reports. For example, stock in the largest mining firm, Wildcatters holding Peabody Energy, fell from a late-May high above 54 to the upper 30s in early August.Fast-forward to third quarter earnings season and the big coal-mining firms have once again posted results that missed expectations. Arch Coal, the first of the big names to report for the quarter, announced third quarter earnings of 19 cents per share, well under analysts’ consensus of around 27 cents.
But investors’ reaction to that news couldn’t have been more different than in July: This time, the coal mining stocks actually shot higher after releasing those negative numbers. Arch Coal is up around 15 percent since reporting.
Whenever you see stocks react positively to what looks like negative headlines, it’s time to sit up and take notice. That’s especially true given the fact that these stocks reacted so differently to equally weak numbers back in July. Something has obviously changed in the ensuing three months.
Conference calls from the miners offer some insight into this seemingly incongruous rally in the face of bad news. The Arch Coal call in mid-October was instructive. Management reported that, although coal prices remained far lower in third quarter 2007 relative to the same time last year, there are real signs of a strengthening in these markets and a tightening of the supply/demand balance.
If anything, that balance is set to get tighter still as we move into 2008. Coal prices could see a significant spike over the next few months.
I outlined some of the basic problems that have been facing the coal miners over the past year in the July 26 flash alert, Earnings Deluge. I issued that flash in response to the wave of second quarter earnings warnings and misses from the group.
(For those unfamiliar with the coal sector, check out the May 2 issue of TES, King Coal, for a review of the domestic mining industry and the Sept. 5 issue, Australia, Asia and Coal, for a closer look at the booming market for Australian coal.)
To summarize, the main problem facing the miners in the past year and a half has been weather. An unusually mild 2005-06 winter season meant that demand for coal-fired electricity was lower than normal; the result was a swelling in coal stockpiles in storage at the nation’s utilities.
With the utilities’ coal needs well supplied, these firms cut back on their coal purchases; the glut of coal spelled falling prices. The chart below shows US coal inventories at electric utilities in the past five years.
Source: Energy Information Administration
There are clearly seasonal swings in coal inventories. Utilities build their stocks ahead of periods of anticipated high demand to ensure adequate supply.
However, despite those small wiggles on the chart, the overall trend here is obvious: Coal stocks at utilities sank broadly from 2002 through 2005. In fact, at the end of 2005, inventories of coal were near multi-year record lows; there was a real danger of a shortage that winter.
But the 2005-06 winter was among the mildest ever recorded. You can see that, in late 2005 and early 2006, coal inventories shot higher rapidly. Since that time, there’s been a gradual build to new five-year highs.
However, data on coal inventories are released by the Energy Information Administration (EIA) with a significant time lag. Moreover, data can be revised significantly months after they’re released; that’s why the chart above only includes data up until July of this year. We can see that inventories of coal did decline sharply in July.
A one-month blip lower in inventories doesn’t make a trend. But the Arch Coal management team made some interesting observations during its call.
Specifically, Arch estimates that coal inventories at utilities stood at 135 million tons as of the end of September. Although accurate EIA data isn’t available yet, Arch is one of the largest miners in the US and management has good insight into the supply of coal its customers (the utilities) have in their coal yards. It can certainly tell if early EIA estimates are accurate or totally infeasible.
Note that inventories of 135 million tons would imply a significant drop on the chart above; that’s actually below where inventories were at the beginning of 2007. The bottom line: There appears to be inventory normalization in progress.
Arch also went on to outline reasons it believes that’s happening. First, although 2006 was an aberrantly warm year, weather patterns in 2007 have been more normal.
According to the CEO, demand for coal from electric power plants was just shy of 100 million short tons in the month of August, a new record in terms of monthly coal demand. And although the weather was relatively warm in January across the Northeast, a cold snap in late winter and a hot summer pulled additional demand.
Overall, Arch pointed out that coal consumption surged 22 million tons in the first nine months of 2007 compared to the same period in 2006. This was primarily because of a surge in demand for electricity. The chart below shows data from the EIA on coal burned in US electric power plants.
Source: EIA
This chart measures the year-over-year change in coal demand by month over the past two years. So, when the line is above zero, that means that coal demand for electricity generation was up year-over-year; values under zero mean that coal demand was lower.
