Year to date, coal-based electricity generation demand has declined nearly six percent from the prior year, or 15 million tons, according to the Energy Information Administration (EIA)—and could fall an aggregate 60 million to 70 million tons compared to 2008. Reduced steam generation combined with cheaper costs of competing power sources, such as natural gas, have contributed to an increase in utility inventory levels of coal, too. At March 31, current stockpiles represented a 21.5 million short ton oversupply, or approximately two-percent on annual consumption of 1.12 billion tons, according to the EIA.
During 2008, more than 80 percent of Peabody’s total sales (by volume), or almost 210 million tons of coal, went to U.S. electric utilities. Looking to address the current oversupply situation, chief executive officer Greg Boyce told analysts on the first-quarter 2009 earnings call to expect total production cuts of about 15 million tons this year, with most of the announced production cuts anticipated to come from its biggest mining operation in the U.S., the low-sulfur producing PRB coal region in Wyoming. Boyce guided listeners on the call to expect full-year 2009 U.S. production of 185 million and 190 million tons.
Entering the second quarter, Peabody was fully contracted for 2009 shipments and roughly 90 percent committed for 2010. Should generation burn continue to fall through the second-half of the year, there is a growing concern that that more customers would pressure the coal miner to renegotiate volume and price breakpoints or defer shipment schedules. Peabody president Rick Navarre stressed on the quarterly conference call, however, that the company was “not in active renegotiations of contracts,” although he admitted the company would welcome talks to customers having “issues”—depressed end-user demand accompanied by growing coal stockpiles.
When asked to quantify how much of the revised 2009 production target was currently under renegotiation, CEO Boyce was evasive, only repeating that the five million tons taken out of Peabody’s forecast accurately represented the “number of customers” whose burn rates were down and needed shipments curtailed.
Huh? As forecasted power demand is unlikely to rebound before first-half of 2010, odds favor additional utility customers petitioning the company for deferral or cancellation of contracted shipments. Boyce commented on the call that the company was open to amending off-take agreements only where “the value of those contracts” could be retained. In my opinion, his comments smacked of a rhapsody of extended delivery schedules designed to smooth out the current glut of coal clogging the distribution pipeline. The success of this value-trap, however, is premised on contango market theory, where coal in succeeding delivery months is contracted at progressively higher prices, due, in part, to an expected rebound in economic activity. In other words, the entire scheme is nothing more than an attempt to protect production output by back loading coal shipments (at higher price points).
Strong contractual commitments do not guarantee financial success in the current environment. Financially strapped utilities are walking away from their contractual obligations. In fiscal 2008, Peabody lost $56.9 million on failed cash buyout offers from such coal supply agreements. Coal-based utility customers are still trying to find a floor for generation demand, which signals more production cuts and broken supply contracts in the second-half of 2009 for Peabody—and more coal in shareholder stockings come Christmas.
Editor David J Phillips does not hold a financial interest in any stocks mentioned in this article. The 10Q Detective has a Full Disclosure Policy.