I’ve highlighted this year’s data in red. As in the prior chart, the most recent accurate monthly data from the EIA is though July.
The striking point here is that, in every month in 2007 except two, coal demand has been far higher than in 2006. And preliminary numbers, as Arch suggested in its conference call, suggest coal demand approaching 100 million tons for August, way ahead of last year’s levels. This just shows that weather in 2007 is more normal than in 2006, and that’s starting to help pull down inventories of coal.
Back to In This Issue
Coal Demand
Although the domestic demand story for coal is compelling, the far more interesting fact to emerge from Arch’s conference call is a burgeoning demand for coal from outside the US. Already international demand is having a marginal effect on US coal supplies. But that’s only the beginning; there’s a real sea change in foreign demand for US coal brewing.According to Arch, US coal imports are up about 1 million short tons year-to-date through the month of August as compared to 2006. EIA data updated through the end of June indicated that total US coal imports were roughly 17.2 million short tons. To put that into perspective, recall that US power plants consumed about 100 million tons of coal in August alone.
But over the same January-August period, Arch indicated that US coal exports were up more than 6 million tons from the same period in 2006. For reference, the EIA data shows that the US exported about 25.8 million short tons of coal in the first six months of 2007. The chart below depicts actual EIA data on imports and exports for 2006 and 2007 with preliminary estimates for the third quarter.
What’s clear from this chart and the data from the Arch call is that imports of coal into the US market are stagnant while exports are rising steadily. To calculate the actual impact on US coal supplies, consider the net export figures for the first nine months of 2006 and 2007.
The term net exports means total exports minus total imports. A higher net export figure means more coal is leaving the US and there’s lower domestic supply. This is bullish for coal prices.
Total net exports in the first nine months of 2006 were 9.4 million tons compared to a projected 15.6 million tons this year, based on preliminary data for the third quarter. That means that the actual swing in demand was 6.3 million tons.
This is how much more coal left the US this year compared to last year at this time. Although that 6-million-ton swing may not seem like a big number, it’s just another marginal source of coal demand that helps to reduce those hefty coal stockpiles referenced above.
But this short-term effect isn’t what I find most interesting. Check out the chart below for a closer look at the destination of US coal exports by region.
Source: EIA
The largest recipient of US coal exports is Europe, where trade surged more than 15 percent year-over-year in the first six months of 2007. If we divide Europe by country, the results are even more telling: Germany’s imports of US coal soared 46 percent in the first half. And exports to the Netherlands and Croatia were up 80 percent and 125 percent, respectively.
Also although Africa isn’t a huge importer of coal from the US, imports surged more than 200 percent this year. That growth was led by demand from Morocco in northern Africa.
These raw numbers indicate growth in the Atlantic coal trade from a low base. However, Arch made some anecdotal comments in its conference call that indicate this is the beginning or a more important trend and what we’re seeing in the raw numbers is only the first act. Arch indicated that it received a bid for coal in the quarter from a European buyer.
Unlike most domestic coal supply arrangements with the major utilities, this wasn’t a long-term contract. Rather, Arch had the chance to sell some coal opportunistically on a one-off basis at a far higher price than it could have in the US in the current environment.
This coal wasn’t metallurgical coal—coal used in steelmaking—but steam coal that’s burned in power plants. Management reiterated the solid returns it garnered from this deal on several occasions during the conference call and Q&A session.
Even more interesting, in answering an analyst’s question, management indicated that there’s significant growing interest in international steam coal term contracts. In other words, European buyers are interested in talking to Arch about long-term, multi-year steam coal supply deals.
This is a highly unusual situation. Management said it hasn’t seen any real sustained interest in term contracts from European buyers since the early 1990s. The company, in fact, now has discussions ongoing for term contract deals and is focusing considerable attention on this market.
And Arch doesn’t produce just steam coal but also metallurgical (met) and pulverized coal injection (PCI) coal. (I described and explained these different coal types in the Sept. 5 issue of TES. I won’t repeat that entire explanation here; suffice it to say that both met and PCI coal is used in steelmaking.) Demand for these coals abroad is also high, and Arch has commenced discussions for term deals for met coal as well.
And it’s not just Europe. Right now, the US exports almost no coal to Asia—less than 1 million tons in the first half of 2007. But that may be changing. Arch alluded to the fact that there’s some significant interest in the industry in exporting coal from West Coast ports to coal-hungry markets like China.
This growing interest in US coal shouldn’t come as a surprise to anyone. Although most investors seem to believe that all coal plants in Europe have been shut down, nothing could be further more the truth. Check out the chart below.
Source: BP
The truth is that Europe burns a great deal of coal and doesn’t produce enough domestically to meet demand. Traditionally, the region has been dependent on seaborne call trade to help fill that gap.
But here’s where the situation gets interesting. As I highlighted at length in the Sept. 5 issue of TES, the global seaborne coal markets are ultra-tight right now both for thermal and met coal. The main drivers of this trend are growing demand from key Asian countries coupled with supply issues at traditional coal export nations.
Specifically, for the first time in history, China is now a net importer of coal. Not only is the country no longer able to supply some of its Asian neighbors with the commodity, it has to import coal in ever larger quantities. A similar situation is ongoing in India.
Meanwhile, the traditional coal suppliers in Asia-Pacific—Indonesia and Australia—both have challenges right now. In Indonesia, domestic coal demand is ramping up quickly, limiting the country’s ability to export to meet all the demand.
And in Australia, demand is booming so much that the nation’s infrastructure just can’t keep pace; congestion in Australian coal export ports is shocking. At last count, the average waiting time for a ship loading cargo at the Port of Newcastle stood at 19.65 days, up from 17.18 a week earlier. Forty-three ships on average are waiting in the harbor for cargo.
With these big traditional exporters challenged, Europe is having problems importing the coal it needs. It’s, in effect, competing with Asia for the world’s scarce, hard-to-obtain coal supplies. That’s why coal prices for delivery in Europe have been spiking in recent months. See the chart below.
Source: Bloomberg
As you can see, steam coal for delivery into Rotterdam cost $68 a metric ton (1.102 short tons) in January and has recently soared to more than $130. Although US prices have also risen in 2007, the gains have been far more subdued.
Spot prices for high-quality, low sulphur steam coal in the eastern US are currently around $49 per short ton. With that sort of a price discount, it’s no wonder European buyers are looking more closely at locking in supply of US coal. I also don’t see much scope for seaborne coal prices to fall anytime soon.
One of the best indicators of coal demand is the Baltic Dry Index. This represents dry bulk shipping rates, the cost of leasing a dry bulk ship to carry commodities like coal. The chart XX shows that dry bulk rates have been on fire recently.
Source: Bloomberg
Dry bulk shipping rates have been soaring in no small part because of import demand for coal from Asia is strong. At the same time, port congestion in Australia and a shortage of dry bulk ships means that it’s difficult to move enough coal to meet that demand. The fact that this trend continues suggests that the supply/demand balance for coal in Asia remains tight.
Back to In This Issue
Changing the Means of Supply
But all those factors relate to the demand side of the coal equation. On the supply front, the market looks equally tight heading into 2008. Again, let’s start with a quick look at the statistics on coal production from the EIA.Source: EIA
This chart shows US coal production broken down by region. As I’ve highlighted before in TES, production from Appalachia, particularly Central Appalachia (CAPP), remains troubled and has been steadily falling over the past year and a half. Production from Appalachia was 103.5 million short tons in the first quarter of 2006, falling to less than 93 million tons in the third quarter of this year.
The reason is mines in this region have been operating for well more than a century. Seams of coal are getting thinner and more difficult to produce. Over time, Appalachia will remain a major coal-producing region but will become increasingly overshadowed in production by western coal from places such as the Powder River Basin (PRB).
Shorter term, a series of regulatory changes and issues are the prime driver of falling production. I detailed many of these changes in the July 26 flash alert.
Basically, surface mining operations in Appalachia can involve stripping large quantities of dirt and rock from the top of a mountain to expose coal seams. Coal mining firms have often applied for permits to dispose of this material in nearby valleys.
The problem with this is that it can cause damage to streams. Environmental groups have been fighting the practice for years. But recently the environmentalists have been winning some notable victories, and the courts have been blocking valley fill permits.
According to Arch, no new valley fill permits have been issued in the past nine months. Recent judicial decisions have effectively shut down this mining practice, a major source of eastern coal.
In addition, new regulations from the Mine Safety and Health Administration (MSHA) have gone into effect in the past year. One key change has been regulations related to sealing off unused sections of older mines. When gases accumulate in unused sections of older mines, a lightning strike can trigger a major explosion.
MSHA has changed its seal regulations mandating that these seals be made far stronger and be checked more regularly. Some older Appalachian mines can have hundreds of seals, making that an expensive endeavor. With coal prices depressed, many miners simply couldn’t afford to make the changes and their mines simply shut down.
MSHA has also changed other safety regulations as part of the Mine Improvement and New Emergency Response (MINER) Act of 2006. These regulations mandate the creation of detailed emergency response plans and provide for more careful federal scrutiny of mines. These regulations also greatly increase mining costs.
Arch thinks these issues are likely to get worse in 2008. Some miners in Appalachia still have valid valley fill permits for their mines but will need to seek new permits once those expire.
As those permits come up for renewal, these mining firms won’t be able to renew, which will lead to still more mine closures. Other miners may be working off longer-term contracts signed at higher coal prices; as those contracts roll off, they’ll no longer be profitable.
Increased mine production from the surface mines of the western US will likely be able to fill in the gap left by falling production from eastern mines. But prices would need to rise enough to make investments in new capacity practical.
All told, the coal supply situation continues to tighten in the US while seaborne coal supply is already tight. When you factor in falling coal production in the East, rising international demand and more normal US consumption, it all adds up to higher prices.
Back to In This Issue
How to Play It
My three plays on coal are Consol Energy, Peabody Energy and Macarthur Coal.Peabody, like Arch, has long had exposure to all major coal-producing basins in the US; in that respect, the two companies have performed similarly. (I wrote about Peabody at some length in the May 2 issue of TES, for those unfamiliar with this story.)
I continue to prefer Peabody over Arch coal for two primary reasons: its direct exposure to the seaborne coal trade through its Australia-based operations and its decision to spin off its eastern mining operations into a separate company, Patriot Coal (NYSE: PCX).
To the first point, Peabody bought Australia-based Excel Coal last year. Excel has traditionally exported the vast majority of the coal it produces in Australia.
Short term, Peabody is suffering, just like all Australian producers, from ongoing port bottlenecks that have slowed exports. This could continue to be an issue over the next few quarters, but I’m not overly worried about that longer term.
These bottlenecks are also serving to tighten up coal supplies and drive prices higher for thermal, met and PCI coal alike. Eventually, port expansions will help ease the problems. But in order to encourage Australian producers to undertake the necessary investments, Asian customers will need to be willing to pay higher prices on a term-contract basis.
For anyone who ever doubted the wisdom of Peabody’s purchase of Excel, note the comments Arch made in its own call. Management indicated that it’s interested in an overseas purchase and in furthering its seaborne coal business. Peabody was clearly the first mover on that, buying into the international coal story early on.
At this time, valuations for purchasing a similar mining franchise would be much higher and a firm would likely encounter something of a bidding war. In this case, imitation really does appear to be the sincerest form of flattery.
As I highlighted in last week’s flash alert, Peabody’s spinoff of its eastern coal assets is now complete; Patriot Coal started trading on the New York Stock Exchange on Nov. 1. For every 10 shares of Peabody you owned, you should have received one share of Patriot on that date.
I’ve long recommended avoiding the eastern-focused miners. These companies face rapidly rising labor and regulatory costs, as well as difficult geology, a euphemism often used to describe older mines with thinning coal seams. I prefer to recommend companies such as Peabody and Arch with exposure to the PRB, a vast reserve of coal in the West that can be mined with a smaller skilled workforce using simpler surface mining techniques.
But my opinion is shifting somewhat. What the eastern mining firms do own is relatively sizeable reserves of high-quality steam and met coal located near Atlantic ports. That means that it’s relatively easy to load this coal onto a dry bulk carrier and ship it to Europe.
Arch’s management sounded extraordinarily excited about its new Mountain Laurel mine in CAPP. This mine produces both steam coal and met coal. The company also noted the potential for this mine to serve foreign markets.
This suggests that CAPP producers with a relatively low cost base, as well as the size and financial power to meet new regulatory requirements, should see ongoing benefits from European coal demand.
Patriot fits well in that mold. The company has some of the highest-quality mines in the East and sports a low cost of production. Patriot also produces a sizeable quantity of met coal that’s in particularly high demand abroad; roughly 20 to 25 percent of production this year is met coal.
As a result of that export potential, I recommend that subscribers hold on to the shares in Patriot Coal received as a result of the Peabody spinoff. I’ll track the stock in my Wildcatters Portfolio.
Logically, one might ask why Peabody would want to sell off such a valuable asset into a separate firm. The fact is, however, that underground mines in the East need to be managed differently from mainly surface mines in the PRB. During the past few quarters, the CAPP operations have been a notable distraction for management.
The skill sets for managers in these regions are very different, as are production growth prospects. Even the customer base is potentially different. PRB coal would be mainly steam coal, whereas Patriot’s mines hold significant met coal. It makes more sense for Peabody to focus its attention and capital spending resources on the two true coal growth markets: the western US and Australia.
Meanwhile, Patriot can focus its attention on managing reserves to maximize profitability rather than generate substantial growth. Peabody Energy remains a buy under 55.
Consol Energy is a slightly different story. Specifically, Consol’s mines are located mainly in Northern Appalachia and CAPP. The company produces a mixture of high-sulphur coal, met coal and low-sulphur steam coal. Northern Appalachian coal production hasn’t experienced the same level of geological difficulty as CAPP.
The growth for high-sulphur steam coal has been subdued in the US because of regulations governing emissions of sulphur dioxide. There are really two ways to reduce these emissions: Burn low-sulphur coal, or install advanced scrubbers.
Because of a lack of scrubber capacity, there have historically been a limited number of potential customers for high-sulphur coal supplies. But that’s changing. Scrubbers are finally being built in the east; as a result, there’s growing interest in high-sulphur coals. As more utes install scrubbers, this market is only going to get bigger.
Consol is also well positioned to benefit from the international story I outlined above. In fact, for the entirety of 2007, Consol expects to export 2.5 million tons of met coal and some 4 million tons of steam coal to Europe. Next year, steam coal exports should be up around 25 percent, and the company will have as much as 3 million short tons of met coal export available.
Like Arch, Consol pointed out the potential for more long-term coal supply contracts with Europe; management echoed Arch’s statements that the strength in these markets represents a major change from the steam coal export markets for the past five years. This is particularly true on the met coal side, where Consol sees export prices at an even bigger premium to domestic coal.
On factor hitting results in the company’s most recent quarter was a cave-in at a disused section of its Buchanan mine in Virginia. But there’s been progress on eliminating potentially explosive gases from the caved-in section of the mine.
Consol already wasn’t factoring in production from this mine in the fourth quarter; this wasn’t new news. Buy Consol Energy.
Finally, Macarthur Coal is our pure play on the boom in Asian demand for coal; the company supplies a fifth of the world’s PCI coal. (I highlighted this company at length in the Sept. 5 issue.) In late October, Macarthur announced a shortfall in revenues and lowered production guidance for the rest of the year.
That sounds like terrible news, but it wasn’t unexpected. The shortfall was entirely because of ongoing port congestion in Australia. Although this may mean that Macarthur doesn’t sell as much coal near term, it’s also a sure sign that demand isn’t slackening one whit.
The stock actually opened lower on that news and then rallied all day—a sign that investors weren’t surprised. Macarthur Coal remains a buy.
Note: Peabody Energy released its third quarter numbers and held its conference call just as this issue was to be posted. My early read is that Peabody has made many of the same comments that Arch did in its call last month. The stock also performed similarly, opening lower and rallying soon thereafter and straight through the company’s conference call. Investors are recognizing the strengthening environment for coal prices.
Back to In This Issue
Oil Services and Drilling
If there’s one conference call I look forward to every quarter, it’s Schlumberger’s. As the world’s largest oilfield services player, the firm is well placed to offer a bird’s eye view of what’s happening in the industry.I held Schlumberger in the Wildcatters Portfolio for many months, finally selling out of the stock in July and August as Schlumberger started rising in a near vertical fashion. As I wrote when recommending subscribers get out of the stock, I see no deterioration in fundamentals; rather, the stock just got ahead of itself and Wall Street expectations were just too high.
In listening to the call and watching the subsequent reaction in the stock, I believe my caution was warranted near term. Although Schlumberger beat earnings expectations and generated growth and profit margins well above expectations, the stock saw a near 11 percent drop the day it released its report (Oct. 19) on heavy volume.
The prime reason for the selling was that some of management’s comments seemed cautious. Given sky-high expectations for the quarter, a modicum of caution was enough to send the stock lower. Specifically, most analysts and investors already know that North American services markets are weak; what really caused alarm were Schlumberger’s comments that suggested slower-than-expected growth outside the US.
Services in North America
The problem with North American markets remains that most drilling activity onshore targets natural gas, not oil. While oil prices have recently pushed to new all-time high, natural gas has remained relatively flat and well off the levels seen in late 2005 and early 2006.
I won’t rehash all of the reasons for that here; suffice it to say that the same warm weather conditions in 2005-06 that pushed up coal inventories also inflated gas inventories. The resulting excess supply that persists to this day has been an ongoing headwind for natural gas prices.
Gas drilling activity has responded to that falloff in prices. In Canada, drilling activity this year is way off 2006 levels; higher cost reserve bases such as Canadian shallow gas have been particularly hard hit.
Also impacting Canadian activity was, of course, the change in the Canadian trust tax law. This tax change reduced incentives to produce gas from mature fields and hit the industry hard.
US drilling activity has held up far better than in Canada, at least on land. The worst affected market within the US has been drilling on the Gulf of Mexico shelf—basically, the shallow waters of the Gulf of Mexico.
Here, production costs are relatively high so producers aren’t willing to undertake major drilling activities unless gas prices are trading at higher levels. But overall, the US rig count remains near multi-decade highs despite all the talk of a falloff in activity. The rig count simply isn’t rising steadily as it was for most of 2005 and early 2006. See chart below.
Source: Baker Hughes, Bloomberg
Schlumberger stated on its call that it expects the US rig count to remain basically flat in the coming year while Canada will remain weak. Although Schlumberger reported an uptick in Canadian demand for the quarter that was mainly because of seasonality, drilling activity picks up in the warmer months.
Some may ask how the rig count can stay relatively stable, even with gas prices where they are. But the reality is that gas prices aren’t exactly depressed by any historical measure and certainly not when compared to the sub-$2 per million British thermal units (MMBtu) price that gas witnessed back in 2001. There are still plenty of drilling projects that make sense at current gas prices.
A perfect example is Wildcatters recommendation EOG Resources, an exploration and production (E&P) firm with a strong position in Texas’ Barnett Shale play. In that company’s recent conference call, management laid out a plan for growth whether gas remains around $7 or rallies back to more than $9.
Specifically, the company stated that in a depressed gas situation, it would simply focus its activities on its lowest cost reserves in the Barnett Shale. If gas prices rise, it’ll look to more aggressively develop some of its other reserves.
Overall, EOG, if anything, would like to have more rigs working in Barnett Shale; its costs in that region are around $3 per MMBtu.
The real problem with the services and drilling markets in North America isn’t the total rig count but capacity, particularly in the area of pressure pumping. And example of pressure pumping is fracturing, a procedure that’s absolutely necessary for producing many North American gas reserves economically.
As long-time readers know, gas doesn’t exist in giant underground caverns but in pores, cracks and crevices of reservoir rocks. If those pores aren’t connected, the reservoir lacks permeability, making it difficult for gas to flow into a well.
In fracturing, a liquid is pumped under high pressure into a reservoir, actually cracking the reservoir rock. This helps to open up channels between pores, improving reservoir permeability.
The problem is that, although gas drilling activity remains relatively healthy, services firms added a great deal of pressure pumping capacity in the past few years. That was fine when the rig count was soaring as in 2005; but as the North American rig count has stagnated, that growth incapacity is overwhelming demand.
This means that pressure pumping operators have to get more aggressive on cutting their prices to compete. Profitability of this service function has been decimated.
Note that this is a very different situation to the last cycle. Back in 2001 when gas prices fell, the rig count fell sharply. The pressure pumping business weakened because of a combination of falling rig count and some increase in capacity. This time around, it’s all a matter of capacity growth.
Schlumberger has only minimal exposure to pressure pumping services in North America. And to the extent that it does have exposure, it’s involved in more complex fracturing operations rather than simple so-called commodity fracturing jobs.
However, management stated that pricing deteriorated in the third quarter and it expects pricing to deteriorate at an even faster pace in the fourth quarter of this year. CEO Andrew Gould said he doesn’t know where the bottom will be for this business. Note that these comments apply only to North America, not to overseas work.
The services companies most exposed to US pressure pumping would be pure play BJ Services and Halliburton. Both BJ Services and Halliburton should be avoided and are rated sells in the How They Rate Table.
In light of Schlumberger’s comments, I’ve also decided to sell Gushers Portfolio holding Carbo-Ceramics for a loss of about 3 percent. My rationale for buying this stock last winter was twofold.
First, a firming up of gas prices would prompt a deceleration in deterioration for pressure pumping margins toward the end of 2007. And second, Carbo doesn’t perform pressure pumping services but sells a specialized product known as ceramic proppant. Proppant is used in fracturing operations to actually prop open the cracks and crevices created during pressure pumping work.
Ceramic proppant is more effective than conventional proppant made of sand particles. And Carbo has also been expanding overseas, with a manufacturing plant in Russia where demand for pressure pumping services is growing quickly. (For a detailed overview of my rationale for recommending the stock, check out the Feb. 21 issue of TES, All Eyes on Gas.)
However, Carbo still has significant reliance on North American revenues, and without growth there, it’s unlikely to see growth overall. Moreover, the fourth quarter is seasonally a weak one for Russia because of the onset of winter, so there’s risk that international growth will seasonally slow down in the next few months. And significant exposure to the ultra-weak Canadian market is also dragging on results.
Carbo reported during its third quarter conference call that, so far, it hasn’t seen much pressure on the prices it can charge for proppant. However, management hinted that may change. After all, the main buyers of proppant are the services companies that perform fracturing work.
If Schlumberger is correct and margins continue to deteriorate in that business, these firms will start putting more pressure on Carbo to cut its own prices.
I firmly believe that Carbo will be a good play on the rebound in pressure pumping demand in North America at some point. But until we get real signs of an upturn, the stock will be, at best, dead money.
Carbo is also among the only losers in the Gushers Portfolio. It’s time to sell it, take a small loss and make room for some new, more promising recommendations in the coming months. Sell Carbo-Ceramics; I will track the stock in the How They Rate Table.
Outside pressure pumping, drilling activity in the Gulf of Mexico was another weak spot for Schlumberger. However, management stated that most of that weakness was due to operators slowing down their activity into the heart of the Atlantic hurricane season, particularly in the deepwater. This activity should rebound strongly in the fourth quarter.
In addition, shallow-water drilling activity—where Schlumberger has almost no exposure—continues to suffer because of low gas prices.
Wildcatter Pride International and Gusher Rowan both have exposure to the Gulf and shallow-water shelf drilling. Both firms are contract drillers that lease their rigs to operators for a fee known as a day-rate.
But Rowan owns mainly high-specification rigs that have the opportunity to seek much higher rates for work outside the Gulf. And within the Gulf, day-rates for high-spec rigs have held up far better than for simple commodity rigs.
I see Rowan as insulated from the worst of the weakness in the Gulf. Rowan remains a buy. The company is up about 12 percent from my original recommendation.
Pride owns a combination of land drilling rigs, deepwater rigs and shallow-water jackups. Rates for deepwater rigs are holding up well even as day-rates for jackup and other shallow-water rigs in the Gulf deteriorate.
I don’t see weakness in Gulf rates as a major problem for Pride. Pride International is up 8 percent from my original recommendation last spring and continues to rate a buy.
Finally, land driller and Gusher Nabors Industries has exposure to day-rate deterioration in North American land markets. I’ve highlighted this stock on a few occasions over the past few month, most recently in an Oct. 5 flash alert, Buying the Dip.
My thesis here remains unchanged: Nabors has seen and will continue to see weakness in its North American operations. However, that weakness is well-known and largely priced into the stock.
Moreover, it’s the highest-quality play in that market because of its high power rigs; these rigs are capable of performing work on more complex gas fields. Therefore, Nabors is insulated from the worst of the weakness that has been concentrated on low-power rigs capable of performing only the simplest jobs.
Nabors also has a rapidly growing international business that’s starting to reduce its historical reliance on revenues from North America. I continue to rate Nabors Industries a buy.
International Services Work
The real crux of concerns surrounding Schlumberger’s conference call was comments relating to international growth prospects. Management didn’t say that international demand was slowing down; Schlumberger stated that growth in these markets is a great deal more sustainable than the market realizes.
However, management did say that Wall Street doesn’t always recognize the potential for lumpiness in these growth rates. For example, because of strong demand abroad, there’s a global shortage of equipment and labor; delays in equipment deliveries or the unavailability of workers to perform work can prompt temporary involuntary delays in international projects.
Management was careful to point out that the growth and demand is still there. It’s simply a matter of slippage in schedules because of shortages and logistical issues related to moving rigs, people and equipment.
He also expressed concern about the market’s perception of offshore drilling activity. Specifically, there are a number of new rigs scheduled for delivery between 2008 and 2012; there are already drilling projects planned that are scheduled to use these new rigs as soon as they’re delivered.
But just because a rig is delivered and goes out on a project doesn’t mean that it’s performing at peak efficiency. It takes time to work out equipment issues and to get a new crew up to speed on operating the rig. Because many new deepwater and jackup rigs are new designs, it would take time for even experienced crews to start operating at peak efficiency.
Schlumberger indicated that Wall Street seems to have assumed that a total of 146 offshore rigs will be delivered in 2008 and 2009 and will immediately begin operating at peak efficiency on new projects. Management believes that view is naïve and there could be offshore project delays because of inefficiencies in new rig operations.
The important point to note is that all the problems that Schlumberger outlined are because of high demand for oil- and gas-related services; shortages are caused by demand outstripping supply. This is hardly a sign of weakness in the international markets but could certainly cause some one-off timing issues for services firms operating in these markets.
Ultimately, it’s healthy that Schlumberger brought up these issues because it’s served to temper investors’ limitless enthusiasm for internationally levered services names. However, these comments have led some analysts to temper their growth expectations for 2008 slightly, which have killed momentum in the group temporarily.
I’m looking for an opportunity to re-enter Schlumberger for the model portfolios because I believe downside in the stock should be limited to the upper 80s. I also believe that Wall Street overreacted to what were really bullish comments.
My strategy for playing this group remains unchanged: Avoid companies overleveraged to North America, and focus on firms with exposure to big international oil and gas projects.
Projects such as the liquefied natural gas (LNG) developments discussed in the most recent issue of TES won’t be canceled regardless of what happens to US natural gas prices. And Schlumberger’s high-tech services will be absolutely necessary for producing oil and gas from more complex reserves such as those in deepwater.
For now, however, my only pure oil services recommendation is Weatherford. Weatherford has been rapidly expanding its presence outside the US, selling services such as underbalanced drilling. (I explained my rationale for owning the stock at great length in the April 18 issue of TES, More Bullish Signs.)
Weatherford remains the fastest-growing internationally exposed oil services company in my coverage universe. And the company’s third quarter release and conference call, released a few days after Schlumberger’s showed no sign of a slowdown on the horizon.
I also believe that there’s upside to integrated project management (IPM) business for Schlumberger and Weatherford alike. Basically, IPM services are when a national oil company (NOC) contracts with a service firm to manage an entire project. That means ordering equipment, providing or obtaining services from third-party contractors and managing the day-to-day operations of the projects.
Historically, many of these management functions have been handled by international integrated oil firms such as BP, Chevron Corp or ExxonMobil. These NOCs would partner with the integrated companies to manage a project and would grant the integrated oil firms a share of the revenues from the project as payment. Because most NOCs don’t have the technical expertise to produce complex fields like the big integrateds, this was a way to improve project development and import know-how.
However, there’s been a wave of resource nationalism in recent years; NOCs, usually controlled by the local governments, don’t want to give up control over resources by partnering with other NOCs. IPM services offer another route: The NOCs can simply pay the services firms to manage their projects for them. They don’t have to cede control of the projects in the same way they do with the integrateds.
This is also great for the services firms. These companies can effectively push their own services on projects they manage, and it gives them preferential access to promising new developments.
Both Weatherford and Schlumberger indicated strong growth in IPM services. And Schlumberger indicated that interest in IPM has spread beyond Latin America, traditionally a big market for IPM, to NOCs in other regions of the world. Weatherford rates buy in my Wildcatters Portfolio.